The European Commission’s (EC) Digital Finance Package (DFP), issued on 24 September 2020, includes a proposal for a pilot regime for market infrastructures based on the distributed ledger technology (DLT). The EC acknowledges that no sustainable and expanding primary crypto-asset market is possible without a secondary market that provides liquidity. The proposal for a pilot regime is, therefore, a logical complement to the recommended EU regulatory framework on crypto-assets reviewed in the October issue of the Digital Regulator. Despite recognising the mutual dependency of the two proposals, the EC takes a very cautious approach by proposing rules for a pilot regime with sandbox characteristics, as opposed to offering a regulation for a fully-fledged regime. The European Council and the European Parliament will decide the fate of the pilot regime, five years after it comes into force. Meanwhile, Switzerland has adopted a full-fledged and final crypto-asset regulation, also covering DLT-based market infrastructure, which comes into force next year after the ongoing consultation on implementing ordinances is over.
The month of October 2020 recorded some other noteworthy regulatory developments in the digital space. The Bank for International Settlements (BIS) issued principles for Central Bank Digital Currencies (CBDCs). The Financial Stability Board (FSB) published final recommendations about Global Stable Coins (GSCs). On the compliance side, the US Financial Crimes Enforcement Network (FinCEN) seeks to lower the applicability threshold for the ‘Travel Rule’, while the UK Financial Conduct Authority (FCA) banned the sale of crypto derivatives to retail consumers due to suitability concerns.
EC proposal for an EU pilot regime for DLT-based market infrastructure
As part of the DFP, the EC issued a proposal for a pilot regime for market infrastructures based on DLT. The proposal aims to allow the development of a secondary market for crypto-assets and is a necessary and ideal complement to the proposal for a regulatory framework on crypto-assets, which was reviewed in the previous issue of the Digital Regulator. The proposed regime for the DLT-based market infrastructure shares the characteristics of a sandbox, as it imposes clear limits on operators and grants regulatory exemptions within these limits; moreover, it has a maximum duration of six years.
- DLT infrastructures: The proposed pilot regime distinguishes between two types of DLT market infrastructures: a DLT multilateral trading facility (MTF) and a DLT securities settlement system (SSS). The DLT MTF shall be operated by a market operator regulated by the Markets in Financial Instruments Directive II (MiFID II). The DLT SSS shall be operated by a central securities depository regulated by the Central Securities Depositories Regulation. National competent authorities (NCAs) grant the permissions to operate a DLT market infrastructure for a period of up to six years. The permission comes as an addition to the authorisation as CSD or investment firm. The EC shall issue a recommendation to the European Council and Parliament regarding its future, five years from establishing the pilot regime.
- Requirements: In principle, DLT market infrastructures—be it MTF or SSS—are subject to all requirements applicable to traditional MTF or SSS under the current financial regulations. However, the proposed regulation foresees several exemptions for DLT market infrastructures, which must be requested at the NCA, while also imposing a few restrictions on their operations. DLT market infrastructures are subject to specific requirements covering the business plan, functioning of the DLT, IT/cyber arrangements, safekeeping arrangements, disclosure obligations, and exit strategy. Finally, the market infrastructures shall report on a semi-annual basis to the NCA the European Securities and Markets Authority (ESMA), in their oversight function, may require corrective measures and may even withdraw the authorisation.
- Exemptions: The EU financial services legislation contains several specific requirements that would prevent a DLT market infrastructure from developing, if not lifted. Thus, a DLT MTF shall be exempted from the book-entry requirement and the recording with a Central Securities Depository (CSD), provided it ensures recording on a DLT solution, segregates the securities on a client basis, and grants robust settlement procedures and custody arrangements. A DLT SSS may be exempted from several provisions, including those concerning transfer of orders, securities accounts, and recording of securities, provided it demonstrates the incompatibility of such provisions with the use of its particular DLT solution and ensures segregation of securities on client basis—among other requirements. Any DLT market infrastructure shall be allowed to use the so-called settlement coins to clear transactions and be able to request an exemption from the obligation of intermediation (to provide direct access to retail clients).
- Restrictions: The DLT market infrastructure shall only admit DLT transferable shares of issuers with a market cap of less than EUR 200 million, and bonds with an issuance size of less than EUR 500 million. No sovereign bonds shall be admitted/recorded by DLT market infrastructures. The infrastructure shall also not record securities with a value exceeding EUR 2.5 billion.
The proposal for a pilot regime for market infrastructures based on DLT is a necessary complement to the proposal for a regulatory framework on crypto-assets; both suggestions have been presented by the EC as part of the DPF. The proposals differ in that the latter indicates an element of finality in the regulation, while the former proposes a pilot regime that contains elements of a sandbox and is at best an intermediate step towards a final proposed regulation. This dichotomy evidences great circumspection by the EC in regulating crypto-asset markets and promoting regulatory certainty. The European Council and Parliament will decide the future of the pilot regime five years after it has come into force, even as the Swiss crypto-asset regulation, also covering DLT-based market infrastructure, launches next year.
Other noteworthy developments
Switzerland has commenced consultation on the blanket ordinance in the area of blockchain. The amendments to the relevant Acts and Ordinances will enter into force during the first half of 2021.
- On 25 September 2020, the Swiss Parliament unanimously adopted the Federal Act on the Adaptation of Federal Law to Developments in DLT. A blanket ordinance is now being planned to incorporate the legislative amendments into law at the federal ordinance level. The consultation will run until 2 February 2021, and it is expected that the amendments to the Financial Services Act and the Financial Institutions Act will come into force during the first half of 2021.
The BIS and the FSB issued principles and recommendations for CBDCs and GSCs, further reinforcing regulatory certainty in these spaces.
- The BIS recognises that CBDCs ‘could provide a complementary central bank money to the public’ and support ‘a more resilient and diverse domestic payment system’. Its report outlines the common principles and key features of a CBDC and a supporting infrastructure. A CBDC should promote innovation and efficiency. A central bank should not compromise monetary or financial stability by issuing a CBDC and should ensure that the CBDC can coexist with and complement the existing forms of money. The BIS anticipates that the next stage of CBDC research and development will focus on practical policy analysis and applied technical experimentation of CBDCs by central banks.
- The FSB framed high-level recommendations for the regulation, supervision, and oversight of GSC. The report notes that such coins may raise the risk of violating the Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) and can result in governance challenges as well as market, liquidity, and credit risks associated with the specific stabilisation mechanisms and redemption arrangements. GSCs may pose operational and cyber-security risks in terms of their infrastructure and transaction management technology. The report offers 10 recommendations for the promotion of effective regulation for GSCs. It calls for regulation, supervision, and oversight proportionate to the risks and stresses the value of flexible, efficient, inclusive, and multi-sectoral cross-border cooperation, coordination, and information sharing arrangements among authorities that consider the evolving nature of GSC arrangements and the attendant risks over time.
The Bank of Japan (BoJ) will begin working on its own CBDC next year, while the Bahamas has become the first country to introduce a retail CBDC.
- The BoJ will conduct the first phase of experiments on issuance and distribution of a CBDC in early 2021. While it aims to create a retail CBDC, the BoJ plans to have financial institutions and other private entities serve as intermediaries between the central bank and end-users, rather than have companies and households hold deposits directly with the BOJ.
- The Central Bank of the Bahamas made available nationwide the country’s ‘Sand Dollar’, making the Bahamas the first country to officially roll out a CBDC. Residents can use the digital currency at any merchant with an e-Wallet approved by the central bank. Each Sand Dollar is pegged to the Bahamian dollar, which is in turn pegged to the US dollar.
The US FinCEN wants to lower the applicability threshold for the ‘Travel Rule’ from USD 3,000 to USD 250, while the UK FCA banned the sale of crypto derivatives to retail consumers on suitability concerns.
- The US FinCEN, with the support of the Federal Reserve, anticipated lowering the USD 3,000 threshold established in 1995 for international transactions, subject to full exchange of information regarding the paying and receiving entity. The target is USD 250 and would specifically apply to virtual currencies through the dedicated ‘Travel Rule’.
- The ban on the sale of crypto derivatives to retail consumers in the UK, promulgated by the FCA, rests on the conviction that retail consumers in the country can suffer harm from these products as they cannot be reliably valued. The ban also applies to instruments in the form of exchange traded products (ETPs).
The EC’s proposal for a pilot regime for DLT-based market infrastructure naturally complements the recommended regulatory framework on crypto-assets reviewed in the October issue of the Digital Regulator. The latter regulates the primary market; the former supports the secondary market. This mutually reinforcing complementarity appears at odds with the ‘pilot’ nature of the secondary market regime compared to the ‘final’ nature of the proposed primary market framework. The EU has chosen a very circumspect approach, while Switzerland will witness the adoption of a fully-fledged regulatory framework for crypto-asset markets and broader DLT applications in early 2021.
October 2020 was characterised by several noteworthy regulatory developments in the digital space, including the start of the consultation in Switzerland on implementing ordinances in the area of blockchain, the issuance of principles for CBDCs by the BIS, and the publication of recommendations about GSCs by the FSB.