Why the EU’s DLT Pilot Regime Matters to Banks
Recent events that highlighted vulnerabilities in the banking industry, has ratified the importance of capital and liquidity requirements. With a constantly evolving regulatory landscape, collateral and balance sheet management remain at the forefront when looking at futureproofing the financial system. Consequently, the ability of modern technology to manage intra-day risk for assets has been brought even more to the forefront of the minds of those working in the space.
With new market models for issuance, custody, distribution and settlement, banks can explore innovative ways to optimize their workflows. The EU’s Distributed Ledger Technology (DLT) Pilot regime stepped in on March 23 as part of the European Commission’s digital finance strategy. The regime will act as a gateway to this evolution for banks to innovate whilst functioning in a controlled environment, mitigating risk.
With the scheme, market infrastructures (MI) can apply for exemptions from different legislations, such as MiFID II and CSDR, which enables MIs to offer a regulated environment for their customers to explore DLT. The European Parliament (EP), the European Securities and Markets Authority (ESMA) and the industry are already backing the pilot, as it seeks to develop the trading and settlement of “tokenized” securities.
Banking on the DLT regime
Open participation and collaboration have been consistent themes as regulated market participants work towards a common goal, and the regime is a well-received addition to this critical cooperation. The regime allows market participants to connect their private placement and internal assets to a regulated secondary market. Buy-and-sell-side participants have already identified opportunities with workflow optimization, strategic positioning, and cost benefit analysis.
The Governing Council of the European Central Bank recently decided to reschedule the launch of the Eurosystem Collateral Management System (ECMS) from 20 November 2023 to 8 April 2024 to help mitigate the impact of the rescheduled T2 launch. On top of this, the RTGS renewal programme as well as changes to mandatory clearing obligations, create an opportunity to futureproof European markets. We must innovate with caution, which is why the regime acts as much appreciated guiding hand.
The ECMS aims to set out a unified system for managing assets used as collateral in Eurosystem credit operations and will replace the existing individual systems of the euro area national central banks. To stay ahead of competition and on top of the impending collateral management changes, banks need to look at the overall digitization of asset management, settlement processes and the acceleration of payments.
DLT and the pilot regime can act as critical cogs in optimizing a total digitization process across banking ecosystems, based on how encrypted distributed ledgers provide real-time verification of transactions, removing time and cost-consuming reconciliation. This ensures processes that typically take a few days can be completed in a matter of minutes.
Capital markets are about networks and standards, and therefore to be successful, these networks need to interoperate with existing processes and systems in a standardized form. This requires a heavy lift in making sure there’s a successful balance between the implementation of new models, integrating to current systems, all whilst making sure they are all complementary to one another and without total disruption to day-to-day processes.
Existing stakeholders in capital markets rely on the trust and resiliency of the market, needing to consistently meet standardised levels of security and trust. This is a key feature they cannot forget amidst innovation, moving from legacy to next-generation systems. To maintain these levels of security and trust, distributed ledgers with permissioned structures can help capital markets meet these demands. With permissioned structures, all data is verifiable using secure cryptography and digitally-verifiable signatures for upmost security and resiliency. These ledgers are also tokenless to offer higher performance for timelier transactions.
If regulated capital markets are to remain as the trusted central counterparty in new asset parties and the digital world, banks and other financial institutions (FIs) need to ‘buy-in’ together. If the financial market infrastructures (FMIs)want benefit from DLT and what the regime has to offer, they must take their members along the journey. Similarly, those members, including the banks and other FIs, should want to stay at the forefront of innovation to the financial evolution with the aim to build a more instant, resilient, and enduring digital economy.
Time is ticking for Europe. The UK Government has also established its experiment with modernising technologies like DLT in financial services, via the UK Financial Services and Markets Bill in 2022. This includes an FMI Sandbox enabling firms to innovate in providing FMI services that underpin financial markets. The FMI Sandbox will be developed by HM Treasury, the Financial Conduct Authority and the Bank of England. With central bank digital currencies (CBDC) around the corner, a coordinated approach will be key in developing national success.
Global regulators are exploring these local versions as they anticipate a flight to progressive regulatory jurisdictions. A heating of global competition to harness emerging technologies in the creation of a more stable, successful digital economy is clear – only those who make the most of these regulatory environments to explore will emerge successful in boosting their relative financial sectors.