The Financial Services and Markets Act: a turning point for DLT in banking?
Distributed ledger technology (DLT) has emerged as one of the core technologies that banks are optimising to future-proof their operations. It is estimated that 43% of banks are engaged in either DLT proofs-of-concept or production implementation. The recent banking crisis has accelerated this journey. With balance and sheet management now at the top of the agenda, many banks are exploring how to harness technologies like DLT to manage intra-day risk more effectively.
The Financial Services and Markets Act (FSMA) represents a landmark in enabling banks to integrate DLT into their operations. It was passed into legislation in June 2023 as part of the Edinburgh reforms package. With the UK government now set to implement these proposals, understanding how the banking community can use DLT to optimise workflow and innovate in a risk-free manner is vital.
Notably, the act puts DLT at the heart of its mission to enable enduring financial services innovation. There are three ways it does this – by introducing a sandbox, enabling better regulation, and reshaping banking.
FMI sandbox: moving to next generation systems
The FMI sandbox is a key provision of the FSMA. It allows banks to explore DLT in a regulated framework by temporarily modifying certain legislation.
The sandbox has been widely dubbed the UK’s equivalent of the European Union’s DLT pilot regime. The Pilot Regime which went live in March 2023, also exempts firms from existing legislation. This is meant to promote the use of DLT and blockchain for the issuance and trading of tokenised stocks, bonds, and funds – including money market funds. Like the FMI sandbox, the objective is to assess whether to retain DLT-based market infrastructure on a permanent basis.
Banks can harness the sandbox and DLT as a means of digitising asset management processes and preparing for upcoming settlement updates. These include:
- Real Time Gross Settlement (RTGS) Renewal Programme – The RTGS service is the infrastructure that holds accounts for banks and building societies and settles interbank payments. As of June 2024 the service is being updated to deliver wider interoperability, improved functionality and strengthened end-to-end risk management of the UK’s High Value Payment System. Innovation must be undertaken with caution, and banks can safely tap into the sandbox to test and implement the updates.
- Tokenization – Tokenization has the potential to unlock faster settlement times and lower costs, and it is estimated that $5 trillion in assets could be tokenized on DLT over the next five years. Major banks such as JP Morgan have already affirmed their commitment to tokenization, with an initial focus on wholesale payments. With pressure on the UK government to introduce regulation for securities tokenization, we expect more banks will follow suit. Banks can use the sandbox to stay ahead of the curve by testing the tokenization of assets to make sure any innovations or proof-of-concepts are compliant with future regulatory frameworks.
- Smart contracts – Smart contracts can signficaintly enhance the speed and efficiency of banking transactions. They go one step beyond blockchain’s utility of keeping an immutable record of financial transactions, to automatically implementing the terms of multiparty agreements. Currently, five global banks are building proofs-of-concept with a trade finance and supply chain platform that uses smart contracts. With this number likely to increase, it is important that banks fully understand the purpose they serve and how best to use them. The sandbox can act as a useful safety net in this journey, providing banks with the opportunity to implement smart contracts in a way that adheres to security and regulatory standards.
Innovation through regulation
Another aspect of the FSMA is that it further establishes smarter crypto asset regulation. Firms engaging in activities relating to stablecoins or crypto assets for payment will become subject to numerous regulatory requirements.
This includes Financial Conduct Authority (FCA) authorisation, capital requirements, rules for ensuring the quality and safekeeping of reserve assets, insolvency requirements, anti-money laundering requirements as well as more robust risk management and governance.
This sets out a similar path to the Europe’s recent Markets in Crypto Assets (MiCA) legislation passed in April, which also introduces more stringent risk management, capital reserve and disclosure requirements.
Regulatory measures will be critical in potentially bridging the gap between banking and crypto asset services. This gap is currently quite wide in the UK; concerns around volatility and fraud mean that almost half of major UK banks do not allow transfers and withdrawals from crypto exchanges.
The introduction of smart regulation will not only help embed greater consumer safeguards into crypto, but also serve as a platform on how the underlying technology is applied. Looking ahead, this will provide banks with more confidence to integrate crypto into their services, in turn making the UK a more attractive destination for more companies in this space to set up and invest in.
The banking ecosystem faces challenges across a range of fronts – everything from expensive and slow settlement to siloed legacy systems and rising operating costs. Permissioned distributed ledgers provide real-time verification of transactions – removing time and cost-consuming reconciliation – whilst also maintaining security and scalability. The FSMA represents a significant change to the UK’s financial regulatory framework, and a major step forward in enabling banks to realise the benefits of DLT-based systems. For banks, this is both an opportunity and necessity. The FSMA will not only help them adapt to future regulations, but also stay at the forefront of innovation as global competition rises