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VI The Future of OTC Derivatives Clearing in Europe, 17 Potential Impact of the Distributed Ledger Technology on OTC Derivatives Markets

Randy Priem

From: Clearing OTC Derivatives in Europe

Edited By: Bas Zebregs, Victor de Seriere, Rezah Stegeman, Patrick Pearson

From: Oxford Legal Research Library (http://olrl.ouplaw.com). (c) Oxford University Press, 2023. All Rights Reserved.date: 18 April 2024

Subject(s):
Derivatives — Settlement — Financial regulation

(p. 499) 17  Potential Impact of the Distributed Ledger Technology on OTC Derivatives Markets

Introduction

1.1  Importance of the Distributed Ledger Technology

Distributed ledger technology (DLT) has received extensive consideration over the past decade from market participants, financial market infrastructures, and regulators. DLT refers to the novel approach to record and share transactions and/or data across multiple participants in a decentralized way. A blockchain, where data is stored in blocks chained together in a chronological sequence, can then be considered as a particular kind of DLT, albeit the terms ‘blockchain’ and ‘DLT’ are often utilized interchangeably. Blockchains use algorithmic and cryptographic methods for the storage and synchronization of data in a network in an immutable manner, thereby making the possibility of fraud or manipulation more difficult.1

Blockchain-based DLT is initially considered as the building block of cryptocurrencies because of its use for the cryptocurrency Bitcoin. Satoshi Nakamoto, the pseudonym for the creator of Bitcoin, described this innovation for (p. 500) the first time in 2008 in its white paper as an ‘electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party’.2

DLT might have a variety of potential applications beyond the realm of cryptocurrencies. Proponents of DLT advocate a number of potential advantages compared to traditional centralized ledgers, such as the greater level of transparency and auditability, the increased speed with which transactions can happen, cost reductions, and potential automation (see later). The technology, in comparison with legacy systems, might thus offer a new, completely digital, and potentially more efficient way of securities trading, clearing, and settlement.3 As per Goldman Sachs, when DLT would be applied by financial market infrastructures (i.e. trading venues, central counterparties, and central securities depositories),4 the costs related to securities post-trading (i.e. clearing and settlement) would lessen by $11–$12 billion.5 An examination of Banco Santander, Oliver Wyman, and Anthemis Group then shows that DLT would decrease cross-border payment and trading costs by $15–$20 billion.6 The World Economic Forum then assessed that almost 10% of the value of the global gross domestic product (GDP) would be recorded on blockchains by 2027.7

(p. 501) 1.2  DLT Pilot Cases

Because of the possible advantages and efficiency gains of DLT, financial institutions have started to experiment in recent years with proofs of concept in specific niches of the trading and post-trading ecosystem.8 For instance, the Australian Stock Exchange (ASX) and Digital Asset started to build a DLT system for the clearing and settlement of shares, which was envisaged to be launched in 2023, but was stopped because e.g. of the technology being too slow.9 Seaboard Corporation Common Stock (SEB) and the National Association of Securities Dealers Automated Quotations (NASDAQ) then created a DLT platform for Swedish mutual fund trading. Furthermore, the Canadian Securities Exchange is developing a DLT platform for securities clearing and settlement. This platform would allow firms to issue shares and fixed-income securities via security token offerings.10 In 2021, Deutsche Börse, in cooperation with the Deutsche Bundesbank and Germany’s Finance Agency, developed and tested an interface for electronic securities that enables payment in central bank money.11 During the testing, the German Finance Agency issued a ten-year federal bond (Bund) in the DLT system where primary and secondary market transactions were also settled using DLT. Clearstream Banking Luxembourg, the central securities depository of the Deutsche Börse Group, is also experimenting on whether they can connect to a new DLT-enabled platform provided by Digital Asset.12

With respect to the OTC derivatives markets in particular, several pilot cases are being created. Fairom, a Canadian portfolio company, is developing a DLT-based tool to automate back-office operations for over-the-counter (OTC) derivatives.13 The intention is to obtain a 30% cost decrease for financial institutions managing these financial products. The Depository Trust & Clearing Corporation (DTCC) then initiated the creation of a solution for credit derivatives processing, like credit (p. 502) default swaps trades, on a DLT network.14 Furthermore, the International Swaps and Derivatives Association (ISDA), in cooperation with REGnosys, developed the common domain model (CDM) to provide a global representative standard for all actions and events happening during the life of a derivative trade onto a smart contract blockchain (see par. 2.4).15

Despite all pilot cases, financial institutions have yet to prove that DLT is a viable and sustainable solution, and it is currently insufficiently clear from the pilot cases whether the trading and post-trading segments will become more intertwined. It is also not yet certain which DLT system in terms of operational functionality would be best suited for the trading, clearing, and settlement of securities. Because most inefficiencies are situated in the post-trading segment, one can assume that these will be addressed first before the various segments of the trade life cycle are potentially merged into one DLT solution. Also, because institutions are still in the experimental phase, the technology might still evolve considerably, and new risks and challenges might still be detected.16

Despite the potential benefits of the technology, there seems to be a widespread prediction that DLT will be implemented gradually. According to the German Banking Industry Committee, legacy systems and DLT will co-exist for the next few decades, with a gradual employment of the technology.17 DLT is, indeed, still suffering from various ‘barriers to entry’, such as the complexity to transition from a legacy system to a DLT-based system, the negative perception of institutions linked to cryptocurrencies (which could be detrimental to the technology itself), inertia in the adoption of the technology, and regulations being unclear.

Compared to previous literature,18 this chapter focuses in more detail on the impact of DLT on OTC derivatives markets. The chapter first explains how DLT and/or blockchains work. When the basic concepts are clear, the current trading life cycle is documented, followed by a discussion on how DLT could make the existing life cycle more efficient. The chapter will focus not only on the potential advantages of DLT but also on new risks to which this technology might give rise. In addition, the impact of DLT on OTC derivatives markets, and specifically the usage of smart contracts, will be discussed. The chapter ends with regulatory evolutions.

(p. 503) Explanation of How DLT and Blockchains Function

2.1  DLT, Blockchains, and Cryptography

Although it has to be stressed that DLT is not yet a well-defined, one-size-fits-all technology, distributed ledgers and blockchains can be considered as specific type of databases where users work in a decentralized manner and data is stored in blocks that are chained together in a chronological order. The digital assets that are traded on the distributed ledger may be created and exist exclusively (self-anchored) on the DLT itself or may rather be digital representations of intangible or tangible assets that exist off the ledger (anchored).19 Crypto assets that are created and exist exclusively ‘on ledger’ are called ‘native tokens’ or ‘native assets’, while crypto assets that represent intangible or tangible assets that exist ‘off ledger’ are called ‘non-native assets’ or ‘non-native tokens’.20

The transaction process in a DLT typically occurs via a few specific steps. First, the usage of cryptography—and thus of public and private encryption keys—is of utmost importance for users to be certain that their counterparties do not execute the same transaction with another party. Hence, DLT deals with this double-spending problem by imposing that when two clients enter into a trade, they first need to sign the deal by using their private keys to unlock the securities and, in a second step, transfer the ownership via the public keys. In general, asymmetric key cryptography, where a public and a private key are used, is most often applied in case of, for example, cryptocurrencies. Both private and public keys are linked in a mathematical manner based on, for example, elliptical curve cryptography.21 This means that the private key can decrypt the information that is encrypted only with the corresponding public key and vice versa. The private key is known only to the receiver (i.e. the beneficiary), while the public key is transmitted to the sender. The public key also represents the ‘address’ to which the crypto assets can be transferred. If beneficiaries lose the private key, they also lose the right to dispose of the assets as this is equivalent to a password. Hence, it is important for beneficiaries to properly protect their private keys.

2.2  Consensus Mechanisms

When a newly signed transaction is entered into the system, it is broadcast to a network of peer-to-peer computers, which can be located in numerous geographical areas. The (p. 504) network of computers, also called nodes, will solve equations in order to validate the transaction. An example of such validation is the proof-of-work consensus mechanism, where the validators have to computationally solve intensive puzzles. Specifically for the Bitcoin blockchain, the process of generating proof-of-work (i.e. the validation process) is called ‘mining’. Another type of consensus mechanism is the proof-at-stake consensus mechanism, where the creator of the next block is chosen via various combinations of random selection and wealth, that is, the stake.22 These consensus mechanisms are applied to reach a consensus between several nodes on the validity of the underlying database.

In proof-of-work consensus mechanisms, hashing algorithms are mostly used. Hashing can be described as a computer algorithm running over a content file generating a compressed string of alphanumeric characters, that is, the hash function. These hash functions cannot be back-computed into the initial content. Every digital financial instrument could be transformed into a hash string as a private and unique identifier. This means that the hash function itself depends on the transaction data, the identities of the counterparties, and the result of previous transactions.23 It is typically impossible to infer the values of the initial transactions and/or data from the hash function, while it is more feasible to compute the hash from the original data values. Every time a validator checks that the records are still the same and no modification has been performed, the same hash algorithm is run, leading to the same hash signature. Typically, blockchains include the hash of the previous version of the ledger, which allows for a validation of the new version of the ledger by checking whether the fixed-length output corresponds to the hash included in the updated version;24 that is, each block encompasses a hash function reflecting the content of the previous block, which itself will have a hash function referring to the block more adjacent to the initial block.

Solving a proof-of-work puzzle is rather difficult from a computational perspective, and a single node in the network only has a small likelihood of generating the required proof-of-work without superseding a massive amount of computing resources. In the Bitcoin network, each miner that produces a valid proof-of-work receives Bitcoins as a reward, serving as a transaction fee. Because all miners execute their calculations, proof-of-work consensus mechanisms typically consume a lot of energy, raising questions on its ecological impact. This disadvantage is not present for proof-at-stake consensus mechanisms as there is less competition between validators to solve the puzzle.

These consensus mechanisms are of utmost importance in a situation where there is no centralized institution, such as a government. The reason is that one of the key goals of the validation process is to ensure that the seller is the rightful owner of the assets being sold, based on the entire transaction history recorded on the DLT system. Hashing can thus be considered as a method to make the blockchain immutable. It also helps to ensure that the seller is the rightful owner of the asset and that they have not (p. 505) yet sold the asset to someone else.25 The consensus mechanisms and hashing, thereby leading to an immutable ledger, also make a cyberattack of a DLT system very difficult. Indeed, the attacker would need to take control of the majority of the validators in order to be successful (known as a 51% attack).26

Once confirmation in the blockchain is achieved (implying that a transaction is legitimate), it is clustered together with other transactions in a block. The blocks are then chained together, creating a history of all transactions. After this chaining, the blockchain is updated and the transaction is considered to be complete. In a distributed ledger, each node thus has a full copy in its own records of all the transactions and/or data since the ledger’s inception. Furthermore, if one node has an error in its own database, it can use all the previous historical transactions as a reference point to correct itself. Because of the validation mechanisms, no computer in the network can alter the information held within the distributed ledger as the latter encompasses the history of transactions in each block, making the distributed ledger irreversible. This process of adding transactions also implies that the distributed ledger grows constantly.

2.3  Permissioned vs Unpermissioned Blockchains

While blockchains, like the ones used for the trading of Bitcoins, can be public and unpermissioned, where each computer can freely join the ledger to read and/or write, other distributed legers, such as Hyperledger Fabric, are non-public and permissioned, where only a few computers are allowed to connect. In an unpermissioned system without a central owner who controls network access and where users can join and add transactions via their relevant software, the validation mechanism plays a key role. Indeed, not every participant in such a blockchain would be a trusted party. Examples of rigorous validations could be the enrolment of numerous nodes as validators or the utilization of a stricter validation algorithm. A disadvantage then, however, is that those DLT systems would be slower.27 In the case of Bitcoins, for instance, miners solve trillions of mathematical puzzles to calculate a hash value. This task limits the maximum quantity of transactions that can be simultaneously handled to a low number.28 (p. 506) Compared to the VISA credit card payment system, which accommodates often peak volumes of 10,000 payments per second, an unpermissioned DLT system can be inefficient in cases where large volumes need to be cleared and/or settled; for example, the Bitcoin (BTC) network only processes 4.6 transactions per second.29

In case of unpermissioned systems, anonymity of the users is often prevalent. For instance, in the case of Bitcoin transactions, all transactions contain a wallet address of a sender and the receiver, which can be thought of a pseudonyms.30 The addresses linked to the transactions (i.e. the public keys) are mostly known, but the owners behind the addresses not, which is comparable to sending a message to an e-mail address that does not contain the name and family name of the recipient. This anonymity often attracts the attention of criminals as the virtual assets can then be used more easily for the financing of illegal activities.

Permissioned systems, with only authorized participants being accepted, are generally considered as more suitable for securities markets.31 The reason is then that only participants being considered as more trustworthy would be able to join.32 This trustworthiness then also requires a less stringent validation process. Furthermore, the risk of money laundering or other illicit activities tends to be lower when only reliable system participants are allowed to utilize the distributed ledger. Also, the need for stringent consensus mechanisms—and thus the necessity to copy all transactions and/or data to the internal databases of the nodes—would be lower when participants are considered as more trustworthy by fulfilling certain predefined access criteria. However, a permissioned system requires one (or more) institutions to act as (a) gatekeeper(s) or system administrator(s). These institutions will then need to screen potential participants before the latter can access the DLT system. These gatekeepers would grant access only to participants meeting the access criteria, which could be included in a rule book of the system.33 The presence of a gatekeeper implies that a central institution cannot be completely ruled out in a permissioned DLT system. Such a system is thus in sharp contrast with the initially developed open Bitcoin system, where there are no access restrictions and no central institution acting as a gatekeeper.34 Also, as there is a central institution granting access to the network, this central entity might be a potential target for cyberattacks.

(p. 507) 2.4  Smart Contracts and Oracles

Apart from data on transactions, distributed ledgers can also contain computer code, so-called ‘smart contracts’. These contracts self-execute and can process a transaction on the ledger automatically when certain predefined conditions are met.35 Smart contracts have become popular since the establishment of one of the most known cryptocurrency applications, Ethereum (ETH). Smart contracts are decentralized: they are not recorded in a single centralized server but are distributed amongst the system participants.36 A smart contract has some identical features as a traditional contract: it is an agreement between two or more parties to do or not do something in exchange for something else. The difference with a traditional contract is that a smart contract is defined by code, which executes without any human intervention under precisely predefined conditions.37 The contracts are considered to be ‘self-enforcing’ as they can execute automatically.38 Some scholars even claim that a complete blockchain economy is emerging, defined as a novel type of economic system where agreed-upon transactions are enforced via rules defined in smart contracts in an autonomous manner.39

Smart contracts might even be executed based on information they receive external to the DLT system. So-called ‘oracles’ might be deployed, which can be defined as computer servers that are programmed to scour data (news) feeds in order to validate whether user-provided expressions (encompassed in the social contracts) hold true.40 These oracles will only act as programmed, avoiding the risk of collusion with a counterparty, given the absence of a human arbitrator.41 Oracles can use multi-signature (multisig) to incorporate outside information into the blockchain.42 Multi-signature requires multiple keys to authorize a transaction rather than a single signature from one key. The oracle thus serves as an additional signatory that attests to information that originates from outside of a particular blockchain, thereby allowing the smart contract to execute.

(p. 508) How DLT Could Impact the Current Trading Life Cycle

3.1  The Current Trading Life Cycle

In order to examine the influence of DLT on trading, clearing, and settlement in general, this section first presents the trade life cycle, of which clearing and settlement (i.e. post-trading) are the last two phases. Figure 17.1 is a simplified representation of the security leg of the trade life cycle.43 Note that this representation will be different based on the type of the financial instrument (i.e. equity, fixed income, or derivative), whether the deal happens on an exchange or OTC, and whether the deal is centrally cleared via a central counterparty (CCP) or not.

Figure 17.1  Simplified representation of the security leg of the trade life cycle

Source: Randy Priem, ‘Distributed Ledger Technology for Securities Clearing and Settlement: Benefits, Risks, and Regulatory Implications’ (2020) 6(1) Financial Innovation 1, available through Creative Commons Attribution 4.0 International License, http://creativecommons.org/licenses/by/4.0 (accessed 23 March 2023).

Trading, clearing, and settlement currently take place in multiple sequential steps. In the trade execution phase, a buy-side and a sell-side client/investor seek to buy or sell financial instruments with each other on a trading venue, which could be a regulated exchange,44 a multilateral trading facility (MTF),45 or an organized trading facility (p. 509) (OTF).46 These investors normally act through their respective brokers. Alternatively, the trade can take place outside of an organized market and thus ‘OTC’. This is often the case for derivatives (e.g. options, futures, forwards, swaps, etc.), where the European Market Infrastructures Regulation (EMIR)47 defines them as derivatives contracts where the execution does not take place on a regulated market, as within the meaning of Directive 2004/39/EC, Art. 4(1)(21) (MiFID II),48 or on a third-country market considered as equivalent. Hence, EMIR considers OTC derivatives contracts being traded on, for example, OTFs as OTC, but they might even be concluded in a non-systematic, ad-hoc manner between two non-financial counterparties as part of a business relationship without any brokers or dealers. In case of financial counterparties, such as credit institutions, broker-dealers commonly send their orders to their own derivatives desks or to other third-party dealers. Trading happens then bilaterally, where the terms may either resemble standardized agreements or be specific to each counterparty’s requirements and needs.

When the trade is executed and the clearing phase starts, the sell instruction and buy instruction are, in case of central clearing, forwarded to the CCP. A novation then takes place whereby the CCP acts as a buyer to the seller and a seller to the buyer. The clearing members, being most likely the direct clients of the CCP acting on behalf of the buy-side and sell-side clients, post collateral (i.e. initial margin and default fund contributions)49 to the CCP to mitigate the latter’s credit and counterparty risk. Clearing members will need to post (or collect) collateral (i.e. variation margin) in function of the financial instrument’s value changes until the instruments finally mature.50

In addition to the novation, CCPs also reduce liquidity exposures via netting, which is a type of set-off that is conducted on a multilateral basis. Netting can be defined as the process where the obligations between participants are offset against each other. This process reduces value and number of deliveries or payments that are needed to settle the set of transactions. Netting thus reduces the number of times cash has to change hands between counterparties; that is, when two counterparties have several outstanding derivatives contracts with one another, the CCP will not pay out each agreement individually but will subtract the losses from the gains and pay the net result. In case of multilateral netting, a movement consolidation among several clearing members occurs.51 In case of bilateral clearing where no CCP is present, counterparties (p. 510) often need to exchange margin without a CCP and/or perform risk mitigation techniques like portfolio reconciliation and/or compression.52

In a next step, the CCP—in case of central clearing—will forward the settlement instruction to the central securities depository (CSD). The CSD will operate the securities settlement system by crediting and debiting its participant’s securities accounts. These participants are most likely to act on behalf of their buy-side and sell-side clients. Note, however, that in case of OTC derivatives, the settlement (being a physical or a cash settlement) mostly does not happen via central securities depositories but via a warehouse receipt or cash being transferred.

As illustrated by Figure 17.1, the current financial industry structure is dominated by centralizing institutions. The trade life cycle can be long, with numerous intermediaries having their own proprietary ledgers having overlapping information on transactions, such as volume, value, the identifiers of the counterparties, timestamps, etc. This long trade life cycle thus leads to a lot of duplication because of each market participant recording the same information internally.53

3.2  A Fictitious DLT System: Advantages, Risks, and the Future for Current Market Participants

Figure 17.2 represents a fictitious DLT system, being only one potential example of how a DLT system, both for currently exchange-traded or OTC instruments, could look.54 As the system is decentralized, all clients could have a copy of the distributed ledger recording the securities, the ownership details, and the entire transaction history of each security.55 When counterparties enter into a trade (i.e. the trading phase), they could first need to sign the transaction by applying their private keys to unlock the securities in a first step and then transfer the ownership to each other via the public key in a second step. The signed transaction could then be broadcast to the entire system in order to get validated. In order for an update of the DLT system to happen, it could require the consensus of all nodes in the DLT network.

Figure 17.2  DLT system in which participants trade securities with one another

Source: Randy Priem, ‘Distributed Ledger Technology for Securities Clearing and Settlement: Benefits, Risks, and Regulatory Implications’ (2020) 6(1) Financial Innovation 1.

Regarding the consensus mechanism, one possibility could be that the originator of the transaction first provides the hash value of the latest version of the ledger and validators then check whether the correct hash function was provided.56 If this proves (p. 511) to be the case, the new transaction would then also get cryptographically hashed and permanently recorded in the distributed ledger. It would thus be difficult to add wrong transactions to the ledger without the consent of the relevant parties involved in the process.

Figure 17.2 shows that—because there could potentially be fewer intermediaries and centralizing institutions involved in the life cycle of a trade—a lot of currently repetitive business processes could be eliminated; that is, the trade life cycle would be simplified, making the distinction between exchange-traded instruments and OTC ones even absent. The simplified trading life cycle could lead to reduced costs because manual reconciliations of potentially conflicting trade data stored in various duplicated ledgers could be eliminated.57 The simplified trading life cycles could thus potentially lead to reduced transaction costs and settlement times. Yet, although proponents of the DLT technology believe that the technology could be applied to achieve instantaneous settlement, it is not entirely clear whether market participants would actually favour this since the ability to net transactions would disappear.58 Netting has advantages in terms of liquidity requirements compared to real-time settlement; that is, the absence of netting would require participants to have all the required funds immediately available to be able to fulfil their payment in real time.59

Specifically with respect to OTC derivatives, DLT can provide a multitude of advantages; that is, the post-trading processes of OTC derivatives currently involve a large number of manual actions, including the maintenance of records about ownership, (p. 512) continuous valuations, and arrangements of cross-system margin obligations. OTC derivatives trading is more costly compared to exchange trading because of the increased amount of required collateral (i.e. initial margins, variation margins, default fund contributions, etc.) that has to be exchanged with the CCP or bilaterally, depending on whether the derivative is centrally cleared or not. DLT and smart contracts could optimize the calculation and posting of margins more efficiently, thereby realizing financial cost savings for market participants. Smart contract could allow for an automatic execution and payment of margins as soon as certain criteria were met, such as the value of the underlying asset being below or above a certain threshold.60 The main mechanisms used to mitigate risk, being delivery-versus-payment (i.e. the transfer of securities can only take place when the counterparty makes the corresponding cash payment), security or collateral exchange, netting, and multilateral clearing of exposures, can be programmed into the functionality of a DLT as smart contracts.61

Another advantage of having the trade life cycle on a DLT is the access of data. Since the global financial crisis of 2008, regulators require market participants to report their OTC derivative transactions to trade repositories.62 The data in the trade repositories would then be made available to regulators in order for them to see whether the risk exposure in the market would increase. Distributed ledgers can thus be considered as useful sources of information for regulators to obtain a view on market microstructures, market expectations, and economic fundamentals. In case of a DLT for OTC derivatives, the reporting to trade repositories might not be necessary anymore. Indeed, the ledger contains all historical transactions, and giving access to a regulator would allow this party to see all transactions at once. Nowadays, there are multiple trade repositories, and market participants can choose which one they report to, so regulators now face the burden of reconciling all reported information coming from multiple sources, which would no longer be necessary in the case of a DLT system. Trade repositories utilize different trade-reporting architectures and software, thereby leading to interoperability issues between them, which hinders the surveillance functions that the trade-reporting requirements seek to achieve. The usage of DLT regarding trade reporting could also reduce data errors as market participants do not have to separately report transactions to trade repositories anymore but could simply make the distributed ledger in which trading is recorded available to their supervisors.

As highlighted before, the presented DLT system in this chapter is only a fictitious example and as the industry is still experimenting with the technology, the final market standard might be different. As an alternative, in the case of OTC derivatives, several interoperable ledgers (derivative ledgers and collateral ledgers) that use smart contracts could also exist.63 In such an ecosystem, the parties to the derivatives transactions would submit bids and asks as usual. The matching would then take place on the (p. 513) blockchain and the CCP would novate the agreements. The novation, resulting in two contracts, would then be uploaded to the derivative ledger. Throughout the lifespan of the agreement, the collateral ledger would use oracles to track price movements in the underlying assets and to automatically adjust positions. In case counterparties would need to post margins to the CCP, they would need to use an interoperable collateral and asset ledger. In case additional variation margin is required, the ledger would automatically send a payment request to the clearing member’s address on the asset ledger. A DLT derivatives contract market could thus look like a system of several interoperable ledgers that use multi-signature smart contracts for effectuating transfers and oracles for collateral management and asset monitoring.

Another alternative solution is where derivative contracts are traded electronically on a private-permissioned blockchain with automatic execution functionalities.64 Smart contracts could then be used, where the contractual terms are pre-programmed and inserted into a code to reflect the counterparties’ intension. For example, in case of an option contract, the strike price, the amount of securities, and the maturity date would be included and trigger the purchase of the underlying securities using the option holder’s private key. This would be followed by the nodes in the ledger verifying whether this trigger took place within the trading window. Also, for credit default swaps, the credit event determination could be contemplated in a smart contract.65

In case of central clearing, an alternative possibility could also be that both counterparties submit their bid and ask orders to their dealers, who would then post them on the blockchain network.66 The CCP would match the orders and, through novation, step into the contract, thereby netting all positions. Initial and variation margin would be posted either on a digital cash account or, in case of assets, transferred onto a collateral ledger being connected with the derivatives ledger. Smart contracts would automatically calculate variation margin, thereby receiving information on price moments through oracles. At maturity or when, for example, an option holder wants to execute the derivative, the smart derivative contract would automatically calculate and close out the netted obligation and the payment would be automatically released on the cash ledger after termination of the contract. Regarding the collateral ledger, this could be a wallet where each party has the amount of collateral necessary and from which the smart contract can automatically take the collateral.67 Clearing members would need to make sure that there are always sufficient funds in order to be able to provide margin when required. In case a clearing member posts insufficient collateral or no collateral whatsoever, the smart derivative contract could automatically terminate its account and protect counterparties from further losses.

The potential aforementioned example indicates that the trading, clearing, and settlement process of a transaction could be contemporaneous, also with the validation (p. 514) process whereby the new asset ownership would be reflected in the system. Post-trading (i.e. clearing and settlement) and trading could become more intertwined in a DLT environment compared to the current sequential processing of securities.68 Some scholars even argue that as the transaction phase and clearing-and-settlement phase will occur simultaneously,69 there will no longer be a need to distinguish between these different phases. This would imply that there is no longer a distinction between trading and post-trading, leading to a reduced role of post-trading market infrastructures.70

As there are many possible future DLT systems, a debate is currently ongoing whether trading venues, CCPs, and CSDs are even still necessary. According to some industry participants71 and scholars,72 regulated markets, MTFs, or OTFs are less likely to be directly affected as their market participants still need to find counterparties to trade with, which will not fundamentally change when DLT is applied. Alternatively, buyers and sellers could first act through brokers (i.e. trade level) and then create a transaction for the transfer of that amount of the asset, which is, in turn, transmitted to the DLT network and verified.73 Trading venues might thus develop their own method of clearing and settlement using DLT, thereby making a CCP or CSD no longer necessary. However, there is also a possibility that market participants rather introduce the technology in a step-by-step manner, thereby first focusing on the post-trading part of the trade life cycle where most inefficiencies (i.e. manual processing, reconciliation, long custody chains, etc.) can be removed. This might be the reason why numerous exchanges are exploring the technology to apply DLT to clearing and settlement activities.

Some argue then that blockchains could make sure that financial derivatives markets do not need to rely on a single CCP anymore. In the case of cleared OTC derivatives, the risk concentration within CCPs gives rise to systemic risk concerns as these financial market infrastructures are considered too big to fail.74 Since the 26 September 2009 summit by the G20 in Pittsburgh, the majority of OTC derivatives markets have moved from bilateral to central clearing. One of the reasons for this was that CCPs functioned as shock absorbers during the crisis and managed to close out all financial contracts with defaulted clearing members in a quick and orderly manner. For non-defaulting clearing members, CCPs guaranteed the execution of their trades and (p. 515) assisted in transferring their outstanding positions to solvent clearing members. CCPs had clear benefits but nowadays have the side effect that they are too big and too important to fail.75 Some proponents of DLT might thus claim that it could be beneficial to somewhat reduce their systemic importance by making many of their risk-mitigating activities redundant with the introduction of blockchains serving as decentralized clearing networks; that is, the blockchain itself could manage the functions usually executed by the CCP, such as the valuation of contracts, the calculation of initial and variation margin, the custody of collateral, the handling of novation and netting, and the management of the final pay-outs. Key functions of CCPs could thus be decentralized amongst nodes in the network and each node could get a specific duty. As the DLT technology could reduce counterparty risk because of the almost instantaneous settlement and pre-trade transparency due to the entire copy of the ledger in their own systems, some market players believe that CCPs, and clearing in general, are no longer necessary. CCPs can, of course, also use the technology but this can be done also by other, competing institutions.

Nevertheless, for non-cash derivatives having a maturity date, central clearing could still be useful for hedging purposes until securities and/or cash are irrevocably and finally exchanged.76 Indeed, a distinction has to be made between transactions having a maturity and spot transactions. For spot transactions having a single clearing and settlement instruction extinguishing the obligations of each party, DLT could reduce the role of CCPs. In contrast, for derivative transactions with a (long) maturity, the outstanding rights or obligations remain throughout the entire life of the contract. Hence, the necessity to mitigate counterparty risk exists until the contract matures. For these contracts, DLT is unlikely to fully eliminate counterparty risk as there is a long time period during which counterparties incur the risk of non-performance.

Some financial institutions are then of the opinion that CSDs are not necessary anymore as the securities’ issuer and the investors acquiring them can directly transact via updates of the distributed ledger. In contrast, market infrastructures could change their roles and start acting as gatekeepers or validators in case of permissioned distributed ledgers as they would face fewer competition issues and conflicts of interests compared to traders.77 Also, CCPs and CSDs could start offering new services, such as the coordination of the evolution of the permissioned DLT protocol (e.g. modifying or updating source codes), the management and safekeeping of private keys in order to ensure network security, and the management of the introduction or cancellation of tokens on the ledger. Yet, because these services are not core clearing or settlement functions, CCPs and CSDs do not necessarily have a competitive advantage here, and other types of financial institutions could also start offering them.78

(p. 516) As discussed above, DLT systems might bring several important advantages when applied to clearing and settlement, such as reduced counterparty risk, lower settlement fees, simplified operational processes because of fewer intermediaries, and a higher transparency level. Yet, this technology still faces challenges which first might need to be considered before the technology can be fully implemented. For instance, in order to increase transparency and trust in the DLT system, all information on the transactions in the ledgers can be observed by all system participants and copied into their own ledgers. All participants would then be aware of all the existing transactions and their details, such as the value and volume of the assets being bought. When applied to financial markets, this transparency might cause a privacy or competition issue, and thus breach applicable laws, such as the General Data Protection Regulation.79 Certain solutions, such as advanced encryption and obfuscation techniques, are currently being explored in order to enhance participants’ privacy together. Obfuscation and encryption techniques enable participants—or a central authority, depending on whether the system is permissioned or not—to validate the transactions by performing mathematical computations without having a view on the exact inputs and outputs of the computations. An example is homomorphic encryption, where the asset quantities for a transaction may be hidden to all participants except for the sender and recipient of those transactions. In such a case, all participants are, however, still able to verify the validity of the transaction. Another example is the Quorum Platform developed by J.P. Morgan. There, transactions are fully replicated across all nodes, with the database being split into a private and a public database. All the participants concur on the public database, but their private databases differ. Furthermore, the industry is currently experimenting with ‘mixers’, which allow users to pool a set of transactions in unpredictable combinations, thereby making the tracking of identities more difficult.80 A potential disadvantage of these techniques is that it might make the detection of insider trading or money laundering more difficult by market regulators and compliance officers as the identity and transaction details are no longer transparent. In contrast, in the absence of proper safeguards, unethical market participants could exploit the shared and public information recorded in the system to conduct unfair market behaviour.

A second vulnerability of DLT is that, as market participants are currently developing their own niche systems, there is a risk that incompatibility issues appear between the different developed systems, leading to fragmentation.81 When each market institution starts using its own proprietary DLT system, more operational risks would occur associated with trying to connect the various systems.82 The lack of standardization could lead to a situation where manual post-trading validation processes are still necessary or (p. 517) become even more important, thereby hampering disintermediation.83 Nevertheless, several market-driven initiatives are currently fostering common DLT protocols and standards. Examples are the HyperLedger Linux Foundation,84 the R3 Consortium,85 the Post-Trade Distributed Ledger Group,86 and the CSD Working Group on DLT.87 Incompatibility issues thus do not seem to be the stopping point for this technology. The establishment of an agreement on standardized DLT solutions, however, is likely to take time and could thus reduce the pace at which this DLT gets implemented. Even more, when existing market participants would want to replace their legacy system with a DLT system, both will need to be interoperable for a short-to-medium period of time.88

As illustrated in this section, the technological challenges of DLT systems, such as fragmentation and privacy issues, are currently being addressed by the industry. It is generally assumed that these risks will cause certain delays but will not be blocking issues. The legal challenges for this technology when applied to clearing and settlement, however, could be a hurdle when not properly addressed. Because of its importance, the rest of this chapter is addressed to these regulatory perspectives and challenges.

Regulatory Developments

Over the past few years, the financial industry has advocated more regulatory guidance (e.g. European CSD Association, ECSDA 2017) and/or an update of the legal framework for providers or users of DLT.89 According to the German Banking Industry Committee (2016), DLT systems indeed function in a fundamentally different manner (p. 518) compared to legacy systems and thus a different regulatory approach could prove useful.90 Existing regulations reflect a conceptualization of the current financial ecosystem, and, at the time existing regulations were drafted, legislators could not have foreseen that DLT could become significant for financial markets.91 However, DLT could pose some novel risks that are not yet properly mitigated by existing regulations.92 For instance, as it is burdensome to correct transaction errors in a distributed ledger, new required procedures would have to be created on how to deal with possible mistakes.93 In addition, requirements covering potential liability issues of users and rules requiring them to put compliance and risk management systems in place could become necessary.94

Several regulatory initiatives have been launched to examine the potential influence of DLT on the (post-)trade ecosystem and to assess the necessity for new requirements or the modification of existing rules. For instance, the European Central Bank’s Target2-Securities (T2S) Harmonization Steering Group chose, in August 2016, to start a task force on DLT to assess the impact on European financial market integration.95 In February 2017, the Bank for International Settlements (BIS) published an analytical framework to examine the usage of DLT in payments, clearing, and settlement.96 The document intends to facilitate markets authorities and central banks to detect the opportunities and risks of DLT in their conceptual, experimental, or implementation phase. Yet, the BIS framework does not include principles to which the industry should adhere.

At the same time, the European Securities Markets Authority (ESMA) published a document outlining its views on DLT in the case where it is applied to financial markets.97 The report discusses the possible risks and benefits of this technology under several scenarios and examines the potential interaction with existing European rules. At the time of the publication of the report, ESMA’s view was that regulatory actions would be premature as the technology is still evolving and the existing number of practical applications is low. In the case that existing clearing and settlement market infrastructures would use DLT as a technological improvement, ESMA foresaw a number of smaller regulatory challenges as the European regulatory framework does not prescribe the type of technology that market infrastructures have to employ and is thus (p. 519) considered as ‘technology neutral’. DLT operationally replacing the current ecosystem of market participants and market infrastructures would necessitate a different view. Permissioned DLT systems would meet two broad legal challenges: (i) existing post-trade regulations could act as a barrier to the introduction of DLT and, in a case where the technology does get implemented, (ii) DLT might introduce prudential and conduct risks that are not sufficiently addressed by the existing regulations.98

In July 2017, the European Commission launched an expertise hub on blockchain technology. This expertise hub started an examination of the feasibility of an EU blockchain infrastructure and investigated the conditions needed to achieve an open, trustworthy, transparent, and EU law-compliant data and transactional environment.99 The European Commission’s Directorate-General for Internal Market, Industry, Entrepreneurship, and Small and Medium Enterprises (SMEs) and its Joint Research Center also launched the #Blockchain4EU project to develop industrial-use cases for DLT and blockchain.100

On 24 September 2020, The European Commission proposed a DLT pilot regime for market infrastructures based on DLT.101 The proposal is part of the digital action plan of the European Commission, which also includes legislative proposals on crypto-assets (MiCA), digital resilience (DORA), and the clarification and amendments of certain related financial services requirements, such as the definition of a financial instrument under MiFID II.102

The DLT pilot regime creates certain exemptions from specific requirements embedded in MiFID II and CSDR103 to allow market infrastructures to experiment with the technology.104 For instance, the DLT pilot regime allows an investment firm or market operator to request its national competent authority whether DLT transferable securities can be admitted to trading, even when they are not first recorded in a CSD. The CSD operating a DLT securities settlement system may then ask its competent authority to be exempted from the application of the CSDR requirements on dematerialized form, transfer orders, securities accounts, the recording of securities, the integrity of the issue, and asset segregation.

The aforementioned exemptions might be considered utile to experiment with a new technology as existing regulations—or at least certain legal interpretations of them—could be considered as a barrier to entry; that is, securities accounts as we currently (p. 520) know them may not exist in a DLT system but existing regulations, such as EMIR105 and CSDR,106 use the terminology without explicitly describing what they should look like and whether there is a legal difference between accounts, records, and/or ledgers. In this sense, these regulations are technology-neutral. Yet, securities on a DLT are not credited on traditional accounts held by a regulated entity and/or intermediary but are rather web accounts realized via electronic annotations.107 Given the definition of a transfer order under the Settlement Finality Directive (SFD)108 and the definition of a securities account under CSDR,109 some Member States might be of the opinion that only double-entry (or multiple-entry) book keepings could be legally considered as accounts and that transfer orders could only happen when legacy ledgers are used. If this is indeed the case, a DLT system without double-entry accounts could potentially not be considered as a securities settlement system. As a consequence, the operator would not be able to obtain an authorization as a CSD and issuers using the DLT system would be in violation of CSDR, Art. 3.110 Other Member States could perhaps be of the opinion that the digital address on a DLT platform to which securities are recorded (i.e. the public keys) can legally be considered as accounts. Because of the lack of clear definitions and possible divergent legal interpretation of the Member States, different views within Europe could arise, leading to a situation where DLT providers would be able to become a CSD in certain countries while not in others. Hence, even when legislators want to be technology-neutral, the interpretation of existing regulations could be such that the law at hand does become a barrier.

Alternatively, market infrastructures might have to keep the securities on securities accounts and tokenize them afterwards into the distributed ledger in order to fulfil the legal requirements, but this process could create additional operational risks. Both EMIR111 and CSDR112 require that CCPs and CSDs keep records and accounts that (p. 521) enable them, at any time and without delay, to segregate in their accounts the securities of their clients from those of any other client and, if applicable, from their own assets. As documented above, security accounts where a debit and/or credit is possible may be considered to be absent in a DLT environment.

The pilot regime then encompasses certain requirements in order to ensure investor protection and protect financial stability. For instance, operators need to establish a business plan including a description of critical staff, technical aspects, and how the performance of functions, services, and activities deviate from an MTF or a securities settlement system (SSS). The latter information has to be provided to the clients, participants, issuers, and/or members of the infrastructure via the infrastructure’s website.

The DLT pilot regime focuses on MTFs, trading and settlement systems (TSS), and SSSs rather than on CCPs. The European Commission is of the view that DLT can allow for nearly real-time settlement, thereby making trading and settlement almost instantaneous. Central clearing is hence not considered as instantaneous trading, and settlement could make counterparty risk nearly absent. Furthermore, OTC derivatives trading is not allowed under the DLT pilot regime. The view that CCPs might still be beneficial to market liquidity, even for equity and fixed-income trading, because of their multilateral netting services is thus not taken into consideration. Yet, multilateral netting done by the CCP can be of utmost importance in stressed market circumstances, given that multilateral netting cancels multiple transactions out between multiple parties, thereby reducing the total notional value of exposure in the market.113 Multilateral netting could happen in a DLT environment when the multi-signature technology is used; that is, multiple participants could agree on the multilateral offsetting of their claims within the market, allowing the system to automatically conduct these tasks.

Besides the fact that OTC derivatives trading is not allowed to be experimented with under the DLT pilot regime, its inclusion would also not have removed all legal barriers; that is, EMIR114 requires standardized OTC derivative contracts to be cleared through a central counterparty. EMIR thus foresees an important role for CCPs in order to reduce counterparty credit risk, granting them a quasi-monopoly. New types of market participants, such as DLT FinTechs operating a permissioned system, may want to enter the market. If they set up a DLT system without a CCP for these types of derivatives, they would be in breach of EMIR. If CCPs would act as validators in a permissioned DLT system, it is still not clear whether the validation of trades, now often conducted by trading venues, would legally be considered as central clearing. In addition to this EMIR requirement, institutions that clear their OTC derivatives through a CCP typically have lower capital requirements. OTC derivatives trades in a DLT environment without a CCP could therefore lead to higher capital requirements for counterparties, which would make DLT systems less attractive.

In addition to the DLT pilot regime, specific new prudential and conducts risks that DLT could introduce might be looked at in the future.115 The potential regulatory (p. 522) barriers discussed above highlight that existing financial regulations were not written with DLT in mind. Legislators were not yet aware that this technology existed—or would even be created—and could thus become important for financial markets. Even if potential regulatory barriers would be eliminated and DLT systems would be operationalized, additional requirements might have to be introduced in new or existing financial legislation in order to address prudential and/or conduct risks introduced by this technology. DLT systems might potentially be secure from a technological perspective but might spread financial risks amongst market participants that were formerly concentrated with a limited number of central institutions.116 These new types of risk need to be formally addressed in order to protect market participants.

BIS shares the opinion that new requirements might have to be introduced, stressing that more work is needed to make sure that the legal underpinnings of DLT arrangements are sound, that their governance is robust, and that appropriate data controls are in place.117 Indeed, DLT might be more efficient with respect to legacy systems but might also turn out to be inferior. For instance, DLTs are immutable, making it difficult to correct transaction errors. New enforceable procedures and governance requirements could be useful in order to deal with possible mistakes both from a governance and a technological perspective.118 For this example, regulators could draft requirements to determine the correcting mechanisms that would apply and the time frame within the error needs to be solved.

In general, new rules that govern participants’ interactions could be reflected upon.119 Examples include requirements on potential liability issues of participants and rules requiring users to put compliance and risk management systems in place. With respect to the underlying software code, requirements and processes regarding changes in the code, and regarding dispute resolution, could be needed. The governance requirements could indicate rules to be followed by the parties setting up the code design, the validators, and the users of the system.120

Finally, more clarification is also needed on the legal status of smart contracts. Until now, only a few legislators, such as those of the state of Arizona, have given a legal status to smart contracts. Even if computer code might be too rigid to allow all contracts to be drafted in an algorithmic way,121 regulators might start examining whether, and how, contract law should be modified for smart contracts to be valid and enforceable, given their automated and deterministic nature. Further reflection is needed on whether smart contracts can ultimately replace existing legal contracts in their entirety (p. 523) or whether they can only be used to automate the execution of the actions that are specified in legal contracts.

Conclusion

DLT has received extensive consideration over the past decade from market participants, financial market infrastructures, and regulators. Because of the possible advantages and efficiency gains of DLT, financial institutions have started to experiment with several proofs of concept in particular niches of the trading and post-trading environment. Also, although not for the trading of OTC derivatives, the European Commission proposed a DLT pilot regime in order for market infrastructures to experiment with the technology.

Nevertheless, despite all pilot cases, financial institutions have yet to prove that DLT is a viable and sustainable solution, and it is currently unclear from the pilot cases whether the trading and post-trading segments will become more intertwined. Moreover, the future role of trading venues, CCPs, and CSDs in a DLT environment is still to be seen. Regarding the trading of OTC derivatives, central clearing could still be useful for hedging purposes until securities and/or cash are irrevocably and finally exchanged. CCPs could also be necessary from a multilateral netting point of view. In addition, CCPs and CSDs could start offering new services, such as the coordination of the evolution of the permissioned DLT protocol (e.g. modifying or updating source codes), the management and safekeeping of private keys in order to ensure network security, and the management of the introduction or cancellation of tokens on the ledger.

Because of the increased interest of applying DLT to securities markets and taking into account that DLT can also introduce new financial risks to the ecosystem, legislators might reflect on drafting new legislation—or adapt existing legislation—in order to mitigate these new risks as much as possible. Specific requirements governing, for example, the interaction between participants, cyber security, and error resolution in an OTC derivatives setting might be explored.(p. 524)

Footnotes:

1  Harish Natarajan, Solvey Krause, and Helen Gradstein, ‘Distributed Ledger Technology and Blockchain’ 2017 1 World Bank Fintech Note 1 (Natarajan et al., ‘Distributed Ledger Technology and Blockchain’).

2  Satoshi Nakamoto, ‘Bitcoin: A Peer-to-Peer Electronic Cash System’, White Paper (2008), p. 1.

3  In this chapter, trading is defined in a broad sense and captures buying and selling one or more financial instruments. This can be done on behalf of clients (i.e. the execution of orders on behalf of clients) or against proprietary capital, that is, dealing on own account. Clearing is defined as in Regulation (EU) No. 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories, [2012] OJ L201/1 (27 July 2012), Art. 2(3) (EMIR) as the process of establishing positions, including the calculation of net obligations, and ensuring that financial instruments, cash, or both, are available to secure the exposures arising from those positions. Settlement is defined in Regulation (EU) No. 909/2014 of the European Parliament and of the Council of 23 July 2014 on improving securities settlement in the European Union and on central securities depositories and amending Directives 98/26/EC and 2014/65/EU and Regulation (EU) No. 236/012, [2014] OJ L257/1 (28 August 2014), Art. 2(7) (CSDR) as the completion of a securities transaction where it is concluded with the aim of discharging the obligations of the parties to that transaction through the transfer of cash, or securities, or both.

4  A trading venue is defined in Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU, [2014] OJ L173/349 (12 June 2014), Art. 4(24) (MiFID II) as a regulated market, a multilateral trading facility (MTF), or an organized trading facility (OTF) (see below for definitions of these types of trading venues). A central counterparty (CCP) is defined in EMIR (n 3), Art. 2(1) as a legal person that interposes itself between the counterparties to the contracts traded on one or more financial markets, becoming the buyer to every seller and the seller to every buyer. CSDR (n 3), Art. 2(1) defines a central securities depository (CSD) as a legal person that operates a securities settlement system referred to in point (3) of Section A of the Annex and provides at least one other core service listed in Section A of the Annex, meaning (i) the initial recording of securities in book-entry system and/or (ii) the provision and maintenance of securities accounts at the top-tier level.

5  Goldman Sachs, ‘Blockchain: Putting Theory in Practice’ (2016), https://www.academia.edu/38946070/Goldman_Sachs_Blockchain_putting_theory_to_practice (accessed 14 April 2023) (Goldman Sachs, ‘Blockchain’).

6  Banco Santander, Oliver Wyman, and Anthemis Group, ‘The Fintech 2.0 Paper: Rebooting Financial Services’ (2015), https://www.oliverwyman.com/our-expertise/insights/2015/jun/the-fintech-2-0-paper.html (accessed 15 November 2021).

7  World Economic Forum, ‘The Future of Financial Services: How Disruptive Innovations Are Reshaping the Way Financial Services Are Structured, Provisioned and Consumed’ (2015), https://www3.weforum.org/docs/WEF_The_future__of_financial_services.pdf (accessed 15 November 2021).

8  See Randy Priem, ‘Distributed Ledger Technology for Securities Clearing and Settlement: Benefits, Risks, and Regulatory Implications’ (2020) 6(1) Financial Innovation 1 (Priem, ‘Distributed Ledger Technology’).

9  Jonathan Watkins, ‘ASX Says DLT Project On-Track for 2023 as Exchange Gets Ticking Off over Clearing and Settlement Issues’, The Trade (23 September 2021), https://www.thetradenews.com/asx-says-dlt-project-on-track-for-2023-as-exchange-gets-ticking-off-over-clearing-and-settlement-issues (accessed 15 November 2021).

10  See https://www2.thecse.com/blockchain (accessed 15 November 2021). A security token offering (STO) can be considered as a public offering in which tokenized digital securities, also called ‘security tokens’, are sold on security token exchanges.

11  Deutsche Bundesbank, ‘DLT-Based Securities Settlement in Central Bank Money Successfully Tested’, press release (24 March 2021), https://www.bundesbank.de/en/press/press-releases/dlt-based-securities-settlement-in-central-bank-money-successfully-tested-861444 (accessed 15 November 2021).

12  Alexander Kristofersson, ‘Clearstream Prepares Shifting Its ICSD to DLT Platform’, PostTrade 360 (8 July 2021), https://posttrade360.com/news/technology/clearstream-prepares-shifting-its-icsd-to-dlt-platform (accessed 15 November 2021).

13  Ajay Singh, ‘Volatility, Settlement Risk and Distributed Ledger Technology’ (28 April 2020), https://medium.com/fairom/volatility-settlement-risk-and-distributed-ledger-technology-b7f3ce6e591a (accessed 15 November 2021).

14  DTCC, ‘DTCC Enters Test Phase on Distributed Ledger Project for Credit Derivatives with Markitserv and 15 Leading Global Banks’, press release (6 November 2018), https://www.dtcc.com/news/2018/november/06/dtcc-enters-test-phase-on-distributed-ledger-project-for-credit-derivatives-with-markitserv (accessed 15 November 2021).

16  See Priem, ‘Distributed Ledger Technology’ (n 8), 1.

17  German Banking Industry Committee, ‘Response to the Consultation on the Distributed Ledger Technology Applied to Securities Markets’ (2016), https://www.esma.europa.eu/press-news/consultations/consultation-distributed-ledger-technology-applied-securities-markets (accessed 14 April 2023).

18  Priem, ‘Distributed Ledger Technology’ (n 8), 1 is written by the same author as this chapter and is thus the main source. See also Christian Chamorro-Courtland, ‘The Future of Clearing and Settlement in Australia: Part II—Distributed Ledger Technology’ (2021). 38 Company & Securities Law Journal 1.

19  Financial Industry Regulatory Authority (FINRA), ‘Distributed Ledger Technology: Implications of Blockchain for the Securities Industry’ (January 2017), https://www.finra.org/sites/default/files/FINRA_Blockchain_Report.pdf (accessed 15 November 2021) (FINRA, ‘Distributed Ledger Technology’).

20  Bank for International Settlements (BIS), ‘Distributed Ledger Technology in Payment, Clearing and Settlement: An Analytical Framework’ (27 February 2017), https://www.bis.org/cpmi/publ/d157.htm (accessed 15 November 2021) (BIS, ‘Distributed Ledger Technology in Payment’).

21  Kariappa Bheemaiah, The Blockchain Alternative (Paris: A. Press, 2017) (Bheemaiah, The Blockchain Alternative).

22  Melanie Swan, Blockchain Blueprint for a New Economy (Canada: O’Reilly, 2015) (Swan, Blockchain Blueprint for a New Economy).

23  Goldman Sachs, ‘Blockchain’ (n 5).

24  BIS, ‘Distributed Ledger Technology in Payment’ (n 20).

25  Rebecca Lewis, John McPartland, and Rajeev Ranjan, ‘Blockchain and Financial Market Innovation’ (2017) 7 Economic Perspectives 1.

26  See Bheemaiah, The Blockchain Alternative (n 21). Also see Euroclear and Oliver Wyman, ‘Blockchain in Capital Markets: The Price and the Journey’ (February 2016), https://www.oliverwyman.com/content/dam/oliver-wyman/global/en/2016/feb/BlockChain-In-Capital-Markets.pdf (accessed 15 November 2023) (Euroclear and Wyman, ‘Blockchain in Capital Markets’). See also Paul Klimos, ‘The Distributed Ledger Technology: A Potential Revamp for Financial Markets?’ (2018) 13(2) Capital Markets Law Journal 194–222 (Klimos, ‘The Distributed Ledger Technology’).

27  Joanna Diane Caytas, ‘Developing Blockchain Real-Time Clearing and Settlement in the EU, US, and Globally’ (2016) Columbia Journal of European Law, http://blogs2.law.columbia.edu/cjel/preliminary-reference/2016/developing-blockchain-real-time-clearing-and-settlement-in-the-eu-u-s-and-globally-2 (accessed 15 November 2021) (Caytas, ‘Developing Blockchain Real-Time Clearing and Settlement in the EU, US, and Globally’).

28  Euroclear and Slaughter and May, ‘Blockchain Settlement: Regulation, Innovation and Applications’ (5 February 016), https://www.euroclear.com/newsandinsights/en/Format/Whitepapers-Reports/BlockchainSettlement.html (accessed 15 November 2021) (Euroclear and Slaughter and May, ‘Blockchain Settlement’). See also Goldman Sachs, ‘Blockchain’ (n 5).

29  See Bheemaiah, The Blockchain Alternative (n 21). See also Swan, Blockchain Blueprint for a New Economy (n 22).

30  Natarajan et al., ‘Distributed Ledger Technology and Blockchain’ (n 1).

31  European Securities Markets Authority (ESMA), ‘Distributed Ledger Technology Applied to Securities Markets’ (2017), https://www.esma.europa.eu/document/report-distributed-ledger-technology-applied-securities-markets (accessed 15 November 2021) (ESMA, ‘Distributed Ledger Technology Applied to Securities Markets’).

32  Michael Mainelli and Alistair Milne, ‘The Impact and Potential of Blockchain on the Securities Transaction Life Cycle’, Swift Institute Working Paper No. 2015-007 (2016), https://www.swiftinstitute.org/wp-content/uploads/2016/05/The-Impact-and-Potential-of-Blockchain-on-the-Securities-Transaction-Lifecycle_Mainelli-and-Milne-FINAL.pdf (accessed 15 November 2021).

33  ESMA, ‘Distributed Ledger Technology Applied to Securities Markets’ (n 31).

34  David Yermack ‘Corporate Governance and Blockchains’ (2017) 21(1) Review of Finance 7.

35  See Bheemaiah, The Blockchain Alternative (n 21; Swan, Blockchain Blueprint for a New Economy (n 22); Ryan Clements, ‘Evaluating the Costs and Benefits of a Smart Contract Blockchain Framework for Credit Default Swaps’ (2019) 10(2) William & Mary Business Law Review 369 (Clements, ‘Evaluating the Costs and Benefits of a Smart Contract Blockchain Framework’.

36  Swan, Blockchain Blueprint for a New Economy (n 22).

37  Bheemaiah, The Blockchain Alternative (n 21). See also Swan, Blockchain Blueprint for a New Economy (n 22).

38  ISDA and Linklaters, ‘Smart Contracts and Distributed Ledger: A Legal Perspective’ (3 August 2017), https://www.isda.org/2017/08/03/smart-contracts-and-distributed-ledger-a-legal-perspective (accessed 15 November 2021) (ISDA and Linklaters, ‘Smart Contracts and Distributed Ledger’).

39  See Fred Niederman, Roger Clarke, Lynda Appelgate, John Leslie King, Roman Beck, and Ann Majchrzak. ‘IS Research and Policy: Notes from the 2015 ICIS Senior Scholar’s Forum’ (2017) 40(1) Communications of the Association for Information Systems 82. See also Roman Beck, Christophe Müller-Bloch, and John Leslie King, ‘Governance in the Blockchain Economy: A Framework and Research Agenda’ (2018) 19(10) Journal of the Association for Information Systems 1.

40  See Priem, ‘Distributed Ledger Technology’ (n 8), 1.

41  Jerry Brito, Houman Shadab, and Andrea Castillo, ‘Bitcoin Financial Regulation: Securities, Derivatives, Prediction Markets, and Gambling’ (2014) 144 Columbia Science and Technology Law Review 144.

42  Ryan Surujnath, ‘Off the Chain! A Guide to Blockchain Derivatives Markets and the Implications on Systemic Risk’ (2017) 22 Fordham Journal of Corporate & Financial Law 257 (Surujnath, ‘Off the Chain!’).

43  See Priem, ‘Distributed Ledger Technology’ (n 8), 1.

44  A regulated market is defined in MiFID II (n 4) as a multilateral system operated and/or managed by a market operator, which brings together, or facilitates the bringing together of, multiple third-party buying and selling interests in financial instruments—in the system and in accordance with its non-discretionary rules—in a way that results in a contract, in respect of the financial instruments admitted to trading under its rules and/or systems and which is authorized and functions regularly and in accordance with MiFID II, Title III (regulated markets).

45  A multilateral trading facility is defined in MiFID II (n 4) as a multilateral system, operated by an investment for or a market operator, which brings together multiple third-party buying and selling interests in financial instruments—in the system and in accordance with non-discretionary rules—in a way that results in a contract in accordance with MiFID II, Title II (authorization and operating conditions for investment firms).

46  An organized trading facility is defined in MiFID II (n 4) as a multilateral system which is not a regulated market or an MTF and in which multiple third-party buying and selling interests in bonds, structured finance products, emission allowances, or derivatives are able to interact in the system in a way that results in a contract in accordance with MiFID II, Title II (authorization and operating conditions for investment firms).

47  EMIR (n 3).

48  MiFID II (n 4).

49  A clearing member is a participant or client of a CCP. Initial margin is the amount of collateral that clearing members need to hold at the CCP in case of central clearing or must exchange bilaterally in order to conduct a transaction. It serves to protect against, for example, the default of the counterparty. Default fund contributions are contributions to the default fund, being the amount of collateral intended to cover losses that exceed the margin collateral and individual clearing members’ default fund contributions in case of a default of a clearing member.

50  Variation margins are the margins being paid (or received, depending on their position) by clearing members to their CCPs based on adverse price movements of the derivative contracts they hold.

51  Surujnath, ‘Off the Chain!’ (n 42), 257.

52  Portfolio reconciliation is a means to ensure that counterparties’ books and records are synchronized and that the effects of trade events, such as novation or amendments, are accurately captured. Portfolio compression is a risk reduction technique where two or more counterparties close some or all of their derivatives and replace them with other derivative contract whose market risk as the same of the combined notional value of all the terminated derivative contracts.

53  See Priem, ‘Distributed Ledger Technology’ (n 8), 1.

54  See Priem, ‘Distributed Ledger Technology’ (n 8), 1.

55  Swan, Blockchain Blueprint for a New Economy (n 22).

56  See Andrea Pinna and Wiebe Ruttenberg, ‘Distributed Ledger Technologies in Securities Post-Trading: Revolution or Evolution?’, ECB Occasional Paper Series No. 172 (2016), https://www.ecb.europa.eu/pub/pdf/scpops/ecbop172.en.pdf (accessed 15 November 2021) (Pinna and Ruttenberg, ‘Distributed Ledger Technologies in Securities Post-Trading’). See also Georgios Patsinaridis, ‘Blockchain Revolution: Mitigating Systemic Risk in OTC Derivatives’, SSRN Working Paper (2018), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3530443 (accessed 15 November 2021) (Patsinaridis, ‘Blockchain Revolution’).

57  See Bheemaiah, The Blockchain Alternative (n 21). See also ESMA, ‘Distributed Ledger Technology Applied to Securities Markets’ (n 31); Euroclear and Slaughter and May, ‘Blockchain Settlement’ (n 28).

58  See Priem, ‘Distributed Ledger Technology’ (n 8), 1.

59  See FINRA, ‘Distributed Ledger Technology’ (n 19). See also Caytas, ‘Developing Blockchain Real-Time Clearing and Settlement in the EU, US, and Globally’ (n 27).

60  Euroclear and Oliver Wyman, ‘Blockchain in Capital Markets’ (n 26).

61  Philipp Peach, ‘The Governance of Blockchain Financial Networks’ (2017) 86 Modern Law Review 1073.

62  A trade repository is defined in EMIR (n 3), Art. 2(2) as a legal person that centrally collects and maintains the records of derivatives.

63  See Surujnath, ‘Off the Chain!’ (n 42), 257.

64  See Patsinaridis, ‘Blockchain Revolution (n 56).

65  See Clements, ‘Evaluating the Costs and Benefits of a Smart Contract Blockchain Framework’ (n 35), 369.

66  See Patsinaridis, ‘Blockchain Revolution’ (n 56).

67  A wallet can be defined as a device, physical medium, (cloud) service, or program to store the public and/or private keys for cryptocurrencies and/or tokens.

68  See Priem, ‘Distributed Ledger Technology’ (n 8), 1.

69  Katya Malinova and Andreas Park, ‘Market Design for Trading with Blockchain Technology’, Working Paper (7 July 2016), http://blockchain.cs.ucl.ac.uk/wp-content/uploads/2016/11/Paper_18.pdf (accessed 15 November 2021).

70  Gareth Peters and Guy Vishnia, ‘Overview of Emerging Blockchain Architectures and Platforms for Electronic Trading Exchanges’, SSRN Working Paper (10 November 2016), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2867344 (accessed 15 November 2021) (Peters and Vishnia, ‘Overview of Emerging Blockchain Architectures’).

71  See Goldman Sachs, ‘Blockchain’ (n 5) and see Euroclear and Oliver Wyman, ‘Blockchain in Capital Markets’ (n 26).

72  Paola Fico, ‘Virtual Currencies and Blockchains: Potential Impacts on Financial Market Infrastructures and on Corporate Ownership.’ SSRN Working Paper (22 February 2016), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2736035 (accessed 15 November 2021) (Fico, ‘Virtual Currencies and Blockchains’).

73  Peters and Vishnia, ‘Overview of Emerging Blockchain Architectures’ (n 70).

74  Emiolios Avgouleas and Aggelos Kiayias ‘The Promise of Blockchain Technology for Global Securities and Derivatives Markets: The New Financial Ecosystem and the Holy Grail of Systemic Risk Containment’ (2019) 20 European Business Organization Law Review 81–110.

75  Randy Priem, ‘CCP Recovery and Resolution: Preventing a Financial Catastrophe’ (2018) 26(3) Journal of Financial Regulation and Compliance 351–365.

76  Priem, ‘Distributed Ledger Technology’ (n 8), 1. See also Pinna and Ruttenberg, ‘Distributed Ledger Technologies in Securities Post-Trading’ (n 56).

77  Pinna and Ruttenberg, ‘Distributed Ledger Technologies in Securities Post-Trading’ (n 56).

78  Priem, ‘Distributed Ledger Technology’ (n 8), 1.

79  Regulation (EU) No. 2016/679 of the European Parliament and of the Council of 27 April 2016 on the protection of natural persons with regard to the processing of personal data and on the free movement of such data, and repealing Directive 95/46/EC (GDPR). See Primavera de Filippi, ‘The Interplay between Decentralization and Privacy: The Case of Blockchain Technologies’ (2016) 9 Journal of Peer Production 1.

80  Rainer Böhme, Nicolas Christin, Benjamin Edelman, and Tyler Moore, ‘Bitcoin: Economics, Technology and Governance’ (2015) 29(2) Journal of Economic Perspectives 213.

81  Goldman Sachs, ‘Blockchain’ (n 5).

82  Pinna and Ruttenberg, ‘Distributed Ledger Technologies in Securities Post-Trading’ (n 56).

84  The main objective of HyperLedger is to achieve cross-industry collaboration with the focus on generating improved performance of the DLT systems being developed. Among the members of the initiative are: ABN Amro, Bank of New York (BNY) Mellon, ANZ Bank, CLS Group, CME Group, DTCC, Deutsche Börse Group, J.P. Morgan, State Street, Swift, and Wells Fargo.

85  The R3 Consortium consists of more than 200 companies, including Barclays, Banco Bilbao Vizcaya Argentaria (BBVA), Goldman Sachs, J.P. Morgan, BNY Mellon, Bank of America, Commerzbank, Deutsche Bank, HSBC, and Unicredit. The Consortium has created an open-source DLT system called Corda.

86  The Post-Trade Distributed Ledger Group is a group of almost forty financial institutions, including financial market infrastructures, which acts as a forum to collaborate and share best practices.

87  The CSD Working Group on DLT is a consortium comprising of Russia’s National Securities Depository, Switzerland’s SIX Securities Services, the Nordic subsidiary of NASDAQ, Chile’s Depósito Central de Valores (DCV), South Africa’s Strate, and Argentina’s Caja de Valores. Together with Swift, this working group is considering the use of ISO 20022 standards for e-proxy voting in order to foster interoperability amongst DLT solutions and legacy systems.

88  Priem, ‘Distributed Ledger Technology’ (n 8), 1.

89  See ECSDA, ‘ECSDA Response to the European Commission Consultation on Fintech’ (2017), https://ecsda.eu/archives/5344 (accessed 15 November 2021). See also German Banking Industry Committee, ‘Response to the Consultation on the Distributed Ledger Technology Applied to Securities Markets’ (2016), https://www.esma.europa.eu/press-news/consultations/consultation-distributed-ledger-technology-applied-securities-markets (accessed 14 April 2023) (Banking Industry Committee, ‘Response to the Consultation on the Distributed Ledger Technology Applied to Securities Markets’); Polish Bank Association, ‘Response to the Consultation on the Distributed Ledger Technology Applied to Securities Markets’ (2016), https://www.esma.europa.eu/press-news/consultations/consultation-distributed-ledger-technology-applied-securities-markets (accessed 14 April 2023); CACEIS, ‘Response to the consultation on the distributed ledger technology applied to securities markets’ (2016), https://www.esma.europa.eu/press-news/consultations/consultation-distributed-ledger-technology-applied-securities-markets (accessed 14 April 2023).

90  German Banking Industry Committee, ‘Response to the Consultation on the Distributed Ledger Technology Applied to Securities Markets’ (n 89).

91  Priem, ‘Distributed Ledger Technology’ (n 8), 1.

92  BIS, ‘Distributed Ledger Technology in Payment’ (n 20).

93  David Evans, ‘Economic Aspects of Bitcoin and Other Decentralized Public-Ledger Currency Platforms’, Coase-Sandor Working Paper Series in Law and Economics No. 685 (2014), https://chicagounbound.uchicago.edu/cgi/viewcontent.cgi?article=2349&context=law_and_economics (accessed 15 November 2021).

94  Dirk A. Zetzsche, Ross P. Buckley, and Douglas W. Arner, ‘The Distributed Liability of Distributed Ledgers: Legal Risks of Blockchains’ (2017) University of Illinois Law Review 1361 (Zetzsche et al., ‘The Distributed Liability of Distributed Ledgers’).

95  ECB Advisory Group on Market Infrastructures for Securities and Collateral, ‘Paper on the Potential Impact of DLTs on Securities Post-Trading Harmonization and on the Wider EU Financial Market Integration’ (September 2017), https://www.ecb.europa.eu/paym/intro/governance/shared/pdf/201709_dlt_impact_on_harmonisation_and_integration.pdf (accessed 28 June 2018).

96  BIS, ‘Distributed Ledger Technology in Payment’ (n 20).

97  ESMA, ‘Distributed Ledger Technology Applied to Securities Markets’ (n 31).

98  Priem, ‘Distributed Ledger Technology’ (n 8), 1.

99  European Commission, ‘Study on Opportunity and Feasibility of a EU Blockchain Infrastructure’ (2017), https://ec.europa/eu/digital-single_market/en/news/study-opportunity-and-feasibility-eu-blockchain-infrastructure (accessed 8 November 2017).

100  Susana Nascimento, Alexandre Polvora, and Joana Sousa Lourenço, ‘Blockchain for Industrial Transformations’ (2018), http://publications.jrc.ec.europa.eu/repository/handle/JRC111095 (accessed 15 November 2021).

101  European Commission, ‘Proposal for a Regulation of the European Parliament and of the Council on a pilot regime for market infrastructures based on distributed ledger technology’, COM/2020/594 final (2020), http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52020PC0594 (accessed 15 November 2021).

102  MiFID II (n 4).

103  CSDR (n 3).

104  Randy Priem, ‘A European DLT Pilot Regime for Market Infrastructures: Finding a Balance between Innovation, Investor Protection, and Financial Stability’, SSRN Working Paper (7 October 2021), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=3919484 (accessed 15 November 2021).

105  EMIR (n 3).

106  CSDR (n 3).

107  Fico, ‘Virtual Currencies and Blockchains’ (n 72).

108  EC, Directive 98/26/EC of the European Parliament and of the Council of 19 May 1998 on settlement finality in payment and securities settlement systems, [1998] OJ L 166. A transfer order is defined as (i) any instruction by a participant to place at the disposal of a recipient an amount of money by means of a book entry on the accounts of a credit institution, a central bank or a settlement agent, or any instruction which results in the assumption or discharge of a payment obligation as defined by the rules of the system or (ii) an instruction by a participant to transfer the title to, or interest in, a security or securities by means of a book entry on a register or otherwise.

109  CSDR (n 3) defines a securities account as an account on which securities may be debited or credited.

110  CSDR (n 3), Art. 3 (book-entry form) states that any issuer established in the Union that issues, or has issued, transferable securities which are admitted to trading or traded on trading venues has to arrange for such securities to be represented in book-entry form as immobilization or subsequent to a direct issuance in dematerialized form. Where a transaction in transferable securities takes place on a trading venue, the relevant securities have to be recorded in book-entry form in a CSD on or before the intended settlement date unless they have already been so recorded. Where transferable securities are transferred following a financial collateral arrangement, those securities have to be recorded in book-entry form in a CSD on or before the intended settlement date unless they have already been so recorded.

111  EMIR (n 3), Art. 39(1) states that a CCP has to separate records and accounts that shall enable it, at any time and without delay, to distinguish in accounts with the CCP the assets and positions held for the account of one clearing member from the assets and positions held for the account of any other clearing member and from its own assets.

112  CSDR (n 3), Art. 38(1) mentions that for each securities settlement system it operates, a CSD shall keep records and accounts that shall enable it, at any time and without delay, to segregate in the accounts with the CSD, the securities of a participant from those of any other participant and, if applicable, from the CSD’s own assets.

113  Patsinaridis, ‘Blockchain Revolution’ (n 56).

114  EMIR (n 3)

115  See Priem, ‘Distributed Ledger Technology’ (n 8), 1.

116  Zetzsche et al. ‘The Distributed Liability of Distributed Ledgers’ (n 94), 1361.

117  BIS, ‘Distributed Ledger Technology in Payment’ (n 20).

118  ESMA, ‘Distributed Ledger Technology Applied to Securities Markets’ (n 31).

119  Zetzsche et al. ‘The Distributed Liability of Distributed Ledgers’ (n 94), 1361.

120  Priem, ‘Distributed Ledger Technology’ (n 8), 1.

121  It is often impossible to include clauses as ‘in good faith’ or ‘commercially reasonable manner’ in a smart contract. The key philosophical question is whether these clauses where discretion is possible should be eliminated via the use of smart contracts. Without them, legal uncertainty could be reduced, but, on the other hand, their absence reduces flexibility and discretion of one of the contracting parties, which might be useful in case of unforeseen circumstances. See ISDA and Linklaters, ‘Smart Contracts and Distributed Ledger’ (n 38).