The outcome of the US elections is poised to have a significant impact on the digital assets industry, according to one of Silicon valley’s biggest investors, Andreessen Horowitz, and the route to global adoption which, in other jurisdictions, has continued at a rapid pace since I published “Digital assets: accelerating adoption under the hood” only five months ago. In each instance, the successful adoption of digital assets clearly requires a core critical mass and ecosystem of financial institution and clients within either a single technology network or across interoperable technology networks. At the end of September, the Bank of England (BoE) and the UK Financial Conduct Authority (FCA) announced the official opening of the UK Digital Securities Sandbox (DSS) which originated in new powers granted to HM Treasury under the Financial Services and Markets Act 2023. Following industry consultation, the BoE and FCA implemented the following key policy changes to create the regulatory environment conducive for DSS entrants to innovate and establish ecosystems:
· extending the DSS to include non-GBP denominated assets.
· adopting a more flexible approach to the capacity limits and allowing uplifts to these limits while firms are in the Go-Live stage, with the intention of allowing smoother transitions to the scaling stage.
· adding the option of a third Gate 3 progress review window to smooth transitions to the scaling stage.
· reducing the minimum capital requirement for Digital Security Depositories (DSD) from nine months to six months of operating expenses.
· reliance on the high-level provisions in the rules based on Article 48 of UK Central Securities Depositories Regulations, to remove detailed provisions relating to the use of bank guarantees and letters of credit used to secure DSD links.
· amending the UK CSDR Article 39-based rule to clarify that adequate protection to participants in any Securities Settlement System (SSS) that a DSD operates can include protection by contractual means.
The BoE and FCA launched the sandbox as a temporary supervisory framework allowing existing UK-based financial institutions including financial market infrastructures (FMI) and new entrants to the market to engage in defined activities within specific limits, which enables the regulators to assess if such activities can be safely integrated into the existing regulatory system. The goal is to foster innovation by adapting current rules that might otherwise restrict participants from pursuing these activities. Principally, the sandbox allows participants to conduct notary, maintenance and settlement activities that are more traditionally associated with central securities depositories (CSD) and potentially to combine these activities with the operation of a trading venue. There are three overarching aims for the sandbox: · facilitating innovation to promote a safe, sustainable and efficient financial system.
· protecting financial stability.
· protecting market integrity and cleanliness.
Earlier this year, the European Securities and Markets Authority (ESMA) stated it would not publish an annual interim report to the European Commission on the Distributed Ledger Technology (DLT) Pilot Regime as “no DLT market infrastructures have been authorised” to operate within it. With four official applications submitted and being assessed by the respective national competent authorities, there was hope that some market infrastructures would eventually be authorised under the Pilot Regime and ESMA identified several key areas for focus. Six months later, CSD Prague became the first institution to be authorised under the Pilot Regime and, from 18 November, can offer issuers of book-entry securities, registration in a DLT-based registry. CSD Prague has based its new service on R3’s open, permissioned Corda DLT technology. CSD Prague is focusing on settlement in its domestic market and the DLT registration fully complies with Czech law, particularly regarding the book-entry requirements of the Civil Code or the Commercial Corporations Act. The scope of the Pilot Regime covers for the use of DLT in financial markets, primarily focused on trading and settlement activities. The Pilot Regime aims to enable the creation of a controlled regulatory environment where DLT-based financial instruments can be tested under real-world conditions. The primary goals are to assess the viability and effectiveness of DLT for securities, identify regulatory gaps and inform potential EU-wide adjustments to FMI regulations. The Pilot Regime aims to create a unified approach for DLT securities across EU member states. The Pilot Regime enables market infrastructures to obtain exemptions from applicable financial regulations and to use DLT for the trading and settlement of securities transactions. Incumbent EU market infrastructures, however, have been slower (according a recent article in the FT) at adopting digital assets than required by the financial institutions they serve/support, both under the Pilot Regime and outside of the temporary regime. This is leading to national variances and an arbitrage opportunity that will help to define which EU member states will be the future global centres for digital assets.
Leading the way in the EU is the Luxembourg government, which submitted Blockchain IV Bill of Law to update the legal framework for dematerialised securities and DLT. Filed in July 2024, the Bill forms part of a national strategy to become a financial sector leader in DLT and tokenisation. Interestingly, Blockchain Law IV introduces a new role of the Control Agent, which can be performed by both financial institutions and market infrastructures. For financial institutions, it allows them to perform notary, reconciliation and corporate action services without being forced to build a custody business, while EU legislation enforces that the only way to issue onto a secondary market is through a CSD. This Luxembourg legislation remains in advance of the German Electronic Securities Act - Gesetz zur Einführung elektronischer Wertpapiere (eWpG) - as well as the French blockchain ordinances and SAPIN II Act. Additional legislation has been introduced by the Italian government on issuing securities tokens and two regulations concerning MiCA transitioning from VASPs to CASPs have added to the European digital landscape. Alongside Spanish Startup Act and its new Ley del Mercado de Valores (LMV) securities markets and investment services law regarding the issuance, registry, transfer and storage of financial instruments on DLT, there is significant momentum across individual EU member states that will help to define the future winners.
In Asia Pacific, multiple jurisdictions are collaborating in Project Guardian, a cross-border initiative to enhance liquidity and efficiency of financial markets through asset tokenisation, led by the Monetary Authority of Singapore (MAS). Project Guardian recently issued its first report on the use of fund and asset tokenisation, where its AWM industry working group piloted and identified benefits from digital assets and confirmed it is now looking to align standards to scale this commercially.
The approach identified in the report for composability and token standards signals a potential significant change not only for investment funds but for the broader financial sector, fostering enhanced adaptability, connectivity and innovation throughout the investment landscape. The output of the first Project Guardian report is timely, in that it can be used to expand on the blueprint for six digital asset securities control principles that were published by three of the largest market infrastructure groups as a means for promoting acceptance of tokenised assets. The six principles provide a roadmap for industry standards that support digital assets, and focus on:
· legal certainty - ensuring operations compliance with related laws
· regulatory compliance - aligning with regulatory requirements
· resilience and security - developing robust infrastructures that are resilient to disruption while protecting sensitive data
· safeguarding customer assets - implementing smart contract governance to securely manage assets
· connectivity and interoperability - enabling efficient settlement across networks
· operational scalability - achieving efficiency and cost-effectiveness through standards.
Therefore, whilst the future state is being driven by new laws and regulations, the structural work in gearing up digital asset ecosystems is fulfilling a key role in accelerating the adoption of DLT and digital assets. As the global shift toward digital assets gains momentum, major players in the UK, Europe and Asia are racing to establish regulatory frameworks and innovative sandboxes. The UK’s Digital Securities Sandbox, Luxembourg’s updated laws, EU Pilot Regime and Singapore’s Project Guardian are all aiming to set standards for tokenised finance, but each has its own approach. So, will these efforts lead to a cohesive, interoperable global digital asset ecosystem, or will fragmented regulations create barriers that limit cross-border innovation? Furthermore, how can we ensure that new digital financial systems are both secure and accessible, and who will emerge as the global leaders in this rapidly evolving space?
This article first appeared in Digital Bytes (18th of November, 2024), a weekly newsletter by Jonny Fry of Team Blockchain.