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Watch Dogs for the Trust Building Machine - Will the EU regulate Blockchain?

17 August 2017

COMMITTEE ON ECONOMIC AND MONETARY AFFAIRS CALLS FOR SMART REGULATION OF VIRTUAL CURRENCIES AND DISTRIBUTED LEDGER TECHNOLOGIES

The draft motion of the Committee on Economic and Monetary Affairs (CEMA) for a European Parliament Resolution on virtual currencies (VCs) and distributed ledger technology (DLT) 2 calls for “smart regulation fostering innovation and safeguarding integrity, while taking seriously the regulatory challenges that the widespread use of virtual currencies and DLT might pose”. CEMA notes that existing legislation3 is likely to apply in line with the activities carried out, irrespective of the use of underlying technology and recommends:

− including VC exchange platforms in the anti-money laundering directive; 4

− reviewing EU legislation on payments (payment services directive and electronic money directive) in light of new technological developments including virtual currencies and DLT;

− creating an EU taskforce to provide the necessary technical and regulatory expertise to support the relevant public actors and, where appropriate, recommending regulatory measures and addressing consumer protection issues and systemic challenges; and

− exploring the need for a legislative proposal as to VCs and other DLT scheme actors. CEMA’s motion demonstrates that policymakers across the globe are developing a keen interest in the opportunities and risks associated with these new technologies.

1 The term “trust machine” was used in the Economist’s leader of 31 October 2015.

2 Draft Report on virtual currencies (2016/2007(INI)) Committee on Economic and Monetary Affairs, Rapporteur: Jakob von Weizsäcker, 23 February 2016. Note that the report currently has still has the status of a draft. Once a draft report has been presented to the committee, members are given the chance to propose amendments before a certain deadline. The amendments will then be discussed and voted upon in the committee. Once a draft report has been amended and a final vote taken, it becomes a report and will then be presented in the plenary session.

3 For example EMIR, CSDR, SFD, MiFID/MiFIR, UCTIs and AIFMD.

4 Directive (EU) 2015/849 of the European Parliament and of the Council of 20 May 2015 on the prevention of the use of the financial system for the purposes of money laundering or terrorist financing, amending Regulation (EU) No 648/2012 of the European Parliament and of the Council, and repealing Directive 2005/60/EC of the European Parliament and of the Council and Commission Directive 2006/70/EC (Text with EEA relevance).

Content of the motion

PAYMENTS SECTOR

CEMA is clearly interested in both the opportunities and the risks of VCs and DLT in the payments sector. CEMA recognises that these new technologies have “the potential to contribute positively to consumer welfare and economic development” by lowering transaction costs, contributing to financial inclusion, enhancing the speed and resilience of payment systems, enabling online micropayments and other innovative solutions. Concerns are expressed about risks regarding money laundering, terrorist financing and tax fraud, as well as issues regarding governance structures, consumer protection, limited capacity of the regulators in the area and legal uncertainty surrounding new applications of DLT.

EMPLOYING DLT BEYOND PAYMENTS

CEMA recognises the potential of DLT beyond payments, both in the financial sector (clearing, settlement and other post-trade management processes) as well as outside the financial sector. They also point to the potential of smart contracts and encourage government agencies to test DLT systems to improve the provision of services to consumers. CEMA recommends that government agencies explore the use of real time DLT-based supervision and reporting tools as part of the RegTech agenda and beyond.

SMART REGULATION TOWARDS FOSTERING INNOVATION AND SAFEGUARDING INTEGRITY

CEMA calls for “a proportionate regulatory approach so as not to stifle innovation at an early stage, while taking seriously the regulatory challenges that the widespread use of DLT might pose”. CEMA welcomes the European Commission’s suggestions for including VC exchange platforms in the AMLD and recommends further extending the scope of custodian wallet providers if and when the use of VC(s) in question becomes so prevalent that users would no longer routinely need to exchange their VCs into legal tender.

CEMA also recommends reviewing the EU legislation on payments (payment services directive and electronic money directive) in light of the new technological developments including virtual currencies and DLT, “with a view to further enhancing competition and lowering transaction costs, including by means of enhanced interoperability and possibly also via the promotion of a universal and non-proprietary electronic wallet”.

CEMA calls for the creation of a horizontal task force DLT (TF DLT) under the leadership of the European Commission, in order to provide the necessary technical and regulatory expertise to support the relevant public actors and, where appropriate, recommending regulatory measures and addressing consumer protection issues and systemic challenges. CEMA also requests the Commission to explore, on the basis of the findings of TF DLT, the need for a legislative proposal requiring VCs and other DLT scheme actors that do not yet have to comply with existing regulations to demonstrate whether their scheme (i) if it used on a large scale, is designed so as to avoid harming consumers and users, and (ii) if it is systemic, is safe, is sound and has a dependable governance structure.

Comments and recommendations

CALL FOR SMART REGULATION

The CEMA position clearly demonstrates that the EU legislator has a keen interest in the opportunities and risks associated with VCs and DLT. In this respect, it is encouraging to read that there is a call for “smart regulation” and a recognition that the regulation should also allow these new technologies to develop.

IMPORTANCE OF EXISTING REGULATIONS AND NEED FOR FURTHER REFLECTION

The motion notes that existing regulations, such as EMIR, CSDR, SFD, MiFID/MiFIR, UCITS and AIFMD, as well as data protection regulations, are likely to apply, irrespective of the use of certain underlying technology, such as DLTs. On the basis of these existing regulations, regulators can assess the technologies used by regulated entities (such entities must have in place sound and controlled business operations). Our reading of the motion is that CEMA anticipates that the framework provided by existing regulation gives a level of regulatory comfort to enable a period of reflection and exploration around other regulations that may be required in the future. Further, according to the IMF Discussion Note, where the DLTs would be used in a closed system administered by regulated financial institutions, this may raise fewer policy concerns. 5 However, the direction of travel seems clear: we should anticipate that European regulators will take a keen interest in the use of DLTs.

5 IMF Staff Discussion Note, Virtual Currencies and Beyond, Initial Considerations, January 2016, SDN/16/03 https://www.imf.org/external/pubs/ft/sdn/2016/sdn1603.pdf.

RECOMMENDATIONS AND ACTION POINTS

In light of the motion from CEMA, regulated financial institutions will need to:

− assess whether new technologies used in their business operations are safe and sound, and meet expectations on financial stability, investor protection, market integrity, privacy and data protection; and

− liaise in a timely way with their regulator before implementing new technology to make sure that the regulator understands that this technology meets existing requirements (“regulatory buy-in”).

Unregulated VCs and DLTs market participants will need to be able to demonstrate that their scheme (i) if used on a large scale, is designed so as to avoid harming consumers and users, and (ii) if it is systemic, is safe, sound and has a dependable governance structure. VC exchange platforms should prepare themselves for meeting Anti-Money Laundering Directive (AMLD) requirements.

NATIONAL LAW REMAINS RELEVANT FOR SMART CONTRACTS

CEMA points to the potential of smart contracts. For decentralised smart contracts, i.e. computer protocols that execute and enforce the terms of an agreement and leverage blockchain, there is not yet a clear legal framework. Tensions could arise between the self-enforcing nature of these arrangements and classic contract doctrines (hardship, force majeure, unfair terms). Can smart contracts remove inherent ambiguity from contract drafting? How will privacy concerns be dealt with? Who will be responsible for the code? New questions in national contract laws may arise. Such questions are not yet addressed by CEMA.

Broader context

A virtual currency is a digital representation of value that can be digitally traded and functions as a medium of exchange, a unit of account and/or a store of value, but does not have legal tender status in any jurisdiction.6 It is the use of DLTs to underpin the functioning of virtual currencies that has sparked the imagination.

DLTs rely on the use of a distributed ledger, i.e. a decentralised database: all participants in the network have a copy of the ledger. The networks’ distributed ledgers – and hence individual transactions – are validated by using technologies derived from cryptography, most often derived from the so-called blockchain technology, allowing consensus across the members of the network regarding the validity of the ledger.7 The ledger provides a secure, permanent record that cannot be manipulated by a single entity and does not require a central registry.8

The application of DLT in the financial sector to support financial market infrastructures has generated a huge amount of interest, as is demonstrated by a number of recent reports (such as, for example, the IMF Staff Discussion Note,9 the European Banking Association’s report,10 the ESMA’s call for evidence,11 the European Central Securities and Depositories Association’s report,12 the Euroclear report13 and the DTCC14 report). There is a lot of activity in the payments sector15 and stock exchanges have also started to develop applications.16 The report from the UK Chief Scientific Advisor17 is a good illustration of interest in the applications of blockchain beyond the financial sector.

Successfully embedding DLTs in the existing financial markets will likely also require industry alignment (common standards and protocols). Efforts in this direction are already underway. One example is the Hyperledger Project, an initiative to develop a cross-industry open standard for distributed ledgers. A number of financial institutions have also joined the R3 consortium.

Across the globe, other policymakers and regulators are also looking with interest at VCs and DLT.

− The Financial Stability Board announced on 22 February that “The FSB is evaluating the potential financial stability implications of emerging financial technology innovation for the financial system as a whole, working with standard setters that are monitoring developments in their respective sectors. We are also working to understand better the potential impacts on financial stability of operational disruption to core financial institutions or infrastructure”. It will discuss its findings at its March plenary meeting.

− The International Organization of Securities Commissions (IOSCO) announced on 22 February that the IOSCO board18discussed and endorsed intensifying work on technological change – with a focus on harnessing the opportunities while mitigating the risks. The Board agreed on further research on financial technology subsectors with particular relevance for securities regulators, including blockchain”. The IOSCO announcement states that the roundtable it held “highlighted the potential new financial technologies can have to improve global market efficiencies, and provide emerging market jurisdictions with the infrastructure needed to further develop their capital market with leading market analysts on block chain, highlighted the potential new financial technologies can have to improve global market efficiencies, and provide emerging market jurisdictions with the infrastructure needed to further develop their capital markets”. IOSCO does not itself make “hard law” but is influential in setting policies and standards for the financial markets.

− The U.S. Commodities Futures Trading Commission held a Technology Advisory Committee Meeting on 23 February, in order to discuss blockchain technology and its potential application to the derivatives market. 19

− In a speech, Christopher Woolard, Director of Strategy and Competition of the UK Financial Conduct Authority, stated that “During the phase of any digital development, it’s crucial that innovators are allowed the space to develop their solutions. The FCA continues to monitor the development of this technology but is yet to take a stance until its application is clearer”. The FCA indicated that it works with firms developing distributing ledger technology solutions via the Innovation Hub to ensure consumer protections are being factored in during the development phase of this technology. The FCA is particularly interested in exploring whether blockchain technology can help firms meet know your customer or anti-money laundering requirements more efficiently and effectively.

− Various national regulators are also taking in an interest in DLT and fintech more broadly, e.g. in the Netherlands20 and Germany21.

As the regulatory responses further develop, it will be interesting to see whether parallels can be drawn between the early days of internet governance and regulation and developments in the blockchain sphere.22 Will governance structures similar to ICANN be developed, allowing stakeholders to exchange ideas and to set standards? Will there be “layer unbundling” allowing room for independent innovation by various players involved, or will vertical integration raise new antitrust challenges?

6 See our bulletin on the topic: http://www.allenovery.com/SiteCollectionDocuments/Virtual %20Currencies.pdf.

7 IMF Staff Discussion Note, Virtual Currencies and Beyond, Initial Considerations, January 2016, SDN/16/03 https://www.imf.org/external/pubs/ft/sdn/2016/sdn1603.pdf, p. 18.

8 IMF Staff Discussion Note, Virtual Currencies and Beyond, Initial Considerations, January 2016, SDN/16/03 https://www.imf.org/external/pubs/ft/sdn/2016/sdn1603.pdf, p. 18.

9 IMF Staff Discussion Note, Virtual Currencies and Beyond, Initial Considerations, January 2016, SDN/16/03 https://www.imf.org/external/pubs/ft/sdn/2016/sdn1603.pdf.

10 Cryptotechnologies, a major IT innovation and catalyst for change: 4 categories, 4 applications and 4 scenarios An exploration for transaction banking and payments professionals, EBA Working Group on Electronic and Alternative Payments, 11 May 2015.

11 European Securities and Markets Authority, Call for evidence, Investment using virtual currency or distributed ledger technology, 22 April 2015, ESMA/2015/532.

12 European Central Securities and Depositories Association, CSDs, virtual currency investments and “blockchain” technology, 20 July 2015, http://ecsda.eu/wpcontent/uploads/2015_07_20_ECSDA_ESMA_VC_DLT.pdf.

13 Blockchain in Capital Markets: the Prize and the Journey https://www.euroclear.com/en/campaigns/blockchain-incapital-markets.html.

14 “Embracing Disruption – Leveraging Blockchain to Improve the Post-Trade Process”http://www.dtcc.com/news/2016/january/25/blockchain.

15 E.g. Ripple, SnapSwap

16 NASDAQ.

17 Distributed Ledger Technology; beyond block chain, a report by the UK Government Chief Scientific Advisor, https://www.gov.uk/government/uploads/system/uploads/attac hment_data/file/492972/gs-16-1-distributed-ledgertechnology.pdf.

18 https://www.iosco.org/news/pdf/IOSCONEWS419.pdf.

19 http://www.cftc.gov/PressRoom/SpeechesTestimony/massadst atement022316.

20 The AFM

21 BaFin has been focusing on DLT for the past few months as a result of its innovative capacity. It is monitoring the latest developments in the FinTech industry very closely and is engaged in discussions related to DLT with other supervisory authorities. BaFin is also actively in contact with experts and market participants for the purposes of identifying any potential supervisory problems. 

22 See comments made by Joi Ito from MIT, http://joi.ito.com/weblog/2015/01/23/why-bitcoin-is-.html