Alongside those, sits a lower-profile, temporary law that seeks to apply the innovations of distributed ledger technology (DLT) to financial market activities that mimic stock and bond trading, offering a more efficient way for the ordinary retail trader to get access to financial markets that are often closely guarded by incumbent players.
Under the law, financial-trading companies can pilot DLT tools to directly settle some trades without having to use an intermediary, saving time and money, potentially meaning retail investors in traditional markets get access that is cheaper, more direct and more efficient.
In practice it might just be financial-market incumbent behemoths able to take advantage, but Web 3 fans should still be cheering about the possibility of cutting out the middleman, CoinDesk has been told. No more dealing via brokers or other financiers – you might soon be able to get hands-on access.
“It’s not a revolution, but it's seeing that politicians in Europe and authorities in Europe are aware of their needs and are trying to do something about it,” João Vieira dos Santos, a law professor at the Universidade Lusófona in Lisbon, said. “It’s a very good thing for the European market.”
The EU agreed to this new pilot regime temporarily allowing DLT-based stock and bond trading earlier this year, and it takes effect in March 2023. Compared with MiCA – which introduces greater control over previously unregulated assets like stablecoins – the pilot seeks the exact opposite: streamlining the rules that apply to crypto tokens that resemble stocks or bonds, and so already fall under financial market law.
In the EU, just as elsewhere, financial trading is an alphabet soup of entities and regulations in which brokers, clearinghouses and trading venues of multiple kinds all play a part. Laws such as the Markets in Financial Instruments Directive (MiFID) and Central Securities Depository Regulation (CSDR) are designed to safeguard stability and prevent clients getting scammed.
Both crypto fans and conventional financiers wonder whether DLT could step in to simplify how stock trades get processed and registered, cutting out some of the intermediaries without compromising on safety. After all, blockchain is all about getting rid of centralized gatekeepers and giving people better, more direct access to finance.
Across the pond, FTX.US’s Sam-Bankman Fried is seeking permission to be able to clear derivative contracts directly, rather than referring them to separate clearinghouses. His pitch to the U.S. Commodity Futures Trading Commission to be allowed to short-circuit financial market rules in the name of efficiency is, perhaps predictably, being fiercely resisted by market incumbents like Chicago’s CME Group.
But in the EU, so far, attempts to get this off the ground have largely failed. The Luxembourg Stock Exchange allows security tokens – crypto versions of financial instruments such as bonds – to be included on its official list. But innovative assets can’t be admitted for trading on the exchange itself due to EU law.
In 2018, France’s ID2S sought to use DLT to disrupt the relatively staid market of securities depositories, the financial infrastructure that records when securities change hands. But by March of this year, the company had given up and asked regulators to withdraw its authorization.
“Though the financial sector got interested early on in this distributed ledger technology via experiments, those embarking on the industrial phase are a rarity,” said a 2021 report by the French central bank.
The new pilot regime streamlines existing arrangements in two ways. It allows securities traders, including regular retail investors, to interact directly with the market – as, under current laws intended to halt mis-selling and malpractice, they have to do so via regulated intermediaries such as brokers.
It also allows exchanges to register the tokens themselves, rather than storing them in a separately regulated securities depository, something that helps realize Web3 ambitions, CoinDesk was told.
“Only one entity being responsible for all the market: This could be one step in the direction of the DeFi [Decentralized Finance] objectives,” said Vieira dos Santos, who serves as an adviser to the Portuguese Securities Market Commission and has written extensively about the plans.
Despite the good intentions of cutting red tape, in some areas the rules may achieve the opposite, Vieira dos Santos worries.
Retail investors trying to use the pilot without a broker will be subjected to a test set by the regulator to ensure they are knowledgeable about the products they buy. In practice, that could prove even more burdensome than existing procedures, which the slicker financial-trading apps like Robinhood can carry out swiftly and automatically.
“Each national authority will assess in their own way,” Vieira dos Santos said. “It’s maybe too careful a step.”
Lawmakers’ caution might also mean that they miss out on another regulatory goal – allowing innovative DLT-based new entrants into the market. Innovative newcomers are given some legal shortcuts to help them get set up – but not many, and hefty capital requirements could prove too costly for smaller companies, he said. That could mean only established players like Nasdaq and Euronext can benefit, and only in larger EU jurisdictions such as France and Germany.
“There are a lot of blockchain companies that are interested … but it's going to be very difficult for them,” he said. “Maybe the only big entities will enter.”
Those problems may be compounded by the rigidity of the law. The experiment is limited to particular technologies, and to crypto versions of conventional financial instruments like securities and derivatives. That means it can’t adapt to new ideas like non-fungible tokens (NFTs), Ian Gauci, managing partner at law firm GTG Advocates and member of the Maltese Blockchain Task Force, told CoinDesk.
In “the normal exchange … that settles only securities, there is no space for other tokenized assets that do not conform to the existing financial services,” Gauci said. “NFTs would become captured only here if they are financial instruments.”
“What if, during this six year timeframe … even the concept of DLT… changes?” he said, adding that markets may in the future decide the Next Big Thing isn’t Web3, but instead some other innovation. “I’ve seen the hype … today it’s DLT, tomorrow it might be AI [Artificial Intelligence].”
Worse still, because it’s just a pilot – lasting for three years with an option to extend by another three – it could throttle the business case. Trading venues may not see returns repaid over that period, especially as they might have to keep their conventional system running in parallel.
“If you’re going to settle securities … using a particular DLT platform, would you invest in something like that for a mere three to six years?” Gauci said. “From the investment point of view, it leaves a lot of questions.”
For the time being, we still don’t know the exact details of the EU’s legal regime. The European Securities and Markets Authority is still consulting on its finer points, like how to apply for permission to run a pilot. (Guidance setting out exactly how carve-outs from current laws will work won’t be out until 2025.)
In the meantime, observers are looking at how the EU compares to the global competition. A June bill proposed by U.S. Senators Kirsten Gillibrand (D-N.Y.) and Cynthia Lummis (R-Wyo.) included some text in this area, but it’s “not so organized and so comprehensible as the European proposals,” Vieira dos Santos said.
Gauci, meanwhile, is watching the U.K. – which has a new regulatory freedom post-Brexit and is committed to becoming a crypto hub.
The U.K. “has already issued an intention to issue a sandbox as well within this sector,” Gauci said. “It's already moving away from the EU regarding AI regulation … they can do it because they're out of the EU.”
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