THE FINTECH EDITION - Queen Mary University of London · the FinTech Edition. This is a dedicated...

THE

FINTECH

EDITION

2019

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The FinTech Edition © 2019

Editors

Professor George A Walker

Jin Enyi, LLB (Hafnia), Cand.jur, LLM (Lon), HD, PhD Candidate

Assistant

Bella Qiuyu Han, BSc Mathematics

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CONTENTS

3 FOREWORD

5 ABSTRACTS

6 THE EMERGING DIGITAL CURRENCY LAW IN CHINA

(Zexing Song)

8 A CRITICAL ANALYSIS OF ICOS AND THE ROLE OF TOKENS, SWITZERLAND’S

REGULATION AS A MODEL

(Gabriele Teodoro)

10 BLOCKCHAIN REVOLUTION AND ITS IMPACT ON THE LENDING INDUSTRY

(Caterina Marinelli)

11 THE WILD-WEST PHENOMENON OF ICOS

(Nabila Iquebal)

13 MUSIC COPYRIGHT MANAGEMENT ON BLOCKCHAIN: ADVANTAGES AND

CHALLENGES

(Tam Ngoc Linh Tran)

15 LEGAL CHALLENGES AND RESPONSES TO DISTRIBUT-ED LEDGER TECHNOLOGY

(DLT) IN THE CLEARING AND SETTLEMENT OF SECURITIES: A STUDY FROM THE COLOMBIAN SECURITIES MARKET AND THE MERCADO INTEGRADO LATINO AMERICANO (MILA)

(Felipe Salazar Acero)

16 REGULATING DIGITAL CURREN-CIES: A COMPARATIVE ANALY-SIS IN THE US, UK, EU AND CHINA

(Ryan P Burton)

18 SELECTED PAPERS

19 COLLUSIVE BEHAVIOR IN PERMISSIONED BLOCKCHAINS

(Ching Tat Chan)

58 DLTS IN CURRENT EU FINANCIAL MARKET INFRASTRUCTURES:

RESTRICTED OR UNRESTRICTED NETWORK? A LEGAL PERSPECTIVE

(Salvatore Pantaleo)

96 DISTRIBUTED LEDGER TECHNOLOGY AND ASSET SECURITISATION: AN ANALYSIS OF

THE BENEFITS AND THE REGULATORY CHALLENGE TO THIS FRAMEWORK

(Victor Da Silveira Vieira)

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NURTURING

ACADEMIC AND

PROFESSIONAL

EXCELLENCE

This is the second iteration of the FinTech Edition. This is a dedicated digital academic and professional research journal focusing on the latest developments in the Law of Financial Technology (FinTech) and associated Regulatory Technology (RegTech). These are exciting and fast changing times and areas of current development. Sub-stantial market revision and adjustment is expected in all fields of financial services as a result of the relentless power of innovation and new technology. Change is inevitable. It is only a question of how severe the accompanying disruption will be. Banking and financial services and markets will be materially impacted by major innovation in associated technology. This specifically includes BigTech and CoreTech as well as other continuing areas of advance, for example, in relation to automation and robotics, Big Data analytics, machine read-ing (MR), machine learning (ML), machine intelligence (MI), and artificial intelligence (AI) more generally, as well as quantum computing, nanotech-nology, biotechnology and synthetic biology or cyborgs.

A new digital world has been created which is dominated by the impact of innovation and technology on older legacy systems. A new technosphere has been constructed. New advances continue to be achieved in areas of distributed ledger technology, including blockchain technology, based on decentralisation and distribution, automation and smart function, and with the endless digitalisation, disinter-mediation, dematerialisation, immobilisation and personali-sation of financial products and services.

"THE FUTURE IS NOW”

While this brings substantial benefit, it also results in significant new risk and exposure. A large number of new legal and regulatory challenges have arisen that have still to be properly examined and fully resolved. It is hoped that the FinTech Edition will become a leading reference tool in this area. The articles are made up of a selection of the highest quality research papers produced by exceptionally talented grad-uate Master of Law (LLM) degree students during 2017-2018. An increasingly large number of students wish to research complex issues and advanced problems in the FinTech and RegTech related areas.

We congratulate all of the contributions selected and must thank all of the candidates involved. We would also express our warmest gratitude to Simmons & Simmons and our other partners for supporting our joint collaborative Student Support Programme. We would also thank our dedicated editorial team for all of their work on this and our other continuing research projects. We very much hope that readers and users will find the studies provided in this second edition valuable and insightful and assist their own understanding and command of this complex and difficult subject. The future is now.

Yours faithfully, Dr George A Walker

Professor of International Financial Law Centre for Commercial Law Studies

London, June 2019

FOREWORD

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ABSTRACTS

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THE EMERGING

DIGITAL CURRENCY

LAW IN CHINA

Zexing Song, LLM

University of Glasgow

For the full paper please contact

[email protected]

With the rise of digital coin technology,

substantial business entities prefer to

apply this technology in the aspect of

financing in order to improve their

business and financial capabilities. The

rising Initial Coin Offering (ICO) projects

generally promise high returns or high

utility value of their issued digital coins (or

private digital coins) that written in the

project whitepapers. However, with the

lack of prompt regulations and legislations

by official authorities, a great number of

fraudulent projects or inferior projects

have participated in the ICO market, which

has incurred losses of investors and has

further amplified financial risks. This

involves the equivocal legal nature of

digital currency and the lack of responsible

regulatory bodies. Besides, most ICO

projects are currently in the initial stage,

the subsequent regulations towards these

projects remain regulatory gaps. There are

also further regulative and legislative

issues with regard to the operation of

digital currency.

This paper aims to give a theoretical

analysis on the forthcoming digital

currency regulation and legislation in

China, with the emphasis of the legal

nature, the macroeconomic impacts and

the possible regulatory and legislative

issues of digital currency. To explain the

necessity of regulating the digital currency

market, the context of digital coins and the

technology within digital coins are

introduced with the evaluation of digital

coin advantages and disadvantages. Also,

the representative countries that

regulating digital currency are presented,

with the focus on Chinese pilot projects

relating to digital currency regulation and

the Central Bank Digital Currency (CBDC

or official digital coins) proceeded by

People’s Bank of China. Next, this paper

proposes a range of feasible regulatory

paths and legislative approaches, following

the reality of Chinese regulatory and

legislative issues. In conclusion, it further

recommends a regulatory balance between

private digital coins and official digital

coins.

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A CRITICAL ANALYSIS OF ICOS

AND THE ROLE OF TOKENS,

SWITZERLAND’S REGULATION

AS A MODEL

Gabriele Teodoro, LLM



[email protected]

ICOs and tokens are financial tools based on the

blockchain technology that are revolutionizing the world

of finance. However, the regulatory uncertainty

surrounding these instruments can be exploited by

criminals in order to commit financial fraud. These risks

represent a challenge for financial regulators. This paper

is going to examine the regulatory pattern in three

different contexts: the US, EU, and Switzerland. Then,

after analysing these phenomena and the specific

regulations applied, it will explain the reasons why the

Swiss regulation should be considered a model to follow

internationally.

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The European Law Students’ Association (ELSA) is an international, independent, non-political and non-profit

making organisation run by and for students and recent graduates, interested in achieving academic and

personal excellence in addition to their legal or law-related studies.

ELSA Queen Mary University of London and 300 other local ELSA groups span across 375 European law

faculties, consisting of 50,000 members. ELSA QMUL is very active at our university, organising seminars,

conferences, lectures, international study visits, as well as organising socials for our members.

Specific ELSA activities include:

Summer Law Schools of one week’s duration with 40 hours of academic programme, followed by a social

programme. There are 42 different summer law schools covering numerous topics of law such as medical

law, business law, IP law, etc. Find out more at: https://lawschools.elsa.org/

Student Trainee Exchange Programme (STEP) gives students the opportunity to obtain international

legal work experience. Depending on preference, the schemes last anywhere between 2 weeks to 2 months.

The schemes are usually paid or the accommodation for the trainee is provided. Find out more at:

https://step.elsa.org/

Moot Court Competitions consisting of EMC2, is a simulated hearing of a WTO dispute settlement and

European Human Rights Moot Court Competitions (EHRMCC), pleaded before judges at the European Court

of Human Rights. Find out more at: https://emc2.elsa.org/

Delegations are unique opportunities where ELSA delegates are sent to international institutions such as the

UN and WTO. The delegates gain insight to the daily work of recognised international organisations and

experience drafting of international legal documents first-hand. Find out more: https://delegations.elsa.org/

For more information, please visit www.elsa.org

ELSA QMUL contact

E-mail: [email protected]

Facebook: fb.com/elsaqmul

Twitter: twitter.com/elsa_qm

10 of 134

BLOCKCHAIN REVOLUTION AND

ITS IMPACT ON THE LENDING

INDUSTRY

Caterina Marinelli, LLM



[email protected]

The interactions between individuals, organisations and

countries are regulated by contracts and transactions,

which are the foundation of our economic, legal and

political systems. However, these processes imply

excessively complicated administrative bureaucracies,

which have not been updated over the years. Moreover,

they still rely on inefficient paper documents and third-

party intermediaries, which make them unnecessarily

onerous and expensive.

Blockchain has reshaped the traditional way of

undertaking transactions, introducing innovation and

efficiency. In particular, one of its advantages is the

possibility to record data permanently, stored with a

digital signature in shared and transparent databases that

are impossible to tamper with. Therefore, there is no need

for intermediaries.

This dissertation aims to verify how this revolution will

affect the lending industry, identifying the inefficiencies of

the current processes of raising money and demonstrating

how blockchain is able to fix them and improve their

efficiency.

In doing so, this dissertation answers the question of how

blockchain has impacted on the lending market, in

particular demonstrating how it improves three different

areas of lending, i.e. corporate lending (analysing two

such lending types, namely equity crowdfunding and peer

to peer lending), retail lending and lending in the

wholesale market, examining the syndicated loan market.

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THE WILD-WEST

PHENOMENON OF ICOS

Nabila Iquebal, LLM



[email protected]

Blockchain technology is revolutionising the

world. Since the first Initial Coin Offering in 2013,

more than 21 billion dollars have been raised to

date. Although the importance of Initial Coin

Offerings is undeniable, little attention has been

paid to both the “economic and regulatory

landscape” of Initial Coin Offerings. This paper

aims to answer: To what extent should tokens be

regulated? This will be gauged by looking at the

valuation of crypto-assets, and the regulatory

approach regarding Initial Coin Offerings by the

United States of America, the European Union

and the United Kingdom. Overall the current

situation for Initial Coin Offerings is not optimal

for both investors and companies. Hence, specific

Initial Coin Offering regulation is necessary and

urgent. Moreover, it is crucial that the chosen

approach does not hinder innovation. Bearing

that in mind, the regulatory approach suggested

is a model based on the ideas of disclosure and

transparency that addresses the predominant

risks of Initial Coin Offerings, namely, investor

and consumer protection, financial stability,

money laundering and terrorism-financing.

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– INSPIRING THE NEXT GENERATION –

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MUSIC COPYRIGHT MANAGEMENT

ON BLOCKCHAIN: ADVANTAGES

AND CHALLENGES

Tam Ngoc Linh Tran, LLM



[email protected]

The emergence of music blockchain-based platforms is

revolutionising the music landscape. These platforms can

enable rightholders to transact directly with users without

the need for the middlemen, namely collective management

organisations. It is expected that blockchain could help to

solve the historic problems, which are associated with the

dominant position of such intermediaries in the right

management system. However, blockchain still attracts

much debate on its practical constraints. Meanwhile, the

music community is still left in the dark of blockchain’s legal

implications. Accordingly, the benefits and drawbacks of

blockchain application in the management of copyright and

related rights are investigated in this research.

Concurrently, this research adds to the current sparse

literature on blockchain’s legal aspects by examining the

new form of right management on blockchain and analysing

its associated legal obstacles. On this basis, the

understanding of the real promise of blockchain application

in the music industry can be elevated. In addition,

recommendations are presented with a view to ameliorating

the legal barriers of blockchain-based platforms.

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LEGAL CHALLENGES AND RESPONSES TO DISTRIBUTED

LEDGER TECHNOLOGY (DLT) IN THE CLEARING AND

SETTLEMENT OF SECURITIES:

A STUDY FROM THE COLOMBIAN SECURITIES MARKET

AND THE MERCADO INTEGRADO LATINO AMERICANO

(MILA)

Felipe Salazar Acero, LLM



[email protected]

New technology has changed the way we perceive financial services today. New technology

companies are taking part in a new market, offering different alternatives to allocate and channel

resources through the use of apps and internet platforms. Mobile payment, issuance of securities,

asset management and money transfer are some of the sectors where traditional finance services

are migrating to a new types of virtualized financial markets that are growing day by day. These

new alternatives could bring efficiencies, as well as cost reduction in capital flows within the

economy, but they also may create systemic risks thanks to the lack of regulations and

supervision, which has permitted a regulatory arbitrage with high potential to affect financial

market stability.

Post-trading of securities, particularly clearing and settlement infrastructure is one of the most

popular areas where the use of Distributed Ledger Technology is being contemplated, in efforts to

reduce intermediations and costs in the value chain and to increase efficiencies in the entire

process. This article analyses the legal implications and explores the challenges that regulators

should consider when migrating to this new technology applied to the post-trading infrastructure,

mainly focused in Colombian capital market and The Mercado Integrado Latinoamericano (MILA).

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REGULATING DIGITAL

CURRENCIES: A COMPARATIVE

ANALYSIS IN THE US, UK, EU

AND CHINA

Ryan P Burton, BA (Wash), LLM (LG), LLM (Glas)

University of Glasgow


[email protected]

After the creation of the notorious Bitcoin cryptocurrency,

an increased number of digital currencies have proliferated

due to the attractive peer-to-peer and decentralized

structure. This has created an abundance of challenges for

regulatory authorities on a national and international level.

In the ever-developing sphere of FinTech and digital

currencies, the mass emergence of new terminology has

led to inevitable misunderstandings and misuse of terms

by individuals, institutions and governments. In law,

precision of words both written and spoken is essential.

Often when cutting-edge technological innovations arise,

laws and regulation can’t keep pace with the fast-changing

new technology. Clarification and harmonization in

defining these terms can reduce confusion and create a

less complicated environment to develop appropriate legal

remedies to efficiently manage the new digital era. This

paper seeks to conduct an overview of FinTech and its

many applications, analyze the legal distinction between

cryptocurrencies as actual currency versus a security

interest, provide a comparative analysis of the legal

framework of cryptocurrencies and ICOs in the US, EU, UK,

and China, and offer proposed remedies to mitigate risk

without stifling innovation.

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SELECTED PAPERS

1. COLLUSIVE BEHAVIOR IN PERMISSIONED BLOCKCHAINS

Ching Tat Chan, LLB, LLM

Degree awarded with distinction by Queen Mary University of London

Contact: [email protected]

2. DLTS IN CURRENT EU FINANCIAL MARKET INFRASTRUCTURES:

RESTRICTED OR UNRESTRICTED NETWORK? A LEGAL PERSPECTIVE

Salvatore Pantaleo



3. DISTRIBUTED LEDGER TECHNOLOGY AND ASSET SECURITISATION:

AN ANALYSIS OF THE BENEFITS AND THE REGULATORY CHALLENGE TO THIS FRAMEWORK

Victor Da Silveira Vieira, LLM



mailto:[email protected]

mailto:[email protected]

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COLLUSIVE BEHAVIOR IN PERMISSIONED BLOCKCHAINS

Ching Tat Chan

ABSTRACT

This paper identifies several collusive behavior that firms may engage within permissioned blockchains.

It examines how firms may exploit the architecture of blockchain such that it becomes possible for them

to participate in such conducts. It analyzes the applicability of EU competition law in these scenarios and

argues that the existing law should be able to deal with the challenges posed by the technology rather

comfortably. The purpose of this paper is to identify the antitrust pitfalls in permissioned blockchains so

that users of blockchain technology may understand the legal risks the use of the technology may pose.

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TABLE OF CONTENTS

1. Introduction

2. Chapter One: Blockchains i. Distributed Ledgers ii. Shared Control of Data iii. Participation Criteria iv. Consensus Protocols v. Immutability vi. Conclusion

3. Chapter Two: Explicit Collusion i. Explicit Collusion ii. Cartel & Information Exchanges iii. Cartel, Smart Contract & IOT iv. Collective Boycotts v. EU Competition Law Application

4. Chapter Three: Concerted Practice

i. Concerted Practice & Information Exchanges ii. Information Exchanges in Permissioned Blockchains iii. EU Competition Law Application

5. Chapter Four: Anticompetitive Foreclosure

i. Consensus in Blockchains ii. Consensus Protocols in Permissioned Blockchains iii. Foreclosure in Permissioned Blockchains iv. EU Competition Law Application

6. Further Research

7. Conclusion

Bibliography

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INTRODUCTION

Blockchains is one of the buzzwords in 2017. Their best-known use is for cryptocurrency such

as Bitcoin, which its unexpected rise and fall has led to increased public interest in digital currencies in general

and their underpinning technology.1 While commentators remain skeptical about cryptocurrency’s long-term

viability, it is well recognized that the technology underpinning Bitcoin – Blockchain – has potential for far

broader applications. It has been suggested that “the way blockchain-based currency transactions create fast,

cheap and secure public records means that they also can be used for many non-financial tasks”. 2

Consequently, some have already been investigating the possibility of applying the technology in areas such

as e-voting, land registry, and the supply chains. While some of these initiatives are government-led, most of

them are funded by private companies.

Indeed, there is a growing number of firms working together to develop commercial applications

using the technology. It is increasing popular for firms to form blockchain consortia, i.e. a group of companies

that join together, seeking to develop and deploy business solutions based on blockchain technology. It has

been estimated that currently there are more than 40 blockchain consortia globally, some of which are formed

by industry leaders.3 An example is Digital Trade Chain (DTC), a blockchain consortium formed by 8 leading

European banks including HSBC, Société Général, UniCredit, and Banco Santander that aims at facilitating

domestic and cross-border commerce for European companies by leveraging the blockchain technology.4

Recently, the consortium announced the establishment of a Joint Venture company, we.trade, that will be

responsible for managing the DTC blockchain network.5 Another example is the R3 blockchain consortium.

Launched in 2015, over 80 of the world’s largest financial institutions, such as HSBC, Bank of America, and

Merrill Lynch, and central banks come together for the purpose of developing blockchain applications to

1 BBC, ‘Bitcoin falls below $6,000’ (BBC News, 6 February 2018) <https://www.bbc.co.uk/news/technology-42958325> last accessed 14 August 2018 2 European Parliamentary Research Service, How Blockchain Technology Could Change Our Lives (Science and Technology Options Assessment 2017) 4 3 Deloitte University Press ‘Banding Together for Blockchain: Does It Make Sense for Your Company to Joint a Consortium?’ (Deloitte University Press 2017) 2 4 KBC Group, ‘KBC and Cegeka Trial Ground-Breaking Blockchain Application for SMEs’ (KBC Group, 12 July 2016) <https://newsroom.kbc.com/kbc-and-cegeka-trial-ground-breaking-blockchain-application-for-smes> last accessed 14 August 2018; The eighth bank, Banco Santander, joined in 2017 5 KBC Group, ‘Digital Trade Chain Consortium Launches we.trade, Announces Joint Venture and Welcomes Santander’ (KBC Group, 17 October 2017) <https://newsroom.kbc.com/digital-trade-chain-consortium-launches-wetrade-announces-joint-venture-and-welcomes-santander> last accessed 14 August 2018

https://www.bbc.co.uk/news/technology-42958325

https://newsroom.kbc.com/kbc-and-cegeka-trial-ground-breaking-blockchain-application-for-smes

https://newsroom.kbc.com/digital-trade-chain-consortium-launches-wetrade-announces-joint-venture-and-welcomes-santander


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address specific business challenges in different industries, including shipping, healthcare, insurance and

financial services. As such, it seems there is a trend that firms are “banding together for blockchain”.6

While in general the emergence of blockchain consortia is a good idea in the sense that everyone is

contributing to release the full potential of the blockchain technology, the fact that firms, especially industry

leaders, are now “assembling together” for blockchains may seem odd for antitrust regulators.7 As with any

new technology, competition authorities are paying close attention to the development of the blockchain

technology. Indeed, two aspects of the technology may raise competition concerns. Firstly, blockchains as a

digital distributed ledger. From a competition law perspective, particularly when several competitors are found

sharing the same blockchain network, such functionality may be regarded as a mechanism to coordinate

collusive behavior because members of the blockchain network may share sensitive information that is capable

of reducing the strategic uncertainty in the market. Secondly, the ‘decentralized’ nature. One of the key

characteristics of the technology is that multiple parties may interact with each other directly without the

presence of a trusted single entity. In enabling this, there are mechanisms in place that help members of a

blockchain network to reach consensuses before making collective decisions. However, it might be the case

that such mechanisms could be exploited by members a blockchain network such that certain members could

no longer use the network effectively. As such, firms may engage in some conducts in blockchains that may

go against competition law principles, and thus prohibited by competition authorities.

This paper aims to identify the antitrust pitfalls in permissioned blockchains and discuss the

applicability of EU competition law in this regard. While the relationship between permissionless blockchains

and competition law is equally interesting, this paper focuses only on permissioned blockchains. Moreover,

the focus of the paper is on competition issues that arises from the architecture of the blockchain technology.

In other words, competition concerns that are unique to blockchains. As such, other antitrust considerations,

such as standard setting and unilateral conduct by a dominant firm, will not be discussed.

6 Deloitte University Press (n 3) 2 7 Adam Smith once famously said: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivances to raise prices […] But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies, much less to render them necessary”; Adam Smith, The Wealth of Nations (Book IV, Chapter VIII, W.Strahan and T. Cadell 1776) 660

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The paper is divided into four chapters. After this Introduction, it commences by providing an overview

of the blockchain technology. In Chapter Two, it explores explicit collusion in the context of permissioned

blockchains. Chapter Three discusses how members of a blockchain network may share information on a

blockchain, while Chapter Four focuses on anticompetitive foreclosure that take place in a permissioned

blockchain. Before ending with a conclusion, the paper explores other areas that is worth to conduct further

research.

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CHAPTER ONE: BLOCKCHAINS

This Chapter provides an overview of the blockchain technology. In general, the technology presents five

key characteristics which can be understood in terms of (a) distributed ledgers, (b) shared control of data, (c)

participation criteria, (d) consensus protocols, and (e) immutability. These features will be outlined in turn below.

The Chapter concludes by providing a summary of how a typical blockchain network run.

Distributed Ledgers

At its simplest, blockchains are digital ledgers that combine certain cryptographic technologies.8

Blockchains can be utilized to record every type of transaction involving value, including money, goods and

property. In the case of Bitcoin, the technology is being used to store the details of every transaction and stops

the same Bitcoin from being ‘double spent’. However, rather than being maintained and stored by a central

entity, this digital ledger is ‘distributed’ to all members of the network. In essence, information that is stored in

a blockchain network will be automatically replicated and shared among the users of the network. In other

words, blockchains enable sharing of data.

Shared Control of Data

In fact, the need of ‘sharing of data’, whether users need to have data access in real-time or not, has

already been solved prior to the invention of blockchains. Consider Cloud Storage. In general, it enables users

to upload data to a network of remote, connected servers, which can then be accessed, modified and shared

across multiple devices by the users. The technology here typically does not involve the blockchain technology.

Being a distributed ledger at its core, a blockchain is capable of sharing data, although the mechanism is

different from the one that is used in Cloud Storage. However, central to the blockchain technology is not the

notion of ‘sharing of data’.

What is fascinating about blockchains is that it enables ‘shared control of data’. This is a new notion. In

the past, data on a digital database is controlled by a single entity.9 As such, at technical level, the stored data

can be modified only when the controlling authority executes the request. For example, in Cloud Storage,

8 In other words, while blockchains are a form of distributed ledgers, it is not true that all distributed ledgers are blockchains. To qualify as a blockchain, a distributed ledger must deploy certain technologies, in particular the hash function. 9 Amazon Web Services (AWS), ‘Cloud Storage’ (AWS, 2018) <https://aws.amazon.com/what-is-cloud-storage/> last accessed 14 August 2018

https://aws.amazon.com/what-is-cloud-storage/

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although it seems users have control over their own data, the stored data is ultimately controlled by the entity

which maintains the severs, although its activities will be constrained by legal and contractual obligations. In

other words, when a user ‘modifies’ his/her own data, the changes are actually made by this single entity.

Accordingly, it can be said that we typically rely on a trusted authority to maintain our records.

In blockchains context, rather than putting control on the hands of a single entity, data are jointly controlled

by the parties according to a set of pre-agreed rules, known as ‘consensus protocols’. In general, consensus

protocols are sets of rules that facilitate members of a blockchain network to reach a consensus regarding how

data should be handled, in particular whether a proposed transaction should be appended to the blockchain.

Accordingly, control is shared in the sense that the power of how data should be dealt with is not vested in a

single entity, but on the hands of all members of the network.

Participation Criteria

In general, there are three types of members in a blockchain network.10 Firstly, the ‘miners’. These are

members who assemble data (e.g. transactions) into blocks and propose blocks to be added on the blockchain.

Secondly, the ‘nodes’. These members are responsible for storing the ledger and validating new blocks. Lastly,

the ‘users’, who are the end users of the functionality of the blockchain technology.

Blockchains can be largely categorized into two models, namely permissionless and permissioned.11 The

only difference between these models relates to who can participate in what. In the permissionless model,

anyone is free to join the network, free to propose new blocks, and free to maintain the ledger. In other words,

such model is completely open such that anyone can be a miner, a node, or a user. An example of the

permissionless model is Bitcoin.

The permissioned model on the other hand can be understood as a closed platform with a defined number

of participants. Typically, only authorized parties can join the network. Therefore, members in the network are

usually known and trusted by each other. Permissioned blockchains can be configured to impose further

10 Jean Bacon and others, ‘Blockchain Demystified’ [2017] Queen Mary University of London, School of Law, Legal Studies Research Paper No. 268/2017, 20 – 21 11 Ramesh Gopinath, ‘Checking the Ledger: Permissioned v.s. Permissionless Blockchains’ (IBM, 28 July 2016) <https://www.ibm.com/blogs/think/2016/07/checking-the-ledger-permissioned-vs-permissionless-blockchains/> last accessed 14 August 2018

https://www.ibm.com/blogs/think/2016/07/checking-the-ledger-permissioned-vs-permissionless-blockchains/

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restraints on the power of the members. Depending on the set-up of the blockchain, it is possible to limit the

power of proposing new blocks and the power of storing the ledger to only a small number of parties.

Consensus Protocols

As mentioned, how data should be handled on blockchains is based on ‘consensus’. In general, before a

miner could propose a new block to be added on the blockchain, he must demonstrate some sort of

‘faithfulness’ such that the proposed block represent the ‘true version’ of the information and he is not malicious.

The nodes will then verify the proposed block individually and, at the end, come to an agreement regarding

whether this block should be appended on the blockchain. Should the nodes validate the block, it will be added

on the blockchain. Otherwise, it will be rejected and sent back to the pool of blocks. The precise rules of a

consensus protocol vary according to the needs of the members of a particular blockchain network, although

consensus protocols such as ‘proof of work’, ‘proof of stake’, and ‘practical Byzantine fault tolerance’ are

commonly used by the blockchain community.

Immutability

Blockchains are immutable in the sense that the content and sequence of the stored data cannot be altered

without being easily detected by other parties in the blockchain. Two elements are key here.

Firstly, hash function. It is a software that converts digital inputs (e.g. a block of transactions) into a string

of digits. This string of digits is known as hash value and is unique to that data item. In other words, the hash

value is effectively the fingerprint of that data item. Importantly, hashing is ‘one-way’ in the sense that it is not

possible to recreate the original input from its hash value. Moreover, if the input data is being modified even in

the slightest, its hash value will be changed as well.

Secondly, blocks. As suggested by its name, data are stored in a blockchain in blocks. Each block thus

contains a bundle of data (e.g. transactions records). However, in addition to data, each block in fact contains

some other items, most notably the hash of the previous block. In other words, the fingerprint of the previous

block is included and forms part of the subsequent block. As a result, this fixes all existing blocks and a tamper-

evident chain of blocks is formed – contents within a block cannot be altered without changing the hash value

of the block. However, any attempt to ‘re-hash’ the block will break the chain between itself and the subsequent

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block as the latter contains the original hash value of that block. Therefore, any tampering will be obvious to a

viewer. Furthermore, as the blockchain technology enables the ledger to be replicated and stored in multiple

locations, this means that all copies of the chain will need to be changed in the same way.

Lastly, it is important to note that data on blockchains is by default not encrypted. Especially when the set-

up of the blockchain requires nodes to certify new blocks, the nodes will need access to the content in the

blocks in order to cross-check with its own local copy of the ledger.

Conclusion

This chapter will be concluded by showing how a typical blockchain network run: (a) After being

authenticated, users of a blockchain network may submit a request to the blockchain network. (b) The message

will be picked up by miners who will pack several transactions together into a block. Miners will then broadcast

this block back to the network and propose it should be added on the blockchain (c) Upon the receipt of the

suggested block, the nodes will verify whether the block contains the valid transactions and references via

hash the correct previous block on their chain.12 (d) Where the nodes come to an agreement that they are

satisfy with the block, they will add the block to the blockchain. Otherwise, the proposed block will be discarded.

12 Konstantinos Christidis and Michael Devetsikiotis, ‘Blockchains and Smart Contract for the Internet of Things’ (2016) 4 IEEE Access 2292, 2293

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CHAPTER TWO: EXPLICIT COLLUSION

This Chapter examines explicit collusion in the context of blockchains. The Chapter will first

provide the definition of ‘explicit collusion’. After that, it discusses three forms of explicit collusion, namely

information exchanges, Smart Contracts & IOT, and collective boycotts. It is then followed by an analysis of

these scenarios under the EU competition law.

Explicit Collusion

Explicit collusion occurs where “undertakings collude, collectively, to exploit their joint economic

power and to improve their profitability”. 13 Explicit collusion may take the form as an anticompetitive

agreement or an anticompetitive concerted practice. Central to notion of ‘explicit collusion’ is that there is direct

communication between the undertakings with the intention to coordinate and/or monitor each other’s actions

for the purpose of raising profits above competitive levels.

Of all explicit collusion arrangements, cartels are seen as the “supreme evil of antitrust”.14

Cartels are explicit attempts to eliminate competition in the market without producing any pro-competitive

effects. Firms to a cartel typically employ means such as price fixing, allocation of production quotas, or sharing

of geographic markets or product markets for the purpose of transferring wealth from consumers to themselves.

These conducts undermine the free market economy and thus provoke hostile reactions from competition

authorities.

Because of the strong attitude of competition authorities towards cartels, it is almost impossible

to identify cartels nowadays. On the bright side, this shows that competition authorities have successfully

created a competition culture, thereby firms are deterred from engaging in conducts that would severely harm

the competition landscape of a market. However, it may also argue that cartels nowadays are working in

secrecy, thereby avoiding being detected by the authorities. Therefore, theoretically, cartels still exist, and it is

likely that they are evolving as well. Blockchains is a buzzword in recent years. As such, there may be a case

that firms may exploit the technology for the purpose of facilitating their collusive behavior

13 Alison Jones and Brenda Sufrin, EU Competition Law: Text, Cases, and Materials (6th edn, OUP 2016) 650 14 Verizon Communications, Inc. v Law Offices of Curtis V. Trinko, 124 S. Ct. (2004) [879]

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Cartel and Information Exchanges

The successful operation of a cartel is dependent on various factors. One of which is effective

mechanisms for coordination.15 After parties have agreed on the course of action that is to be taken on the

market, it is then for them to implement the agreement. In doing so, there is the concern that firms in a cartel

may cheat on the agreement, knowing that, according to the prisoners’ dilemma,16 it will profit the most if it

charges a low price while its competitors are charging a high price. Hence, cartels would design measures to

monitor output and prices of individual certain members in order to detect cheating. In some cases, however,

these measures may detect cheating but in fact it is the market condition that affects the result.17 Building

trust among members is therefore difficult for cartels as, at the least, it may be hard to tell whether or not

someone is cheating. As such, it is essential to have effective mechanisms to facilitate coordination among

the firms.

In this regard, blockchains may represent a solution. The idea is that a blockchain may be

employed solely for the purpose of exchanging strategic information. In the context of explicit collusion,

members of cartel may first agree on the course of action that is to be taken on the market. This will then be

followed by the creation of a permissioned blockchain to exchange sensitive information, such as prices and

sales. Information exchanges in blockchains will be discussed in detail in the next chapter in the context of

concerted practice.

For cartels, the use of permissioned blockchains may enhance coordination between members.

First and foremost, only authorized persons would be able to access to a permissioned blockchain. The then

satisfy the need of secrecy for cartels. Moreover, in blockchains, information is shared directly between the

members without the presence of middlemen. Consequently, this lessen the possibility of miscommunication

or tampering by third parties. Furthermore, blockchains could be transparent in the sense that all information

could be available to all members in the network in real-time. It is believed this would promote trust among

members and reduce the incentive to cheat on the cartel agreement.

Cartels, Smart Contract, and Internet of Things

15 Margaret Levenstein and Valerie Suslow, ‘What Determines Cartel Success?’ (2006) 44(1) Journal of Economic Literature 43, 45 16 ibid. 17 Ibid. 71

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Alternatively, cartels may combine the blockchain technology with smart contracts and Internet

of Things to run a cartel more effectively. Where a smart contract and Internet of Things is placed on a

blockchain, automate process will be enabled.

A smart contract is “a computerized transaction protocol that executes the terms of a contract”.18 In

other words, contractual clauses are translated into computer code which will then be placed on a computer

program that allows it to self-execute. In fact, computer codes that enable automate processes is not a new

concept – we have been able to do the same ever since computers are invented. One example is the monthly

direct debits out of a bank account. However, modern smart contracts take such coding, and combine it with

the potential of the blockchain technology.

Placing a smart contract on a blockchain means this set of computer code will run in an interoperable

and incorruptible computer program. In blockchains context, the computer code executes independently and

automatically on every node in the network in parallel once the predetermined terms and conditions are met,

in particular when the triggering and output events have been checked and verified by the participants.19 As

such, the execution of the smart contract is not controlled by a single entity. Instead, multiple parties are jointly

responsible to update the computer code in order to trigger the automate process and to approve whether the

process should be triggered. Moreover, the computer code is replicated and shared among all members,

rather than within the hands of a single entity. This does not only allow authorized parties to see the computer

code, but more importantly any attempts to modify the computer code will be visible by other participants in

the network. Therefore, should anyone wish to alter the computer code, this must be done jointly by the

members of the blockchain network.

The Internet of Things (IOT) is another technology that is becoming increasingly popular. In

essence, IOT can be understood as “the interconnection via the Internet of computing devices embedded in

everyday objects, enabling them to send and receive data”.20 This network of interrelated electronic devices

18 Nick Szabo, ‘The Idea of Smart Contracts’ (Nick Szabo, 1994) <http://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOTwinterschool2006/szabo.best.vwh.net/idea.html> last accessed 14 August 2018 19 Konstantinos Christidis and Michael Devetsikiotis (n 13) 2296 20 Jon Wood, ‘Blockchain of Things – Cool Things Happen When IOT & Distributed Ledger Tech Collide’ (Medium, 20 April 2018) <https://medium.com/trivial-co/blockchain-of-things-cool-things-happen-when-iot-distributed-ledger-tech-collide-3784dc62cc7b> last accessed 14 August 2018

http://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOTwinterschool2006/szabo.best.vwh.net/idea.html

https://medium.com/trivial-co/blockchain-of-things-cool-things-happen-when-iot-distributed-ledger-tech-collide-3784dc62cc7b

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is typically employed for the purpose of collecting data in its surrounding area, monitoring remotely, or even

interacting with other similar devices and make decisions without human intervention.21 The blockchain

technology may further enhance the functionality of IOT in two ways. Firstly, by placing IOT on a blockchain,

IOT users may then have a verifiable, immutable, and secure method of recording data processed by these

devices. The activities of these devices will also become visible to users. Secondly, it is possible to link

blockchain-based smart contracts by the IOT, thereby enabling automated processes, for example large scale

remote systems management.

It is argued that the combination of the above technologies is particularly appealing to cartels.

Where a blockchain-based smart contract is being used by cartels, firms not only can share information more

efficiently, they could also codify the cartel agreement into the blockchain. As a result, where punishment

mechanisms are agreed into the agreement, the blockchain-based smart contract enable firms to enforce the

punishment more effectively.22 More specifically, when certain conditions indicate that some members deviate

from the agreement, the inserted punishment mechanisms will be triggered, and compensation from the

cheating members will be automatically made to the cartel. As the smart contract is implemented on a

blockchain, there will be no single source of control in relation to cartel agreement. Therefore, unless all other

members approve, the cartel agreement cannot be modified. Consequently, the credibility of the punishment

is increased and the incentives to cheat is deterred. Furthermore, with IOT being connected to a blockchain-

based smart contract, cartel members’ behavior can be monitored by its fellow members remotely and directly

through these smart electronic devices, rather than relying on each other’s self-reporting. When these devices

collect data that signifies that certain members are cheating on the cartel agreement, such data may trigger

the smart contract to impose punishment on these members. As such, for cartels, the combination of IOT,

smart contracts, and blockchains ensures members commit to the agreement and improves the accuracy of

information in relation to members’ behavior.

Collusive Boycott

21 Margaret Rouse, ‘Internet of Things (IOT)’ (IOT Agenda, June 2018) <https://internetofthingsagenda.techtarget.com/definition/Internet-of-Things-IoT> last accessed 14 August 2018 22 Harrington observed that enforcing punishment in cartels may not be as straightforward as first thought. In some cases, some firms may be reluctant to make compensation; Joseph Harrington, ‘How Do Cartels Operate?’ (2006) 2(1) Foundations and Trends in Microeconomics 1, 59

https://internetofthingsagenda.techtarget.com/definition/Internet-of-Things-IoT


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Moving away from cartels, explicit collusion in permissioned blockchains may take the form of

collective boycotts. A collective boycott can be understood as an agreement between a group of competitors

to “exclude an actual or potential competitor”.23 In the blockchains context, a firm may be excluded by other

members of the network via the consensus protocols.

Central to the blockchain technology is the idea of ‘shared control’. As such, whether a

transaction can be settled depends on whether members of the blockchain network agree that the transaction

should be settled. In blockchains language, when a miner proposes a new block to be appended on the

blockchain, the block in question will need to be verified by the nodes independently. The block would only be

added on the blockchain if the nodes reach a consensus regarding its validity. The question is then how much

consensus is required. Normally, in permissioned blockchains, a consensus is reached if 2/3 of the nodes

agree on the same matter24. In other words, a unanimous decision is not required. Accordingly, it is argued

that some firms may utilize this 1/3 ‘buffer’ to exclude their competitors. More specifically, these firms may

agree among each other that they would not verify certain members’ transactions. Alternative, where the they

are not the nodes of the network, they may instruct the nodes to do the same.

EU Competition Law Application

Explicit collusion fall within the scope of, and is prohibited by, Art. 101 TFEU.25 In general, the

provision prohibits certain joint conduct between two or more undertakings “which have as their object or effect

the prevention, restriction, or distortion of competition”.26 While the blockchain technology, along with smart

contracts and IOT, are relatively new concepts, it is argued that existing laws remain applicable to cases where

these technologies are involved.

The notion of ‘agreement’ in EU competition law has been broadly construed. In Bayer, the

Court summarized the notion of ‘agreement’ as emanated in EU case law and suggested that the notion

“centers around a concurrence of wills between at least two parties, the form in which it its manifested being

unimportant so long as it constitutes the faithful expression of the parties’ intention”.27 As such, the notion of

23European Commission, ‘Guidance on Restrictions of Competition “By Object” for the Purpose of Defining Which Agreements May Benefit from the De Minis Notice’ (SWD(2014) 198 final) 11 24 The mechanisms of consensus protocols in permissioned blockchains will be discussed in detail in Chapter Four 25 Article 101 of the Treaty on the Functioning of the European Union 26 ibid. 27 Case T-41/96 Bayer v Commission [2000] ECR II-3383 [69]

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agreement is rather non-formalistic. This then allows competition authorities to utilize the notion in more

imaginative ways. For example, in AEG-Telefunken, the Court confirmed that an agreement exists even if it

was imposed by one party on another unilaterally.28 Crucial to the notion of ‘agreement’ is therefore not the

form taken by the agreement but a joint intention to behave in a way that would restrict competition.

In blockchains context, it then seems firms may ‘accidentally’ ‘agree’ into an anticompetitive

collusion in various ways. For example, the mere fact that a firm agree to participate in a network that aims to

facilitate an anticompetitive agreement may satisfy the element of ‘agreement’. In Cement, it was held that “it

is sufficient for the Commission to show that the undertaking concerned participated in meetings at which anti-

competitive agreements were concluded, without manifestly opposing them, to prove to the requisite standard

that the undertaking participated in the cartel […] The principles […] also apply to participation in the

implementation of a single agreement”.29 Putting this in blockchains context, it appears that where a firm joins

a blockchain network that is set up for the purpose of conducting some anticompetitive collusive activities, it is

argued that such firm will be deemed as one of the participants to that agreement simply because it became

one of the members of the blockchain network even if it actually has no intention to put the agreement into

effect. This remains true even if the firm is capable of adducing evidence showing that its behavior did not

reflect the terms of the agreement, and thus arguing that it did not participate in that agreement. Another

scenario concerns the situation where firms are already in a blockchain network but the anticompetitive

agreement emerges subsequently. A collective boycott case may illustrate this scenario. For example, a

blockchain which contains 9 firms is launched for facilitating normal business operations. Five of the firms

decide to boycott three other members of the network with the remaining firm did not indicate whether or not

it would participate in this collective boycott. According to Cement, it would appear that the mere fact that the

firm remain in silence is sufficient to establish that it is one of the participants to the agreement as it “has given

the other participants to believe that it subscribed to what has decided there and would comply with it”.30 As

such, firms must not only be careful not to explicitly agree to participate in anticompetitive agreements, they

must also mindful of falling into what is known as “passive mode of participation”.31

28 Case 107/82 AEG-Telefunken v Commission [1983] ECR 3151 29 Cases C-204, 205, 211, 213, 217, and 219/00 P, Aalborg Portland AS v Commission [2004] ECR I-123 [81] – [83] 30 ibid. [82] 31 ibid. [84]

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Where it is established that firms are engaging in an explicit collusion, there should be no

dispute that the use of blockchains would not afford a defense. Inherently, blockchains are merely distributed

ledgers. As such, no matter how transformative it may seem, a blockchain is not capable of self-learning. As

such, where anticompetitive agreements are found, humans, instead of the technology, remain as the ‘master-

mind’ of the collusive behavior in question. Where firms exploit the technology to run the cartel more effectively,

a blockchain is simply being used as an ‘extended arms’ of the firms in the sense that “cartel members program

the computers to help effectuate the cartel, and monitor and punish any deviation from the cartel

agreement”.32 This is to be contrast to the “Digital Eye” scenario, whereby “the machines, through self-learning

and experiment, independently determine the means to optimize profit”.33 In other words, computers in the

latter scenario is capable of engaging in ‘collusive behavior’ automatically on behalf of humans. However, in

the blockchains context, humans, as opposed to artificial intelligence, remain to be the main actors, and are

responsible to make decisions. This is still the case even where IOT is involved as these electronic devices

are involved just for the purpose of monitoring any deviation, thereby ensuring the success of the cartel in

question. As such, competition authorities will have no difficulty in relying on the established case law and the

general framework of Art. 101 TFEU to prove its case.

Conversely, a blockchain may in fact become a useful evidence for competition authorities to

strengthen its case. Blockchains’ immutability means that all information that is stored on the network, most

notably records about prices, sales, data collected by IOTs, and the cartel agreement which is embedded on

the blockchain via smart contracts, will be in theory permanently available in the network. Accordingly, when

competition authorities gain access to the blockchain network, a ledger which shows the entire history of the

cartel in question would be resurfaced. The recovered information will then be critical for the purpose of

assessing the scope of the agreement and its competitive outcomes

32 Ariel Ezrachi and Maurice Stucke, ‘Artifical Intelligence & Collusion: When Computers Inhibit Competition’ (2016) 2017(5) University of Illinois Law Review 1776, 1784 33 ibid. 1783

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CHAPTER THREE: CONCERTED PRACTICE

This Chapter primarily concerns information exchanges that take place in a blockchain network.

The Chapter will start by discussing the relationship between concerted practice and information exchange.

The next section explores how members of a blockchain network may share information and the type of

information that is typically shared. The last section analyzes information exchanges in blockchains context

under EU competition law.

Concerted Practice & Information Exchanges

Information exchanges can take place in different context. In general, there are three main

scenarios: (a) Information exchanges as part of an agreement, (b) information exchanges as part of a cartel,

and (c) pure information exchanges.34 An information exchange that is ancillary to an agreement or a cartel

will be assessed in the context of the agreement or cartel in question.35 As far as pure information exchanges

are concerned, such information sharing between undertakings is ‘stand-alone’ in the sense that it is not

dependent on a cartel or an agreement. The focus of this chapter will be pure information exchanges. From

the outset, it is important to note that the law in this area is rather controversial and thus there is no clear rules

for firms to adhere to.

Pure information exchanges are typically assessed as concerted practices under Art. 101 TFEU.

The term ‘concerted practice’ can be understood as a ‘catch-all’ provision that aims to capture undertakings

which seek to evade the application of Art. 101 TFEU by colluding in a way that fall short of an ‘agreement’.

The classic definition of ‘concerted practice’ can be found in Dyestuff,36 in which the Court held that it is “a

form of coordination between undertakings which, without having reached the stage where an agreement

properly so-called has been concluded, knowingly substitutes practical cooperation between them for the risks

of competition”.37 Far from requiring an actual plan to be worked out, the Court in Suiker Unie held that it

would be sufficient if there had been “any direct or indirect contact between operators, the object or effect

whereof is either to influence the conduct on the market of an actual or potential competitor or to disclose to

such a competitor the course of conduct which they themselves have decided to adopt or contemplate adopting

34 Organization for Economic Co-operation and Development, ‘Roundtable on Information Exchanges Between Competitors Under Competition Law’ (DAF/COMP/WD(2010)118 3 35 ibid. 36 Cases 48, 49, and 51–57/69, ICI v Commission [1972] ECR 619 [64] 37 ibid. [61]

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in the market”.38 As ‘concerted practice’ does not require an actual plan, it appears all that is required is the

existence of a “reciprocal cooperation or a joint intention to conduct themselves in a specific way, disclosed

through direct or indirect contact, designed to influence the conduct of an actual or potential competitor or to

reveal to them the course of conduct that will or may be adopted on the market”.39

As such, a reciprocal information exchange may constitute a mechanism for substituting

practical cooperation between the undertakings involved for the risks of competition. The concept of ‘reciprocal’

is however a broad one. In Cimenteries, it was held that the condition is met “where one competitor discloses

its future intentions or conduct on the market to another when the latter requests it or, at the very least

accepts”.40 As such, the concept of information exchange encompasses cases where undertakings have

discussed and communicated their future plans in the market, as well as cases where the conveyance of

information does not involve an express endorsement on the part of all the participants.41 The Court in Tate

& Lyle took this one step further by holding that the condition would be met even where “the participation of

one or more undertakings in meetings with an anticompetitive purpose is limited to the mere receipt of

information concerning the future conduct of their market competitors”.42 Stretching this decision further, it

would appear that the requirement would be satisfied even if an undertaking receives an unsolicited email or

fax from its competitors disclosing their future intention. Therefore, information sharing between undertakings

would be prohibited where it eliminates “the risks of competition and the hazards of competitors’ spontaneous

reactions”.43

Information Exchanges in Permissioned Blockchains

At its core, a blockchain is a distributed ledger. It is therefore natural for members of a

blockchain network to store information on it and share the stored information across the network. In

permissioned blockchains, only trusted nodes will be authorized to store copies of the blockchain. These nodes

38 Cases 40-48, 50, 54-56, 111, 113 & 114/73, Suiker Unie [1975] ECR 1663 [174]; The rationale behind this decision is that the notions of ‘coordination’ and ‘cooperation’ within the definition of ‘concerted practice’ must be understood in the light of a traditional concept that is inherent in EU competition law, that is each economic operator must determine the policy that it intends to adopt on the market in the future independently. 39 Alison Jones and Brenda Sufrin (n 13) 153 40 Cases T-25, 26, 30–32, 34–39, 42–46, 48, 50–71, 87, 88, 103, and 104/95, Cimenteries CBR v Commission [2000] ECR II-491 [1849] 41 Albertina Llorens, ‘Horizontal Agreements and Concerted Practices in EC Competition Law: Unlawful and Legitimate Contacts Between Competitors’ (2006) 51(4) The Antitrust Bulletin 837, 859 42 Case T-202/98, T-204/98 & T-207/98 Tate & Lyle plc v Commission [2001] ECR II-2035 [57] – [59] 43 ICI v Commission (n 31) [119]

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may or may not be the users of the blockchain network. Where a node is a user at the same time, it should be

able to see the stored information anytime it wants. Otherwise, where a user is not a trusted node, it would

have to access the blockchain through a node. In general, new information will be available as soon as the

block carrying the said information has been verified and added to the blockchain. In some permissioned

blockchains, such process could be dealt with within seconds.44 In other words, new information could be

available to all users of a blockchain network almost immediately after a new request is submitted to the

network.

However, it may also be argued that certain users could acquire new information even earlier.

As will be explained in more detail in Chapter Four, it is common to see permissioned blockchains feature a

‘leader’ whose responsibility is to propose blocks to be verified and added on the ledger. Similarly, such leader

may or may not be a user of the blockchain network. Where the leader is a user of the blockchain network at

the same time, he may acquire information as soon as when he is required to verify the proposed transaction.

It is argued that the idea that blockchains are encrypted may be a misleading thought. This is because, as

mentioned in Chapter One, parties that are responsible to certify transactions would require access to at least

a subset of information that is stored in the blocks so that they can cross-check the proposed blocks against

their records in order to verify the transactions. Therefore, it seems unlikely that users of a blockchain network

would encrypt the entire transaction before submitting a request on the network. As such, leaders may obtain

certain information during the transaction verification process and disclose it to other members of the

blockchain network. Alternatively, leaders may add comments, known as ‘noise’ in blockchains language, to

blocks during the verification process, although such comments are unlikely to be useful to others and are not

necessary for the blockchain to function.45 Nodes may then acquire certain information from these comments

when they are asked to confirm these blocks. It is argued that the presence of these two mechanisms allow

members of a blockchain network to gain information before the nodes have updated their local copies of the

ledger.

As mentioned, blockchain can be programmed to record virtually everything of value. Currently,

blockchains are mainly used by businesses to record economic transactions. This entails information such as

44 More details will be provided in Chapter Four. 45 Kiran Desai, ‘Blockchain and Competition Law’ (Law Alert, Ernst & Young LLP 2018) 2

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parties to the transaction, transaction history between the parties, payment, amount, etc. could be found within

a block and, depending on the degree of encryption configured by the parties, such information may be visible

to members of the blockchain network.46 Where however a smart contract is being placed on a blockchain, a

wider variety of information may be found in the blocks. In particular, parties to such a blockchain network

would store information regarding what has occurred, thereby triggering the automated process. As such, what

is actually contained in a blockchain depends on how it is being set-up and how the parties intend to use the

blockchain for.


Pure information exchanges in itself may be sufficient to establish a violation of Art. 101 TFEU

by object. In T-Mobile, it was held that an information exchanges is tainted with an anticompetitive object “if

the exchange is capable of removing uncertainties concerning the intended conduct of the participating

undertakings” and facilitating, directly or indirectly, the fixing of selling prices or any other trading conditions.47

In its Guidance Paper, the Commission summarized information that is capable of reducing certainty in the

market as ‘strategic data’, and such data includes information relating to prices, customer data, sales figures,

individual output.48 As such, where such information is stored on a blockchain, it seems that the very use of

this blockchain network is susceptible to antitrust scrutiny. In particular, competition authorities may deem the

sole purpose of setting up this blockchain network is to coordinate anticompetitive collusive behavior.

Where an information exchange is not found to have its object the restriction of competition, it

may still fall foul of EU competition law if the effect of such exchange is likely to have restrictive effects on the

market. In assessing whether the sharing of information may restrict competition by effect, the Commission

considered that the test is to compare the “likely effect of the information exchange with the competitive

situation that would prevail in the absence of the specific information exchange”.49 For this purpose, regards

will be given in relation to “the economic conditions on the relevant markets and the characteristics of

information exchanged”.50 As far as market characteristics is concerned, the Commission stated that certain

46https://www.blockchain.com/btc/block/0000000000000000062e8d7d9b7083ea45346d7f8c091164c313eeda2ce5db11 shows a Bitcoin blockchain. This provides an insight regarding that is typically stored in a blockchain. 47 Case C-8/08 T-Mobile [2009] ECR I-4529 [37], [43] 48 European Commission, ‘Guidelines on the Applicability of Article 101 of the Treaty of the Functioning of the European Union to Horizontal Co-operation Agreements’ (2011/C 11/01) 19 49 ibid. 16 50 ibid.

https://www.blockchain.com/btc/block/0000000000000000062e8d7d9b7083ea45346d7f8c091164c313eeda2ce5db11

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market conditions would render it easier to sustain coordination. In particular, an information exchange will be

more likely to restrict competition in markets which are “sufficient transparent, concentrated, non-complex,

stable and symmetric”.51 As for the characteristics of information, the more strategic the information the more

likely the Commission will find the exchange restricts competition. In assessing the strategic nature of the

information involved, the Commission will consider factors such as age of the information, aggregation of the

information, market coverage, frequency of the exchange, and the venue where the exchange of information

took place.52

Applying the above to the blockchains context, it is argued that, even if strategic data is not exchanged,

where several competitors are found to be sharing the same blockchain network, it is highly suspicious in the

eyes of competition authorities. Concluding from the previous section, it seems that currently information that

is stored on blockchains primarily relates to firms’ past and current behavior. Although firms’ future intentions

are normally not found in a blockchain network, competition authorities may argue that the existing information

may nevertheless provide the firms a ‘focal point’ at which they can “reach a common understanding about the

terms of coordination”.53 Moreover, such information may also “facilitate stability of collusion by enabling

monitoring of deviations”.54 Accordingly, where the existence of parallel conduct between undertakings is

established, competition authorities may argue that such conduct is the result of coordination based on the

information exchanged on a blockchain network. In other words, blockchains may well become a ‘plus factor’

for competition authorities to conclude that the parallel conduct in question is the result of coordination.

Where a blockchain network is held to be a mechanism that facilitates coordination between

undertakings, whether it is by effect or by object, it is argued that the leader will be held liable as well even if

he is not a member of the cartel. EU competition law precludes any direct or indirect contact between

undertakings which aims at influencing each other’s conduct on the market. Therefore, any indirect exchange

of information between undertakings (the ‘spokes’) that take place through an intermediary (the ‘hub’) is also

prohibited. For example, in JJB Sports plc,55 it was held that a concerted practice in the context of ‘hub and

spoke’ arrangements may be established where (a) a retailer intended that the information be passed on by

51 ibid. 17 52 Para. 19 – 21 53 Organization for Economic Co-operation and Development (n 29) 2 – 3 54 ibid. 55 JJB Sports/ All Sports v Office of Fair Trading [2006] EWCA Civ 1318

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the supplier, (b) another retailer knew that the information had been provided by the first retailer, and (c) the

second retailer used that information in setting its conduct in the market.56 In the blockchains context, nodes

or users of a blockchain network will be regarded as the spokes, whereas the leader will be deemed as the

hub. Where a case of ‘hub and spoke’ arrangement is established, the hub may be held liable as well.57

However, there are two areas that competition authorities must pay attention to when proving the

existence of a concerted practice in the context of an online system, which arguably includes the blockchain

technology. Firstly, while the concept of ‘reciprocal’ is widely defined and clearly covers the sharing of

information in blockchains context, it nonetheless has limits. The case Eturas concerned an allegation of

coordination that was taken place via an online travel booking system used by more than 30 travel agents in

Lithuania.58 The Court was asked whether the fact that a message, which concerns the capping of the level

of online discounts which the travel agents should grant to customers, was sent via a personal electronic

mailbox on the online system is sufficient to establish that its addressees became or should have become

aware of its content and by fail to oppose the application of such a discount restriction they acquiesced in a

way that would be held liable for engaging in concerted practices.59 Central to this case was the contention

by the applicants who argued as they had not opened and read the message they could not be presumed to

have been aware of the message and so could not have engaged in a concerted practice. In its response, the

Court suggested that “infringements of competition law are subject to the presumption of innocence”. 60

Accordingly, where there is no evidence that the applicants have actually read the message, competition

authorities are precluded from inferring that they ought to have been aware of the content of the message

simply from the mere dispatch of the message. As such, it seems that one lesson can be learnt from this case

is that ‘actual awareness’ is one of the essential elements to demonstrate that an information exchange has

taken place. Applying this in the blockchains context, it is argued that, in order to show that parties to a

blockchain network have shared information, competition authorities must show the users have actually read

their local copies of the ledger. This is particularly true where a user could only access to the blockchain

through a node.

56 ibid. [91] 57 In Case AT. 39861 Yen Interest Rate Derivatives, the Commission sanctioned ICAP as one of its borker facilitate the cartel in question by serving as a conduit for collusive communications 58 Case C-74/14 Eturas UAB v Lietuvos Respublikos konkurencijos taryba EU:C:2016:42 59 ibid. 25 60 Ibid. 23

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Another area competition authorities must pay regards to is the line of case law relating to Business-

to-Business (B2B) e-marketpalces. B2B e-marketplaces are “software systems that allow industrial buyers and

sellers to transact business online over the Internet through a central node”.61 While B2B e-marketplaces

increase communication and transparency in the market, the flipside of the coin is that it is susceptible to being

exploited as a platform for exchanging strategic data between competitors. Nonetheless, the Commission

recognizes the pro-competitive effects of such marketplaces and has largely accepted that such platforms do

not infringe Art. 101 TFEU. For example, in Volbroker, the Commission cleared the creation of an electronic

brokerage service for trading foreign currency options after the founding firms gave several undertakings to

the Commission which aimed at “building ‘Chinese walls’ between the joint venture operating the exchange

and the parent companies which are active as market participants”.62 As such, it seems that the Commission

is in principle not against the use of e-marketplaces as long as the anticompetitive concerns had been dealt

with. Perhaps more guidance could be found in Covisint.63 After clearing the establishment of an automotive

e-marketplace, the Commission commented it is satisfied with the potential competition concerns had been

eliminated, particularly because the platform is “open to all firms in the industry on a non-discriminatory basis,

is based on open standards, allows both shareholders and other users to participate in other B2B exchanges

[…]”.64 It is argued that the Commission’s approach regarding e-marketplaces may to some extent reflect

where the law will stand in relation to blockchain networks. The blockchain technology largely produces the

same pro- and anticompetitive effects as B2B e-marketplaces do: On one hand, it enhances communication

and transparency, improves efficiency, and reduces costs. On the other, it may be exploited to facilitate

collusion. As such, it is believed information exchanges that is taken place in the context of blockchain networks

may not rise competition concerns as long as the Commission is satisfied that the anti-competitive concerns

have been eliminated, especially those as set out in Covisint.

61 Joachim Lücking, ‘B2B E-Marketplaces: A New Challenge to Existing Competition Law Rules?’ (Paper Presented at the Conference “Competition Law and the New Economy” at the University of Leicester 2001) 1 62 ibid. 7 63 Comp/38.064, IP/01/1155 Covisint Automotive Internet Marketplace 64 EU Commission, ‘Commission Clears the Creation of the Covisint Automotive Internet Marketplace’ (Comp/38.064, IP/01/1155 2001) <http://europa.eu/rapid/press-release_IP-01-1155_en.htm?locale=en> last accessed 14 August 2018

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CHAPTER 4: ANTICOMPETITIVE FORECLOSURE

In this Chapter, we will see how firms may collectively exclude a firm from participating in a

permissioned blockchain through the consensus protocols. The first part of this Chapter explores the notion of

‘consensus’. It will then be followed by a detailed explanation of consensus protocols. The final two section

discusses how firms could be excluded in a blockchain network and the applicability of EU competition in this

respect.

Consensus in Blockchains

Consensus is the heart of the blockchain technology. The notion of ‘consensus’ can be

understood as a state of agreement on which all or a majority of people agree. The lack of trust inherent in the

technology is particularly relevant to the notion. In a blockchain network, all authorized parties can propose a

transaction to be added to the ledger. While parties to permissioned blockchains are in theory more

collaborative, the possibility that some may betray their counterparts and disrupt the blockchain operation

cannot be precluded. It is therefore necessary for the nodes of a blockchain network to evaluate and agree on

the transactions before they are permanently incorporated into the blockchain. As such, the notion of

consensus plays a key role in determining whether the blocks store the ‘true version’ of a group of transactions.

Here, it is important to note that the concept of ‘truth’ as applied to blockchains does not refer to the traditional

understanding of the word. It merely means that the nodes are in agreement or consensus that the transaction

or event in question has happened. Accordingly, what has been agreed as valid by the nodes does not

necessarily mean that it has actually taken place. As long as an agreement is reached among the nodes, a

block could be appended to a blockchain. To some extent, this shows the process of adding blocks to a

blockchain “may be arbitrary or even controlled by an adversary”.65 In any case, the notion of consensus

enables multiple untrusted parties in a blockchain network to directly interact with each other without the

presence of a trusted intermediary. Achieving consensus in such a distributed system however is not an easy

task. For this purpose, a pre-agreed set of rules, known as ‘consensus protocols’ in blockchains language,

must be designed.

Consensus Protocol in Permissioned Blockchains

65 Shehar Bano and others, ‘SoK: Consensus in the Age of Blockchains’ (arXiv:1711.03936v2 [cs.CR], 2017) 4

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Currently, there are three main consensus protocols: (a) Proof-of-Work (POW), (b) Proof-of-

stake (POS), and (c) Practical Byzantine Fault Tolerance (PBFT). POW and POS are usually used in

permissionless blockchains, although it is also possible to employ these protocols in permissioned blockchains.

In general, POW and POS require miners to demonstrate some proof before proposing a valid block.66 Miners

in POW protocols must invest resources to find the answer to a computationally difficult puzzle, whereas for

POS they must show a ‘stake’ in the system, such as the number of coins held by the miner. Requiring miners

to ‘work’ in order to gain the right to propose new blocks means a high level of security is ensured as miners

who invest resources into updating the blockchain can be seen as a demonstration of good faith. However,

this would also result in a low transaction speed. For example, the Bitcoin protocol, which adopts POW, would

automatically adjust the difficulty of the puzzle.67 Currently, a new block can be added to the ledger only every

ten minutes.68 This is perhaps not ideal for businesses which prefer instant settlements.

It is more common to find permissioned blockchains employ PBFT protocols rather than POW

or POS. Derived from the Byzantine Generals’ Problem, PBFT is a solution for distributed computer networks

to operate as intended and correctly reach consensus despite the disruption of malicious or failing nodes.69

PBFT aims to mitigate the negative consequences of these dishonest participants have on the right consensus

that is reached by the honest parties. In blockchains context, PBFT protocols allow the signing of a block even

when 1/3 of the participants in the network fail or act maliciously.70 The flip side of the coin however is that,

for the protocol to work, the amount of dishonest nodes in the network cannot exceed 1/3 of the overall nodes

in the system at any point of time (the ‘assumption’). In general, instead of requiring miners to prove or

demonstrate something to gain the right of proposing blocks, PBFT protocols usually feature a predefined

validator (or ‘leader’) who is primarily responsible for such task. Accordingly, the leader would perform an initial

computation after it receives a message from blockchains users. It would then multicast the result to all other

nodes and ask them in turn to confirm whether the result is valid. The leader then awaits f + 1 (f = the number

of ‘dishonest’ nodes) replies from different nodes with the same result.71 Assuming the amount of malicious

nodes is less than 1/3 of the overall nodes in the blockchain network, this f + 1 replies should be the decision

66 Jean Bacon and others (n 10) 15 67 Satoshi Nakamoto, ‘Bitcoin: A Peer-to-Peer Electronic Cash System’ (2009) 3 68 Jean Bacon and others (n 10) 14 69 Miguel Castro and Barbara Liskov, ‘Practical Byzantine Fault Tolerance’ (Proceedings of the Third Symposium on Operating Systems Design and Implementation, 1999) 1 70 Christian Cachin and Marko Vukolić, ‘Blockchain Consensus Protocols in the Wild’ (IBM Research – Zurich, 2017) 6 71 Brian Curran, ‘What is Practical Byzantine Fault Tolerance? Complete Beginner’s Guide’ (Blockonomi, 11 May, 2018) <https://blockonomi.com/practical-byzantine-fault-tolerance/> last accessed 14 August 2018

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of the honest nodes. After confirming validation, the predetermined validator would then broadcast the decision

to the network, so that all nodes can update their local copies of the ledger. As such, comparing to POW and

POS protocols, it can be said that PBFT protocols are more centralized. This allows higher transaction speed

however scarifies the requirement of ‘trustless’ to some degree. Hence, it is not suitable for permissionless

blockchains which typically involve dynamic, large scale of unknown participants.

Moreover, PBFT’s centralized nature enables the blockchain to return to the traditional synchronous

protocols. In such protocols, nodes would “agree on a total ordering of the accepted blocks by adding agreed

blocks one at a time”.72 More specifically, they would “ensure every node has updated its copy of the

[blockchain] before moving on to the next block”.73 Contrasting with the asynchronous model typically used

by permissionless blockchains, the former is more capable of guaranteeing consistency between the copies

held by nodes.

Consensus is the backbone of a blockchain. As such, consensus protocols, which manifest how

members of a given blockchain intend to reach consensus, is capable of shaping the characteristics of the

blockchain. Permissioned blockchains normally employ PBFT protocols and synchronous protocol. This then

explains the common features of such blockchain model, which typically include: (a) few number of participants,

(b) static number of participants, (c) operated by known entities, and (d) a level of trust exists among the

participants.

Foreclosure in Permissioned Blockchains

It is argued that the use of PBFT protocols may lead to foreclosure risk, which may be

manifested in two forms: (a) Access refusal, and (b) prioritization.

It is likely that access to a permissioned blockchain will be restricted by members of the

blockchain consortia in question. PBFT protocols perform better when there are few nodes and they are known

to each other due to their centralized nature. Similarly, synchronous protocols work where there is only a

limited number of nodes.74 As such, members of a blockchain network that adopts such protocols would want

72 Jean Bacon and others (n 10) 13 73 ibid. 74 Some suggested that a few tens of nodes is the maximum; Jean Bacon and others (n 10) 13

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to set up the blockchain in a way that only authorized parties can join and participate in the network. In

competition law language, such access control by existing members of the blockchain consortia is known as

gating, and in certain circumstances such conduct may fall foul of EU competition law.

Even if a firm is given authorization to join the network, original members may engage in some

conducts such that the firm is effectively being precluded from using the technology. For example, they may

configure the blockchain so that the new entrant only has limited permission to store the blockchain and add

new blocks. Moreover, since PBFT protocols require merely 2/3 members come to an agreement for the

purpose of signing new blocks instead of demanding a unanimous consensus, it would also be possible that a

firm’s proposed transactions are all rejected by other members without objective cause. As such, while a firm

may be granted access to the blockchain network, original members of the network may still constructively

refuse certain parties, thereby preventing them from participating in the blockchain network meaningfully. To

some extent, these conducts can also be seen as collective boycott.

Foreclosure in permissioned blockchains may also take the form of prioritization. In essence,

prioritization can be understood as certain members’ transactions are given precedence over the others. The

issue of ‘prioritization’ in blockchains, in some way, resembles the net neutrality debate. The EU described net

neutrality as “a non-discrimination principle, requiring that all electronic communication passing through an

internet service provider (ISP) network is treated equally”.75 In other words, without net neutrality, ISPs would

be free to offer varying levels of connectivity to content providers at different price range. Naturally, a multi-

tiered Internet system may emerge, and this would create competition concerns. For example, start-ups that

could not afford for the ‘best connection’ service would have to resort to the ‘standard connection’ which in turn

may lead to poorer accessibility and speed of access to its products.

Similarly, ‘prioritization’ in a blockchain would create at least a two-tiered system, whereby certain

members’ transactions would be dealt with more efficiently. In PBFT protocols, it is necessary for a

predetermined validator or leader to first verify the proposed transaction before broadcasting the results to

other nodes for confirmation. When working in conjunction with the synchronous protocol, this would mean

75 Tambiama Madiega, ‘The EU Rules on Network Neutrality: Key Provisions, Remaining Concerns’ (European Parliament Research Service 2015) 1

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that transactions can only be verified one at a time in order to ensure new blocks would be added to the

blockchain in the same logic. As a result, a ‘queue’ for transactions verification would be formed. Depending

on the precise set-up of the blockchain, the leader may be given discretion in determining whether any of such

transactions should be given priority. It would then be possible that the leader may work in an unfair or bias

way, for example favors corporate affiliations over the others, so that the clearance of transactions of certain

members would always go first. Alternatively, certain members of the blockchain network may collude with the

leader in order to ensure their transactions are given preferences over the others. In any event, distinguished

from the collective boycott situation as discussed in Chapter Two, all transactions in this case would be verified,

although some may be processed later than the others. Consequently, members whose transactions are

inferior to the others would feel that they are being placed at a competitive disadvantage position.


Traditionally, anticompetitive foreclosure is dealt with by Art. 102 TFEU. However, it is argued

that the provision may be ineffective in blockchains context. Competition authorities must therefore seek

alternate recourses.

It is clear that the Commission intended to prohibit anticompetitive foreclosures by Art. 102

TFEU.76 In its Guidance Paper, the Commission described foreclosure as “a situation where effective access

of actual or potential competitors to supplies or markets is hampered or eliminated as a result of the conduct

of the dominant undertaking”. 77 Importantly, EU competition law targets not just ‘foreclosure’ but

‘anticompetitive foreclosure’, thus it requires such exclusion of competitors to have “an adverse impact on

consumer welfare”. 78 Considering the wordings used by the Commission, in particular ‘dominant’ and

‘conduct’, it can be said that the definition fits more comfortably with Art. 102 TFEU, which was designed to

prohibit unilateral abusive conduct of undertakings in a dominant position. Therefore, for the purpose of

establishing anticompetitive foreclosures under Art. 102 TFEU, two elements are crucial: (a) Abuse, which in

this case would be the anticompetitive foreclosure, and (b) a dominant position. However, it may be

problematic to demonstrate the element of ‘abuse’ in the blockchains context.

76 Article 102 of the Treaty on the Functioning of the European Union 77 European Commission, ‘Guidance on the Commission’s Enforcement Priorities in Applying Art. 82 of the EC Treaty to Abusive Exclusionary Conduct by Dominant Undertakings’ (2009/C 45/02) [19] 78 ibid.

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Abuse

The conducts identified in the previous section can be analyzed under a line of EU case law

known as “refusal to supply”. In general, where a dominant undertaking refuse to supply its products or services

or grant access to its facilities it may infringe Art. 102 TFEU. Moreover, the notion of refusal to supply includes

constructive refusals, i.e. where the supply, known to the supplier, is unacceptable or unduly delayed.79

Although EU competition law does not impose a duty to dominant undertakings requiring them to supply

products or services to whoever requests them to do so, in certain situations a refusal to supply constitutes an

‘abuse’. Of relevance here is the situation of ‘essential facility’ doctrine.

At its simplest, the concept of ‘essential facility’ denotes the situation where a competitor need access

to something that is owned or controlled by a dominant undertaking such that the former can provide products

or services to its customers. In B&I/Sealink,80 the very first case that saw the expression ‘essential facility’

being used, the Commission, after defining ‘essential facility’ as “a facility or infrastructure without access to

which competitors cannot provide services to their customers”,81 stated that where a dominant undertaking

refuses its competitors access to such facility or grants access to them only on less favourable terms “thereby

placing the competitors at a competitive disadvantage” infringes Art. 102 TFEU.82 The principle was then

applied in several subsequent cases decided by the Commission. It is argued that, with hindsight, the doctrine

was in fact used in even earlier cases. For example, the Commission in London European/ Sabena decided

that Sabena’s refusal to grant London European access to its Saphir system, an online system which

“streamlined the procedure of travel agents to consult flight schedules, fares and seat availability of airlines

included in the system, and to make reservations”, constitutes an abuse of its dominant position in the relevant

market.83 To some extent, the online system in this case is similar to a blockchain network in the sense they

are both ‘online platforms’ in the broadest sense. Thus, it can be argued that the Commission would have no

difficulty in concluding a blockchain network is an ‘infrastructure’ for the purpose of satisfying the ‘essential

facility’ test.

79 Napier Brown/ British Sugar [1998] OJ L284/41 80 IV/34.174, Sealink/B&I Holyhead: Interim Measures 11 June 1992 81 ibid. [41] 82 ibid. 83 London-European/ Sabena [1988] OJ L317/47

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The ‘essential facility’ doctrine represents a powerful intrusive measure for competition authorities

such that it can force dominant undertakings to share its valuable assets or resources where necessary.

Unsurprisingly, as it may severely interfere an undertaking’s rights, the Court halted the expansion of the

doctrine. In Bronner, the Court held that access to a facility would be ordered only in very limited

circumstances.84 In particular, such order would only be permitted where the refusal is likely to “eliminate all

competition” in the market on the part of the person requesting the service or product and that the access must

be “indispensable to carry on that person’s business, inasmuch as there is no actual or potential substitute in

existence” for it.85 As such, Bronner sets a high hurdle for invoking the ‘essential facility’ doctrine: the refusal

has to be likely to ‘eliminate all competition’, but not merely leading it ‘more challenging’ to compete; the access

must be ‘indispensable’, but not merely ‘desirable’.

While a blockchain could be regarded as a ‘facility’ for the purpose of ‘essential facility’, it is argued it

would be difficult to invoke the doctrine as a whole in the blockchains context. The following example may

provide an illustration. Several European banks, including one major bank, form a blockchain consortia for the

purpose of facilitating interbank payments. The traditional way of clearing interbank payments remains

available, although in comparison it would be much slower and costly. Accordingly, being a member of the

blockchain consortia may be necessary if a bank wants to be competitive in the market in question. Where it

is being refused access to the blockchain, it appears this constitute an abuse. Here, the blockchain seemingly

represents an important facility without access to which the bank may not be able to effectively provide services

to its clients. However, according to Bronner, the ‘essential facility’ test is in fact not satisfied. Having access

to the blockchain is merely desirable for the bank but not indispensable as the traditional way of settling

payments is still available. The fact that the traditional way is much slower and costly does not mean that all

competition has been eliminated. On the contrary, it is just more difficult for the bank to compete with its rivals.

As such, it is argued that it would be a daunting task for competition authorities to prove a blockchain is an

‘essential facility’.

Similar conclusion can be made in relation to the issue of ‘prioritization’. The problem of ‘prioritization’

is also a case of a refusal to supply in the sense that the blockchain is set up in a way that some of its member

84 Case C-7/97 Oscar Bronner GmbH & Co KG v Mediaprint [1998] ECR I-7791 85 ibid. [41]

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is denied having access to prioritized services. Slightly different from the scenario of ‘access refusal’ as

discussed above, what is at stake here is the ability to have access to prioritized services. Nonetheless,

Bronner remain to be applicable: prioritization is not indispensable as there is an alternative method being

available, namely non-prioritized transaction verification; the presence and availability of non-prioritized

transaction verification means that competition is not eliminated in its entirety. Accordingly, it is almost certain

that, under the current law, dominant undertakings are not prohibited from providing prioritized services.

Collective abuse

Even if the element of ‘abuse’ is seemingly established, it may not amount to an abuse of a collective

dominant position. It is settled law that ‘one or more undertakings’ in Art. 102 TFEU can refer to economically

independent undertakings which together hold a ‘collective dominant position’ in the market, provided that they

are “united by […] economic links”.86 The notion of ‘economic links’ must be understood broadly such that

“from an economic point of view they present themselves or act together on a particular market as a collective

entity”.87 In other words, the form of ‘collaboration’ between such undertakings is irrelevant. Rather, as long

as they hold themselves out as a collective entity and act together independently of their competitors, the

requirement of ‘collective dominance’ will be satisfied. Given this broad view of the links required to establish

a finding of collective dominance, it is argued that the presence of undertakings within the same blockchain

network may represent as a plus factor for competition authorities to demonstrate that a collective entity indeed

exists. The question is then whether this collective entity holds a dominant position. If this is answered in

affirmative, then it would be necessary to consider whether the requirement of ‘collective abuse’ is satisfied.

Central to the issue of anticompetitive foreclosure in the context of blockchains is that the exclusion is

conducted by multiple parties collectively, yet the case law on what amount to abuse by collective dominant

entities is underdeveloped. For example, in TACA the Court simply held that, on the facts, the Commission

failed to demonstrate that the undertakings could induce potential competitors wishing to enter the market to

join the TACA by the measures in question without further explaining the legal rationale behind.88 It is

therefore uncertain whether a collective decision refusing to supply an undertaking in general would be

86 Cases T-68, 77, and 78/89, Società Italiano Vetro SpA v Commission [1992] ECR II-1403 [357] 87 Joined cases C-395 and C-396/96P, Compagnie Maritime Belge Transports SA and others v. Commission (‘Cewal’), [2000] ECR I- 1365 [36] 88 Cases T-191 and 2120214/98 Atlantic Container Line v Commission [2003] ECR II-3275

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deemed as an abuse of collective dominance. Where however the ‘essential facility’ doctrine is successfully

invoked, it is possible that refusing to grant access to a blockchain network could amount to abuse. This is

because in such scenario, given all competition has been eliminated, it is arguable that the exclusionary

conduct engaged by the firms would “hinder the maintenance of the degree of competition existing in the

market or growth of that competition”, thereby strengthening the collective dominant position.89 However, as

mentioned, it would not be an easy task to invoke the doctrine. Accordingly, it seems questionable whether

the concept of abuse, which has been primarily developed in the context of individual dominant firm, is the

ideal mechanism for the propose of prohibiting practices that may facilitate or stabilize a collusive strategy

engaged by several undertakings in the market.

In any case, it seems difficult to explain a collective decision to refuse to supply to an undertaking

without considering the element of collusive behavior. For example in both Compagnie Maritime Blege and

TACA the Commission had found that the parties did engage in some liner conferences before embarking the

alleged abusive conducts. Moreover, in proving these cases, the Commission in essence simply recycled the

facts of the Art. 101 infringement to demonstrate a violation of Art. 102 TFEU. As such, it is argued that, to a

large extent, cases that involve collective abuse overlaps with Art. 101 TFEU. Against this backdrop, it

therefore appears that Art. 101 TFEU may be more relevant when it comes to anticompetitive conducts in

blockchains context. Indeed, in Chapter Two, the paper showed that the notion of ‘agreement’ in fact capable

of encompassing far more context, including unilateral conduct by one firm to another; in Chapter Three, the

paper stated that the notion of ‘concerted practice’ must be understood broadly, in particular it seems the only

way for firms to escape being scrutinized by competition authorities under the application of concerted practice

is to demonstrate that they had decided their future conducts in the market independently. Accordingly, these

broad and liberal definitions allow competition authorities to apply Art. 101 TFEU to capture all sort of loosely

formalized forms of cooperation. It is therefore argued that Art. 101 TFEU is perhaps the better venue to prove

anticompetitive foreclosures in permissioned blockchains.

89 C-209/10 Post Danmark I EU:C:2012:172 [24]

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FURTHER RESEARCH

Before moving on to the conclusion, this paper would like to highlight its limitation and

recommend an area for further research.

This paper has primarily focused on the ex post regulation of blockchain networks. Indeed,

competition law is typically regarded as an ex post market regulation tool in that competition authorities react

only after the emergence of anticompetitive practices. In blockchains context, as can be seen, Art. 101 and

potentially Art. 102 TFEU would be invoked after the formation of blockchain network and after anticompetitive

conducts are observed. The question is then whether competition authorities would regulate these networks

prior to their establishment?

Beyond Art. 101 and 102 TFEU, European Merger Control Regulation (EUMR) may be deemed by

the regulators as a useful tool to regulate blockchains network ex ante. In general, the current EUMR prohibits

‘concentrations’ with an EU dimension that would impede effective competition in the internal market or a

substantial part of it. In other words, the purpose of EUMR is to prevent changes in market structure that would

have a negative impact on the competition landscape in the internal market. As far as the notion of

‘concentration’ is concerned, it has been widely defined in order to cover mergers, acquisitions of control, and

the creation of full-function joint ventures.90 Of relevance for the blockchains context is the last point – joint

ventures. Art. 3(4) EUMR provides that a joint venture will give rise to a concentration where the following

conditions are met: (a) its parent companies reserve joint control on the joint venture, (b) lack of autonomy in

the joint venture, and (c) the joint venture is not intended to operate on a lasting basis.91 As mentioned in the

introduction, firms, including market leaders, are now working together for the purpose of developing the

blockchain technology for commercial applications. Some blockchain consortium, such as the Digital Trade

Chain, have even emerged into joint ventures that operate in the reality. As such, where the joint venture is in

essence a sham for the firms to strengthen their dominant positions in the market, it may appear that the EUMR

may be applicable in blockchains context, enabling competition authorities to adopt pre-emptive measures on

blockchain networks.

90 Article 3(1) and (4) European Merger Control Regulation 91 Article 3(4) European Merger Control Regulation

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However, the application of EUMR in blockchains context may not be as straightforward as first

thought. Art. 2(3) EUMR requires that competition authorities to demonstrate that the concentration would

“significantly impede effective competition in the common market or in a substantial part of it, in particular as

a result of the creation or strengthening of a dominant position”.92 This then entails that competition authorities

must make an assessment in the market in question, in particular it must decide what the market in question

is and the market power of the firms is involved. Similar assessment has to be done under Art. 102 TFEU and

it has been proven that this may be a tricky task. The question is then whether the fact that blockchain

technology is employed would make this assessment easier or even more difficult. As such, there are a number

of gaps in our knowledge around blockchain and merger control and thus it is believed that further research

focusing on this area would be beneficial.

92 Article 2(3) European Merger Control Regulation

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CONCLUSION

This paper has examined how firms may exploit the architecture of blockchains such that it

becomes possible for them to participate in certain collusive behavior. Two features of the technology are

particularly relevant. Firstly, blockchain as a distributed ledger. Secondly, blockchains’ consensus protocols,

in particular the PBFT protocol.

In Chapter Two, the implication of the blockchain technology on explicit collusion is discussed.

It is suggested that the technology, along with Smart Contracts and Internet of Things, may offer an efficient

way to enforce an explicit agreement with an anticompetitive intention, for example cartel agreements. Outside

the context of cartels, the paper considered that firms may agree to boycott their competitors collectively via

the consensus protocols so that the affected undertakings could not participate in the blockchain network

meaningfully. It is argued that these issues should not pose any difficulty for competition authorities that are

seeking to prohibit such conducts through EU competition law as parties to these agreements remain to be

the main actors and the blockchains are merely tools for these parties to facilitate their agreements.

In Chapter Three, the paper discussed how firms may share information between themselves

on a blockchain. Central here is blockchains’ core functionality: distributed ledger. Accordingly, in blockchains,

information is exchanged simply when firms store records on the blockchain as these records will be replicated

and shared automatically among all members once being put on the network. Under EU competition law,

information exchanges are usually assessed as concerted practice as, according to one of the inherent

competition principles in EU law, firms must formulate their future conduct in the market independently. It is

recognized that the law is this area is not settled and currently there is no bright-line rule for reference. As

such, while it is argued that EU competition law is largely applicable to the situation, competition authorities,

or professional advisors, may need to take two lines of case law into account, namely the requirement of

‘awareness’ in relation to information available on various online platforms and B2B e-marketplaces.

Chapter Four focuses on anticompetitive foreclosure. The paper suggested that the notion of

‘consensus’ is the heart of the blockchain technology, and the way how the firms intended to reach

consensuses will be codified into a consensus protocol. In most permissioned blockchains, the protocol that is

being commonly used is known as the PBFT protocol, which is a protocol that allows firm to tolerate 1/3

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indifferent results. This could be deemed as a loophole such that firms could exploit it to exclude certain

members in blockchain network. Traditionally, under EU competition law, anticompetitive foreclosure is a topic

that is assessed under Art. 102 TFEU, which is a provision that has been primarily developed to sanction

unilateral conducts performed by individual dominant firms. It is therefore argued that Art. 102 TFEU could not

comfortably deal with antitrust issues that arise from permissioned blockchains, a technology that emphasize

the notion of ‘shared control’. However, collective abuses are inherently creatures of collusive behaviors.

Accordingly, this entails that Art. 101 TFEU should be available for tackling the issue of anticompetitive

foreclosures, despite this is a topic that is typically assessed under Art. 102 TFEU.

Immediately before this conclusion, this paper has suggested that further research in relation

to the relationship between blockchains and competition law can be made in the area of merger control. As

firms have acquired more understanding regarding the blockchain technology, it is increasingly popular for

firms to form joint venture to put the concept into reality. It therefore appears that there is an imminent need

for competition authorities to investigate the applicability of EUMR on blockchains.

Overall, EU competition law, in particular Art. 101 and 102 TFEU, is applicable to blockchains

uses. As such, when firms, especially competitors, are sharing a blockchain infrastructure, they must be

mindful of the implication of the antitrust rules in this regard. In particular, firms must be careful of what

information they are sharing with the other firms and they must not engage in conducts such that other

members in the blockchain network are prevented from using the facility.

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DLTs in current EU financial market infrastructures:

restricted or unrestricted network?

A legal perspective

Salvatore Pantaleo

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Table of Contents

ABSTRACT ..................................................................................................................................................... 60

INTRODUCTION ............................................................................................................................................. 60

1 RELEVANT CONCEPTS OF BLOCKCHAIN TECHNOLOGY AND ITS ATTRACTIVENESS TO FINANCIAL MARKETS. .................................................................................................................................. 62

1.1 INTRODUCTION ................................................................................................................................... 62 1.2 BLOCKCHAIN. ..................................................................................................................................... 62 1.3 UNRESTRICTED LEDGER ..................................................................................................................... 63 1.4 RESTRICTED LEDGER ......................................................................................................................... 64 1.5 SMART CONTRACT.............................................................................................................................. 64 1.6 DISTRIBUTED LEDGER ........................................................................................................................ 65

2 WHY IS BLOCKCHAIN ATTRACTIVE TO FINANCIAL MARKETS? ................................................... 65

2.1 INTRODUCTION ................................................................................................................................... 65 2.2 IMMUTABILITY ..................................................................................................................................... 67 2.3 TRUSTLESSNESS ................................................................................................................................ 68 2.4 TRANSPARENCY ................................................................................................................................. 69 2.5 AUTOMATION ..................................................................................................................................... 70 2.6 RESILIENCE ....................................................................................................................................... 72

3 FMIS: RESTRICTED OR UNRESTRICTED DLT? ................................................................................. 73

3.1 INTRODUCTION ................................................................................................................................... 73 3.2 BRIEF HISTORICAL EVOLUTION OF CENTRALISATION IN FMIS ................................................................. 74 3.3 REGULATORY FRAMEWORK: PFMI AND EU REGULATION ...................................................................... 77 3.4 WHY IS AN UNRESTRICTED DLT NOT SUITABLE FOR FMIS? A GOVERNANCE ISSUE. ............................... 80 3.5 WHY IS A RESTRICTED DLT SUITABLE FOR FMIS? ................................................................................ 84

4 A CASE STUDY ON CENTRAL SECURITIES DEPOSITORY ............................................................. 86

4.1 INTRODUCTION .................................................................................................................................. 86 4.2 DLTS AND CSDS’ NOTARY FUNCTION AND RECONCILIATION PROCEDURE .............................................. 87

5 CHALLENGES ........................................................................................................................................ 88

5.1 INTRODUCTION ................................................................................................................................... 89 5.2 HARMONISATION OF THE ISSUANCE PROCESS ...................................................................................... 89 5.3 SSS AND PAYMENT SYSTEMS INTEROPERABILITY IN DVP ..................................................................... 89 5.4 FMIS AND EXTERNAL SYSTEMS INTEROPERABILITY ............................................................................... 90 5.5 SETTLEMENT FINALITY IN INSOLVENCY PROCEEDINGS .......................................................................... 90 5.6 NATURE OF THE ASSET IN DLTS AND COLLATERAL MANAGEMENT ......................................................... 91

CONCLUSIONS .............................................................................................................................................. 91

LIST OF ABBREVIATIONS ............................................................................................................................ 93

BIBLIOGRAPHY ............................................................................................................................................. 95

Abstract

The purpose of this study is to show that European financial market infrastructures should opt for restricted distributed ledger technologies when considering a potential implementation of this new technology to reduce both costs and risks over financial transactions. The idea of technology that can eliminate financial intermediaries is debunked by careful historical and technical analysis in relation to operational risk management, formal governance, and the underlying regulatory framework consisting of both international standards and EU legislation. An example, in support of this analysis, is given about the potential use of restricted DLTs by a central securities depository that has to carry out its notary function and reconciliation procedures in order to ensure the integrity of the issue of securities. The result is the complete exclusion of unrestricted DLTs in favour of the restricted ones. However, certain challenges remain to be solved before a large-scale implementation of such a technology may occur.

Introduction

Starting from 2009 with the debut of Bitcoin, different types of distributed ledger technology (DLT) have spread

in the market providing different models that could be used in different financial and non-financial fields.

Although Bitcoin is a technology that was invented to deploy a peer-to-peer version of electronic cash, starting

from 2015, DLTs have been considered as a new technology that may revolutionise current financial market

infrastructures (FMIs)93 in the name of greater efficiency and higher security with the final objective of removing

the so-called financial intermediaries.

Such a technology came up with features like immutability, transparency, automation, and resilience that

appeared to be attractive to financial markets. Advocates of this technology, who base their analysis on these

characteristics, argue that this innovation will eliminate current financial intermediaries in favour of direct trade

between seller and buyer. However, each of those features requires a trade-off in order to meet current

regulatory constraints which are the result of a historical process that has led to increasingly efficient risk

management. Saying this does not imply that DLTs cannot be implemented in FMIs. In fact, major financial

institutions, central banks, and consultancy firms have published many reports on the subject highlighting the

potential of this new technology together with correlated challenges. What emerges from these publications is

an inclination towards the implementation of restricted DLTs in FMIs instead of the unrestricted ones.

The European Securities and Markets Authority (ESMA) “stresses that entities or groups of entities willing to

use the DLT should be mindful of the existing regulatory framework. In addition, they should be mindful of a

number of principles, which underpin the current market infrastructures, in particular, the CPMI-IOSCO

Principles for Financial Market Infrastructures (PFMIs).”94 Not doing so would bring to a replacement of the

93 Components of FMIs are: Systemically Important Payment Systems (SIPS), Central Securities Depositories (CSDs), Securities Settlement Systems (SSSs), Central Counterparties (CCPs), and Trade Repositories (TRs). 94 ESMA, 'Discussion Paper - The Distributed Ledger Technology Applied To Securities Markets' (2016) s 2.2, para 7 <https://www.esma.europa.eu/press-news/esma-news/esma-assesses-usefulness-distributed-ledger-technologies> accessed 11 August

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current set up of FMIs with new risks that should be addressed by a completely new regulatory framework.

Something that is unlikely to be undertaken by the regulators at this early stage. For these reasons, DLTs

should be seen as a technology capable of improving internal processes of already existing FMIs. However,

this will only be possible after overcoming some regulatory and operational challenges.

Section 1 provides a concise background to the analysis covered by the rest of the study highlighting and

explaining the relevant technical terminology involved in DLTs. Section 2 examines five main features of DLTs

that make this technology attractive to financial markets together with regulations that require a trade-off of

these characteristics for compliance reasons. This section also provides suggestions regarding a potential

regulation of DLT systems by comparing the automation features of DLTs with the regulatory provisions

concerning the algorithmic trading in EU. Section 3 starts by analysing the rationale of FMIs with a brief

historical study that explains the natural process of centralisation and the importance of CCP in risk

management. This study is essential to better understand the following regulatory framework regarding the

FMIs’ governance arrangements and operational risk management. Such regulations force FMIs to opt for a

restricted DLT system instead of an unrestricted one. Section 4 is an example of how a restricted DLT can be

used by a CSD to carry out its notary function and reconciliation procedures under CSD Regulation (CSDR).95

Although the use of a restricted DLT system complies with most of CSDR, some amendment of ESMA’s

regulatory technical standards (RTS) on reconciliation procedures are required. This section provides

suggestions in this regard. Section 5 examines five challenges both at the regulatory level and operational

level that have to be faced before FMIs can implement DLTs in large scale. These challenges are: i) the need

of harmonisation of the securities issuance process at national level; ii) the lack of interoperability between

SSS and payment systems in delivery versus payment (DvP) procedures; iii) the lack of interoperability

between FMIs’ DLTs and other external participants’ systems; iv) the incompatibility of DLTs with the

Settlement Finality Directive (SFD)96 in relation to the opening of insolvency proceedings against participants;

and v) the nature of the asset registered on a DLT in relation to collateral management. The last part of the

2018; CPSS-IOSCO, 'Principles For Financial Market Infrastructures' (2012) <https://www.bis.org/cpmi/publ/d101.htm> accessed 18 July 2018 (CPSS-IOSCO, PFMIs). 95 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 236/2012 [2014] OJ L257/1. 96 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 166/45 as amended (SFD).

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study draws conclusions, from the analysis in the previous sections, on the potential implementation of

restricted DLTs in EU FMIs instead of unrestricted ones.

1 Relevant concepts of blockchain technology and its attractiveness to financial markets.

1.1 Introduction

In discussing what blockchain architecture is the most suitable to the evolution of current EU FMIs in correlation

with the UE legal framework, it is necessary to understand the current landscape of this technology. The

terminology used in this field is still evolving, and terms like distributed ledgers, blockchain, shared ledgers are

used interchangeably. Given the lack of legal or formal definitions, this section defines the key concepts that

are useful to understand the potential implementation of blockchain in FMIs. Technical terminology is indicated

in Italic the first time it appears in the text.

1.2 Blockchain.

As mentioned above, there is no specific legal definition of blockchain. However, a link with the law can be

found within the “Directive on the legal protection of databases” that defines, in broad terms, a database.97

Pursuant to Article 1(2), a database is “a collection of independent works, data or other materials arranged in

a systematic or methodical way and individually accessible by electronic or other means.”98 A blockchain is, in

fact, a type of shared database or ledger that collect a specific amount of transactions (data) into blocks rather

than recording them one after the other in a continuous ledger. The ledger runs on a distributed peer-to-peer

network on the top of the internet.99 This network is composed of independent nodes (computers or servers)

that perform various functions depending on the role they take.100 Every block is composed by a predefined

number of transactions that represent the fundamental unit of a blockchain. Each transaction is stored within

97 Directive 96/9/EC of the European Parliament and of the Council of 11 March 1996 on the legal protection of databases [1996] OJ L77/20. 98 Ibid art 1 (2). 99 Imran Bashir, Mastering Blockchain: Deeper Insights Into Decentralization, Cryptography, Bitcoin, And Popular Blockchain Frameworks (Packt Publishing 2017) 17. 100 ibid 21.

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an address, a unique identifier on the blockchain that denotes the sender and the recipient of the transaction,101

and represents a value or an asset that has been tokenised through an encryption algorithm (hash function)

and validated by one or more nodes (validators).

Moreover, to further corroborate the truth of the ledger, every block, except the first block (genesis block),102

is cryptographically linked with the previous one with a hash pointer. The latter is created through a validation

protocol of the previous block carried out by a validator on the network by running a consensus protocol (or

algorithm) that is tailored to the type of blockchain.103 If everyone can participate in this process, the blockchain

is called unrestricted. If participants are preselected, the ledger is called restricted. The data structure, as

described above, together with cryptographic algorithms allow blockchain to be used as a ledger that is, at

least in theory, more resilient, secure, transparent, and censorship-resistant than a typical database. However,

the qualitative aspect of each characteristic depends on the way the technology is structured.

1.3 Unrestricted ledger

An unrestricted (also called public or permissionless) ledger is a database in which everybody can participate

by making legitimate changes, reading, adding and validating transactions or blocks (as long as he or she

follows the rules). Every node has an identical copy of the ledger (decentralisation), and a validator can walk

away from the network and come back in every moment without disrupting the ledger. The other participants

(nodes) “maintain the integrity of the ledger by reaching a consensus about its state.”104 The best example is

Bitcoin’s blockchain.

101 ibid 19. 102 A genesis block is the first block of a blockchain. 103 The type of consensus mechanism in a blockchain is fundamental in terms of scalability of the system: the ability of the network to handle a significant amount of transaction at a certain point in time or to be potentially enlarged to face growth in the number of transactions. An FMI requires high performances in this sense, and they cannot be achieved with a consensus algorithm that is slow in validating transactions. Proof of work (PoW) used in Bitcoin’s architecture is one of them. For a short guide regarding consensus algorithm, see Bashir (n 99) 28-30. 104 David Lee and Robert Deng (eds), Handbook Of Blockchain, Digital Finance, And Inclusion. Chinatech, Mobile Security, And Distributed Ledger, vol 2 (Academic Press 2017) sub-s 12.3.

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A public blockchain is, in theory, decentralised also in terms of software governance, a crucial aspect for the

purpose of this paper.105 For now, it is important to understand that every software needs to be updated, fixed,

and improved with new features by software developers and that the software governance deals with this issue.

1.4 Restricted ledger

A restricted (also called private or permissioned) ledger is not open to everyone so that participation is

restricted to identified entities. The ledger’s integrity is ensured by trusted nodes (for instance, banks or

government departments) and the network is owned by one, some or all of them. The owners usually oversight

the whole system. There are two kinds of restricted ledgers: (i) a restricted egalitarian ledger where all users

can play any role; and (ii) a restricted tiered ledger where the owner(s) chooses the validators and decide the

role of any participant together with their degree of access to information stored within the ledger. These

structures are considered less censorship resistant but faster in terms of scalability than a public blockchain.

Moreover, the software is governed by a formal type of governance that can help to solve some of the major

problems of a public blockchain in relation to FMIs.106

1.5 Smart contract

Another difference with regular databases is that the blockchain can set rules about a transaction allowing the

creation of self-enforcing contracts that will modify the blockchain’s data (business logic).107 The latter can be

done through smart contracts, programs that “run on the top of the blockchain and encapsulate the business

logic to be executed when certain conditions are met.”108 There are different interpretations of the concept of

smart contracts. However, for this paper, I will take into consideration the definition of “smart legal contract” of

105 A blockchain can include on-chain voting mechanisms that formalise the governance transforming it into a democracy where every participant can vote to decide the sort of the network. With this arrangement, the software governance remains decentralised. If this is not the case and the network is based on open-source code, then the software governance tends to be technocratic so that a few stakeholders control the core’s development roadmap. However, if other stakeholders disagree with technocratic rulers, they can “revolt” by creating a new project based on the old one (fork). See Taylor Pearson, 'The Downside Of Democracy (And What It Means For Blockchain Governance)' (CoinDesk, 2018) <https://www.coindesk.com/downside-democracy-means-blockchain-governance/> accessed 8 July 2018. See also sub-ss 2.3, 3.3, 3.4, 3.5. 106 See sub-s 3.5. 107 For a further discussion about the difference between blockchain and database, see Gareth Peters and Efstathios Panayi, 'Understanding Modern Banking Ledgers Through Blockchain Technologies: Future Of Transaction Processing And Smart Contracts On The Internet Of Money' (SSRN, 2018) <https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=2692487> accessed 5 July 2018. 108 See Bashir (n 99) 21.

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Josh Start, endorsed by the International Swaps and Derivatives Association (ISDA), which considers these

piece of code “as a complement, or substitute, for legal contracts.”109 In practice, this means that a legal

contract can be executed in part or total by a machine. To this purpose, the digital time stamp embedded in

the validation protocol of a transaction could be utilised to indicate that a contract between two parties is

initiated or completed. This feature can improve efficiency in SSSs even though some challenges have yet to

be solved in regard to settlement finality and collateral management.110

1.6 Distributed ledger

A distributed ledger is always a type of shared database across multiple participants (nodes) in which records

are stored one after the other rather than in a block structure. A new record can only be added if a quorum is

reached by participants that validate the new version of the ledger ensuring its integrity. In this way, a

consensus is reached upon the state of the ledger. While this kind of technology is considered less censorship

resistant than a public blockchain, it is significantly faster. The real-time gross settlement system (RTGS)

Ripple is an example.111 Distributed ledgers should not be confused with the terminology used to indicate both

distributed ledgers and blockchain technology: Distributed Ledger Technologies (DLTs).

2 Why is Blockchain attractive to financial markets?

2.1 Introduction

In November 2015, the Bank of International Settlement (BIS) Committee on Payments and Market

Infrastructure (CPMI) said that “Distributed ledgers could in principle be re-engineered and adapted to new or

existing payment systems without necessarily involving the issuance of a digital currency (…).”112 Moreover,

109 Stark identifies a second definition of a smart contract called “smart contract code” intended as a piece of code “governing something important or valuable” on a blockchain. See Josh Stark, 'Making Sense Of Blockchain Smart Contracts' (CoinDesk, 2018) <https://www.coindesk.com/making-sense-smart-contracts/> accessed 5 July 2018; cf ISDA, Smart Contracts and Distributed Ledger – A Legal Perspective (whitepaper, 2017) 4-6 <https://www.isda.org/2017/08/03/smart-contracts-and-distributed-ledger-a-legal-perspective/> accessed 14 August 2018. 110 See sub-s 5.5. 111 See Lee and Deng (n 104). 112 See CPMI, 'Digital Currencies' (BIS 2015) 2 <https://www.bis.org/cpmi/publ/d137.htm> accessed 10 July 2018.

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in 2017, the same committee stated that “[A] DLT arrangement may have possible effects on the overall

financial market architecture.”113 Even one of the most criticised report from the cryptocurrency world of the

BIS, published in June 2018, talks about a promising underlying technology (of cryptocurrencies) in relation to

two aspects: i) the potential combination of “cryptopayments with sophisticated self-executing codes and data

permission systems.”; ii) the adoption of DLTs “by registered exchanges in permissioned protocols that use

sovereign money as backing, simplifying settlement execution.”114 The list goes on. It appears clear that all

reports of the major financial institutions, central banks, and consultancy firms emphasise this new technology

in term of as potentially transformative for FMIs.

This Section analyses the core DLT’s characteristics that could be potentially attractive to financial markets as

described by the reports mentioned above, alongside regulations that may support or contrast these futures.

In some cases, like the one of algorithmic trading, regulations can be seen as an example of how to regulate

specific aspects of this new technology. It has to be noted that not all DLTs have these features, as each of

them depends on the way the system is built. In fact, such characteristics may be questioned or criticised.

However, I firmly believe that with a dedicated platform and the overcome of the challenge of interoperability

among old and new arrangements,115 these attributes can play a significant role within the current legal and

economic framework in financial markets. The five main features consist of:

1. Immutability (Subsection 2.2)

2. Trustlessness (Subsection 2.3)

3. Transparency (Subsection 2.4)

4. Automation (Subsection 2.5)

113 See CPMI, 'Distributed Ledger Technology In Payment, Clearing And Settlement - An Analytical Framework' (BIS 2017) 3.4.2 <https://www.bis.org/cpmi/publ/d157.htm> accessed 11 July 2018. 114Jeremy Allaire, the CEO of Circle (the Goldman Sachs-backed crypto company), told Business Insiders that BIS’ employees “haven't done much research at all clearly. They're looking back at stuff that's year's old, they're not looking at what's actually going on in terms of the real R&D in this space.” The BIS’ report, in Section V, emphasises the problems of the proof of work protocols in terms of scalability and loss of trust while contradictorily mentioning how the industry is responding to these problems in endnote n 27. One of the absurd claims was that the associate communication volumes associated with a large distributed ledger “could bring the internet to halt”. See BIS, 'Annual Economic Report' (2018) 91-110 <https://www.bis.org/publ/arpdf/ar2018e.htm> accessed 9 July 2018; Oscar Williams-Grut, 'Central Bankers Claim Bitcoin Could Break The Internet — The Crypto World Thinks They're Missing The Point' (Business Insider, 2018) <http://uk.businessinsider.com/crypto-responds-to-the-bank-of-international-settlements-bitcoin-report-2018-6?utm_content=buffer67139&utm_medium=social&utm_source=facebook.com&utm_campaign=buffer-ti&r=US&IR=T> accessed 10 July 2018. 115 See sub-ss 5.3, 5.4.

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5. Resilience (Subsection 2.6)

2.2 Immutability

Blockchain’s advocates glorify the immutability of the ledger meaning that once an entry is added into a

validated block, it cannot be unilaterally removed or altered unless a consensus is reached. If on the one hand,

this feature is attractive to participants that may rely on a tamper-proof ledger, on the other, it is not suitable

for an FMI. Hence, in limited circumstances, such as inadvertent errors (fat fingers), fraud, or statutory

reconciliation procedures, the ledger has to be modified to ensure the accuracy, consistency, and

completeness of the database. In addition, a self-executed contract, triggered by those errors, may create or

contribute to a disorderly market in a similar fashion, but in larger scale, as algorithmic trading does as

mentioned by Article 17(1) of markets in financial instruments and amending Directive (MiFID II).116 Hence, by

reference to the Article 17(3) of MiFID II Regulatory Technical Standard (RTS) 6 on the organisational

requirements of investment firms engaged in algorithmic trading, an FMI using a DLT arrangement should also

provide a post-trade reconciliation process that “shall be made in real-time where the aforementioned market

participants provide the information in real-time”.117 This process ensures that internal records are matched

across relevant parties, from the issuer or CSD to all intermediaries. To conclude, blockchain platforms in FMIs

need governance and operational procedures that allow a certain degree of modification of the ledger in the

circumstances mentioned above.118 As explained in Subsection 3.5, the only way to achieve this is through a

restricted blockchain.

116 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 L 173/349, art 17 (MiFID II).

117 Commission Delegated Regulation (EU) 2017/589 of 19 July 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying the organisational requirements of investment firms engaged in algorithmic trading [2017] OJ L 87/417, art 17(3), (MiFID II RTS 6). 118 The problem can be solved by adding a new transaction that contains a note that nullifies the wrong transaction by leaving the previous version of the ledger unchanged. The old (wrong) transaction remains on the ledger. However, this may not solve the problem of the right to erasure personal data and can result in a longer ledger that, in turn, results in less scalability. However, more than legal, these are technological problems that, most likely, will be fixed by the blockchain community in the near future.

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2.3 Trustlessness

The decentralised nature of the system is the most attractive feature to financial markets. In theory, it allows

eliminating the need for risk aggregators such as central counterparties (CCPs), central banks, central

securities depositories. Thus, participants in an unrestricted DLT no longer need to trust a central trusted party

since they trust the network that will be responsible for updating the ledger, the code, and maintaining the

truthfulness of the ledger.

Notwithstanding the hype around the potential reduction in costs, the trust is just transferred from well-

grounded financial institutions to the developers, the integrity of the code, and good faith of the majority of

validators. According to Primavera De Filippi, a blockchain researcher at Harvard, Bitcoins technology

“remains subject to the (invisible) politics of a handful of individuals – the programmers who are in charge of

developing the technology and, to a large extent, deciding upon its functionalities.”119 A “technocratic” approach

to governance that goes against Satoshi Bitcoin conception.

Contrarywise, other blockchains projects may involve an on-chain voting system that results in a democratic

governance mechanism with people voting for all changes in the system.120 In this scenario, the trust can rely

on the network as a whole (direct democracy), on representatives (representative democracy), on delegates

(delegative democracy),121 or on proxies (proxy democracy)122. Once again, we need to understand which

governance mechanism satisfies FMIs needs and complies with the current legal framework. In doing so, we

need to understand if financial markets prefer democracy or a technocracy and if the latter should be run by

informal, unknown, and unreliable subjects or by institutional and accountable institutions identified by the

law.123 The answer seems obvious.

119 See Primavera De Filippi and Benjamin Loveluck, 'The Invisible Politics Of Bitcoin: Governance Crisis Of A Decentralised Infrastructure' (2016) 5 Internet Policy Review <https://policyreview.info/articles/analysis/invisible-politics-bitcoin-governance-crisis-decentralised-infrastructure> accessed 13 July 2018. 120 cf Pearson (n 105). 121 In a delegative democracy, also called liquid democracy, “voters can either vote directly or delegate their vote to other voters” which, in turn, “may delegate their own vote to another proxy, and, in doing so, further delegate all the votes entrusted to them.” See Anson Kahng, Simon Mackenzie and Ariel D. Procaccia, 'Liquid Democracy: An Algorithmic Perspective', Thirty-Second AAAI Conference on Artificial Intelligence (AAAI 2018) 1 <https://www.aaai.org/ocs/index.php/AAAI/AAAI18/paper/view/17027> accessed 14 August 2018. 122 In a proxy democracy, voters can either vote directly or delegate their vote to other proxies that cannot further delegate all the votes entrusted to them. 123 See s 3.

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2.4 Transparency

Transparency is one of the most supported blockchain features of traditional public blockchain like Bitcoin or

Ethereum where the ledger is visible to all participants that have an up-to-date version of it. Changes in the

chain can be seen in real time as they are made, and they represent the truth. In financial markets, this would

result in more accurate assets’ prices and reduction of settlement risk.

In the first case, there would be a more effective risk management across system given the higher availability

of information. Moreover, the fact that information could come from one or more trusted interconnected ledgers

thanks to automatic processes enabled by standardised smart contracts should solve the problem of redundant

production.124 There would be no issues of too much or too little information. Hence, a public blockchain would

become the producer of reliable information itself making it available to the public with no restriction in support

of the economic theory that considers information as a public good. 125 In the same fashion, the whole

arrangement would help to reduce costs related to mandatory disclosure regulations,126 mandatory reporting

requirements for post-trade transparency 127 and, traceability for compliance with Anti-Money Laundering

Requirements (AML), Counter-Terrorist Financing Regulations (CTFR) and Know-Your-Customer Rules

(KYC).128

124 Different parties in an FMI may produce information about the same activity with different or similar outcomes resulting in redundant information. At the moment, mandatory market disclosure regulations address this problem. See generally Frank H. Easterbrook and Daniel R. Fischel, 'Mandatory Disclosure And The Protection Of Investors' (1984) 70 Virginia Law Review 669 <https://chicagounbound.uchicago.edu/journal_articles/1177/> accessed 7 August 2018. 125 For further information about this concept, see Richard A Musgrave, The Theory Of Public Finance (McGraw-Hill 1959); Mancur Olson, The Logic Of Collective Action: Public Goods And The Theory Of Groups (Harvard University Press 1975). 126 Directive 2004/109/EC of the European Parliament and of the Council of 15 December 2004 on the harmonisation of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market and amending Directive 2001/34/EC OJ L 390/38 as amended, (Transparency Directive). 127 MiFID II; Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Regulation (EU) No 648/2012 OJ L 173/84 (MiFIR); 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 OJ L 201/1, art 9 (EMIR); Commission Implementing Regulation (EU) No 1247/2012 of 19 December 2012 laying down implementing technical standards with regard to the format and frequency of trade reports to trade repositories according to Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories OJ L 352/20, art 5 (EMIR RTS 1247/2013). 128 For the impact of DLTs in KYC, AML and CFTR rules, see Advisory Group on Market Infrastructures for Securities and Collateral (AMI-SeCo), 'The Potential Impact Of Dlts On Securities Post-Trading Harmonisation And On The Wider EU Financial Market Integration' (European Central Bank 2017). <https://www.ecb.europa.eu/paym/intro/governance/shared/pdf/201709_dlt_impact_on_harmonisation_and_integration.pdf> accessed 16 July 2018.

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In the second case, the settlement risk would be, in theory, reduced close to zero thanks to real-time

settlement.129 The economic outcome would be more liquidity on the market since there is no more need to

reserve against settlement risk.130 Further, according to the chairman of the United States Commodity Futures

Trading Commission (CFTC), prudential regulators could recognise, in a faster way, anomalies in financial

activities preventing a systemic crisis such as the one of 2008.131

However, the above-described level of transparency granted by a public blockchain does not entirely fit

financial markets for two reasons. First, such transparency may spoil participants’ trading strategies that should

be kept confidential for a healthy and functioning market. Second, financial institutions have privacy obligations

towards their clients’ personal and financial data.132 In conclusion, as stated by the CPMI in its report of 2017,

transparency and traceability “should be weighed against privacy and the need to keep certain information

confidential.”133 This can be achieved only with a permissioned ledger where participants have different layers

of access to information.

2.5 Automation

This concept refers to the ability of a DLT to have attached on the top of it a self-enforcing contract that

executes a part or the totality of a legal contract in automatic.134 The potential of this technology is enormous

in terms of reducing costs in FMIs. For instance, several reports highlighted the possibility to use blockchain

in the clearing and settlement system due to its self-enforcement ability. Besides the execution of legal

contracts, smart contracts can also automate or optimise reporting processes, risk management procedures,

KYC, and AML-CFTR.

129 For challenges related to the real-time settlement, see sub-s 5.5. 130 See Lee and Deng (n 104) sub-s 11.1.2. 131 See J. Christopher Giancarlo, 'Special Address Of CFTC Commissioner J. Christopher Giancarlo Before The Depository Trust & Clearing Corporation 2016 Blockchain Symposium. Regulators And The Blockchain: First, Do No Harm' (Cftc.gov, 2016) <https://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-13> accessed 15 July 2018. 132 For natural persons, financial institutions are subject to Regulation (EU) 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 OJ L 119/1 (GDPR). 133 CPMI, 'Distributed Ledger Technology In Payment, Clearing And Settlement' (n 113) sub-s 3.3.5. 134 See sub-s 1.5.

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However, smart contracts do not come without flaws. A bug in the code may lead fraudster or hacker to steal

money.135 Further, smart contracts, triggered by input errors or hacker attacks, may create or contribute to a

disorderly market or, in extreme cases, trigger a systemic event. In using this kind of device, all financial

Institution should always take into consideration the cyber risk as defined in the “Guidance on cyber resilience

for financial market infrastructures” published by the CPMI and IOSCO in 2016.136 According to it, cyber risk

is “The combination of the probability of an event occurring within the realm of an organisation’s information

assets, computer and communication resources and the consequences of that event for an organisation.”137

More specifically, at EU level, according to Article 14 (1) of the “Directive on security of network and information

systems”,138 FMIs (operators of essential services) have to “take appropriate and proportionate technical and

organisational measures to manage the risks posed to the security of network and information systems which

they use in their operations.”139 It has to be noticed that the ability to evaluate this risk in relation to the

codification of smart contracts in order to take appropriate and proportionate measures would be a challenging

aspect for regulators, supervisors, and operators.

Going back to the scope of this analysis, it is important to repeat that one of these measures could involve the

modification of the ledger that has been changed by the erroneous smart contract. This brings up again the

issue of allowing a certain degree of modification of the database.140 In fact, when this cyber risk becomes a

reality, an FMI should be able to recover from the situation in a prompt manner so that, once again, a restricted

network with an efficient and effective governance mechanism may be the best solution. This capability of a

system to recover from or adjust to a change or a disruptive event like a cyber-attack is called resilience.

135 In June 2016, The Decentralised Autonomous Organisation (DAO), an automated venture capital fund built on top of the Ethereum blockchain, was hacked by someone that was able to transfer 60 million of ether (the Ethereum’s currency) to itself. This was possible due to a bug in the software code of smart contracts that run the organisation. In July 2016, the core developers of Ethereum decided to persuade the network to update the software and, by doing so, taking back the hacked ether. This episode demonstrates how core developers in a blockchain possess a centralised power in term of software governance. Eventually, not all miners updated the software. This lead to a hard fork with two blockchains: i) the new Ethereum, and the old one ii) Ethereum Classic with different core developers and miners. See Lee and Deng (n 104) sub-s 11.3.3.3. 136 CMPI and IOSCO, 'Guidance On Cyber Resilience For Financial Market Infrastructures' (BIS-IOSCO 2016) <https://www.bis.org/cpmi/publ/d146.htm> accessed 19 July 2018. 137 ibid Annex A. 138 Directive (EU) 2016/1148 of the European Parliament and of the Council of 6 July 2016 concerning measures for a high common level of security of network and information systems across the Union OJ L 194/1 (NIS Directive). 139 ibid art 14(1); According to ANNEX II (4) of the NIS Directive, a financial market infrastructure is an “operator of essential services” as defined by the point (4) of Article 4. 140 See sub-s 2.2.

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2.6 Resilience

The decentralised structure of the ledger implies that the ledger is stored in an up-to-date and operational copy

on every node in the network. This prevents the possibility of a single point of failure due to a disruptive event

since the database is up and running on every node. Hence, the chance that all node fail simultaneously is

extremely rare. In practical term, there would be no outage of the system fostering the resilience of the whole

financial infrastructure.

This is in harmony with many countries’ regulation of FMIs based on the April 2012 “Principles For Financial

Market Infrastructures” (PFMI) report by the BIS’s Committee on Payment and Settlement Systems (CPSS,

now CPMI) and the Technical Committee of the International Organization of Securities Commissions

(IOSCO).141 According to Annex F (3) “A critical service provider is expected to implement appropriate policies

and procedures, and devote sufficient resources to ensure that its critical services are available, reliable, and

resilient. Its business continuity management and disaster recovery plans should, therefore, support the timely

resumption of its critical services in the event of an outage so that the service provided fulfils the terms of its

agreement with an FMI.”142

At the moment, FMIs replicate their infrastructure in three or four different places, at least one of which is

located in a different region to decrease the likelihood that it is affected in the case of regional disaster.143 The

most distant location can be hundreds of kilometres away from the primary infrastructure so that it will receive

data asynchronously from the primary site. This means that some transactions accounted for in the primary

centre, and in closer synchronised centre, have not been broadcast to the other distant centres by the time

the primary centre stops working.144 DLTs can solve this problem by reducing to zero the maximum amount of

time that can pass before changes to data are saved in other centres (Recovery Point Objective - RPO=0).145

141 CPSS-IOSCO, PFMIs (n 94). 142 This provision can be linked to principle 17 of PFMIs regarding operational risk, and in particular with the key consideration n°7. According to it, an FMI should have a business continuity plan in case of a disruptive event interrupts operations. The FMI’s critical information technology systems should be able to resume operations within two hours following disruptive events, and, in case of extreme circumstances, to complete the settlement by the end of the day of the disruption (Recovery Time Objective – RTO=2h). See sub-s 3.3. 143 See AMI-SeCo (n 128) sub-s 11.2.1. 144 ibid. 145 ibid.

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This is possible because all nodes that have participated to validation of the latest transaction hold an updated

version of the ledger.

Theorizing a restricted blockchain as an arrangement for an FMI, in case of regional disasters, the resilience

feature is maintained if the number of validation nodes necessary to reach the validation quorum resides in a

different region from where the disruptive event occurs. As the AMI-SeCo points out, “a greater network of

validating nodes is more resilient, and consensus algorithm requiring lower quorum ensure availability of the

service against the failure of a higher number of nodes.”146 However, a trade-off is required for two reasons:

“i) a high number of validation nodes increases latency”147 and scalability problems; and ii) a low quorum

increases the risk of organising a cartel of validation nodes that may tamper the ledger with their consensus.148

3 FMIs: restricted or unrestricted DLT?

3.1 Introduction

From the previous analysis, it is clear that the above characteristics have to be balanced with the current needs

of FMIs in terms of operability and regulatory constraints. Today, financial markets rely on a complex

infrastructure shaped by historical and technological innovation and backed by a solid legal framework that

ensures safeness and accountability for both market participants and financial institutions. A complex structure

that seems to work well according to the Bank of International Settlement (BIS) but that can be further improved

by the use of DLT and the implementation of Central Banks Digital Currencies (CBDCs).149 The fundamental

aspect that characterises the whole system is centralisation of the main functions toward central institutions150

to reduce risks and costs of financial transactions and increase reliability, integrity and scalability.

146 ibid. 147 ibid. 148 This is called the 51% attack. In short, whatever 51% of the validation nodes “decides to do is done as the network run through majority rule.” See Lee and Deng (n 104) sub-s 11.3.3.4. 149 See generally Bank of International Settlement, 'Central Bank Digital Currencies' (BIS 2018) <https://www.bis.org/cpmi/publ/d174.htm> accessed 5 April 2018. 150 Central banks, central counterparties (CCP), clearing houses, central securities depositories (CSDs).

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Contrariwise, since 2009, advocates of blockchain technology support a total decentralisation of all those

functions with the aim to dismiss all financial intermediaries starting with the central banks’ monopoly on money

issuance thanks to “a purely peer-to-peer version of electronic cash”.151 Academics have linked this innovation

with F.A. Hayek’s theory of the denationalisation of money 152 and free competition between private

currencies.153 However, on the blockchain community side, it seems that the centralisation of power over

money (monopoly) in the hands of central banks (or governments for Hayek) has returned to be a problem.

This, despite the economic results achieved through the independence of central banks over monetary

policy.154

The purpose of this section is to demystify the possibility of a complete decentralisation of powers in FMIs by

analysing the rationale of FMIs regulation. In doing so, Subsection 3.2 outlines a brief historical introduction of

FMI with a focus on a post-trade market and the importance of central counterparties in reducing counterparty,

operational, settlement, and default risks for market participants.155 Subsection 3.3 analyses the regulatory

framework governing FMIs’ governance arrangements and risk-management with a particular focus on

operational risk. These legal aspects are then related to a potential implementation of unrestricted and

restricted DLTs in FMIs in Subsection 3.4 and 3.5.

3.2 Brief historical evolution of centralisation in FMIs

The financial sector is constantly evolving since the beginning of the civilisation when the first money (clay

tokens) was invented in Mesopotamia.156 Later, the invention of the bill of exchange and the promissory

151 See Satoshi Nakamoto, ‘Bitcoin: A Peer-to-Peer Electronic Cash System’ 1, available at <https://bitcoin.org/bitcoin.pdf> accessed 29 March 2018. 152 See generally Friedrich A. von Hayek, Denationalisation of Money —An Analysis of the Theory and Practice of Concurrent Currencies (3rd edn, IEA 1990). 153 See Policy Department for Economic, Scientific and Quality of Life Policies (IPOL), 'Virtual Currencies In The Eurosystem: Challenges Ahead' (European Parliament 2018) sub-s 2.3.5 <http://www.europarl.europa.eu/committees/en/econ/monetary-dialogue.html> accessed 24 July 2018. 154 Since the end of the 1980s and the beginning of the 1990s, most of the central banks acquired their independence from governments in conducting monetary policy to promote monetary stability. In doing so, they solved one the main problem on which Hayek’s theory is based: the persistent abuse of government over depreciation of currencies to finance themselves. However, the central bank independence raises major economic issues and complex problems in terms of supervision, accountability, democratic legitimacy, and other factors, which exceed the scope of this study. For a comprehensive study of central bank independence, see Rosa Maria Lastra, International Financial And Monetary Law (2nd edn, OUP 2015) paras 2.104-2.194. 155 CCPs also help to reduce market and legal risk. 156 3000 BCE.

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note,157 together with the creation of fiat money158 by the first prototype of the central bank in Amsterdam

during the 17th century159 have paved the way to the modern payments.160

As regarding the root of the modern clearing and settlement systems, the first instance goes back to the

beginning of the 15th century when three municipal banks,161 situated in the Mediterranean trading area, set

up the first interbank clearing system.162 During the restoration of Charles II (1660), London’s goldsmith-

bankers took a step forward in this sector by creating a resilient interbank network based on mutual acceptance

of rival notes and a monitoring system without a formal coordinating institution or a formal regulatory

framework.163

The reasons for the rise of interbank clearing systems were based on the reduction of two types of risk and

their consequent costs: the operational risk and the credit risk involved in any transaction between banks. The

former results mainly in higher probabilities of theft during the transportation of the asset from a bank to

another,164 especially “when the settlement asset was specie or (gold) Bullion”.165 As regarding the credit risk,

this arose from the possibility of counterparty’s default. In such a case, the costs related are inherent to the

loss occurred from the counterparty’s inability to pay its debt. The mutual acceptance systems reduced this

risk and its related costs in two ways. One was through a monitoring practice based on group behaviour.166

The second way was through the prompt redemption of each other’s (banks) claims on behalf of their

customers.167 However, claims of this embryonic system were settled on a bilateral basis every few days. We

157 See generally Sergii Moshenskyi, History Of The Weksel - Bill Of Exchange And Promissory Note (Xlibris 2011). 158 See generally Stephen Quinn and William Roberds, 'How Amsterdam Got Fiat Money' (2014) 66 Journal of Monetary Economics <https://www.sciencedirect.com/science/article/pii/S0304393214000476> accessed 25 July 2018. 159 See generally Stephen Quinn and William Roberds, 'The Big Problem Of Large Bills: The Bank Of Amsterdam And The Origins Of Central Banking' (2005) FRB Atlanta Working Paper No. 16/2005. <https://ssrn.com/abstract=814004> accessed 25 March 2018. 160 Today, payments are made mostly by E-money, cash, and book-money, however, some say that virtual currencies will takeover in the future. Nevertheless, on the institutional side, this possibility is discarded since, at the moment, virtual currencies do not qualify as “money status”. See IPOL (n 153) s 4, para 2. 161 The modern concept of bank dates back to the 14th century when the development of the international trade allows the proliferation of numerous banks in Europe starting from Italy. The Bardi and the Peruzzi families first, and the Medici after dominated the banking market during the 14th and 15th centuries. 162 The three banks were: Taula de Canvi (Barcellona 1401), Banco di San Giorgio (Genoa 1407), and Taula de Canvis i Depòsits (Valencia 1408). See Mark Manning, Erlend Nier and Jochen Schanz, The Economics Of Large-Value Payments And Settlement (Oxford University Press 2009) ch 1.2; At the end of the same century (Venice 1494), Luca Pacioli, an Italian Franciscan friar and mathematician, added another milestone to the financial world with the codification of the double-entry bookkeeping system. See generally Alan Sangster and Giovanna Scataglinibelghitar, 'Luca Pacioli: The Father Of Accounting Education' (2010) 19 Accounting Education 423-438 <https://www.researchgate.net/publication/272304355_Luca_Pacioli_The_Father_of_Accounting> accessed 23 March 2018. 163 Stephen Quinn, 'Goldsmith-Banking: Mutual Acceptance And Interbanker Clearing In Restoration London' (1997) 34 Explorations in Economic History, 411-432 <https://www.sciencedirect.com/science/article/abs/pii/S0014498397906823> accessed 31 March 2018. 164 Operational risk includes human errors, management failure, and inadequate controls. 165 Manning (n 162). 166 See Quinn (n 163) 418; According to Manning, banks were monitoring each other’s ability to over-issue notes, a practice that could have threatened their existence. See Manning (n 162). 167 With this tool, scenarios in which a bank should become insolvent before a claim was redeemed were reduced depending on the time in which that claim was settled: the higher the time, the higher the risk. See Manning (n 162).

https://ssrn.com/abstract=814004

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need to wait more than 60 years, in 1841, after the establishment of one of the first bankers’ clearing house in

the world in Lombard Street,168 to see the start of multilateral settlement.169

Moreover, with the interbank market, localised banks started to place their interbank deposit with larger,

centralised banks for several reasons such as safety, reputation, connection with other banks, information

advantages, and easier payment services.170 A natural process that would not require a prior existence of a

central bank.171 However, the need of many states “to employ a bank to carry out certain financial functions

for it [them], such as issuing notes, holding deposits, making payments, and arranging loans at home and

abroad” brought this centralisation process to the next level.172 From this period onwards, central banks

became the main pillar of the settlement process since bankers started to settle in central bank’s notes rather

than specie assets.

Overall, the clearing and settlement infrastructure remained unaltered until the volume of transactions in debt

and equity securities became so large that trading became slow, cumbersome, and expensive. A new strategy

had to be implemented thanks to the electronic innovation: the immobilisation and dematerialisation

systems.173 In 1968, the first CSD the “Central Securities Services” (CCS), now Depository Trust Company

(DTC), was established by the New York Stock Exchange (NYSE)174 “to transfer securities electronically,

eliminating their physical handling for settlement purposes”.175 Starting from that moment, most of paper

certificates and instruments were not physically traded or issued but held (immobilised or dematerialised) in a

centralised electronic ledger of the CSD that will transfer the ownership of securities through the book-entry

accounting system.176 As a result, investors do not hold any certificate, and with multilateral netting, the number

of transactions and risks are further reduced. However, this system added another layer of intermediary risk

to the whole infrastructure, a well-known trade-off for a more efficient and secure market. Finally, with the

168 London 1775. 169 See Manning (n 162). 170 See Charles Albert Eric Goodhart, The Evolution Of Central Banks (MIT Press 1991) 34. 171 ibid. 172 ibid 35. 173 According to UNIDROIT, immobilisation is “The act of durably concentrating the holding of securities certificates with a repository to allow the crediting of an equal amount of securities to securities accounts and the transferability of such securities by the way of book entry.”; Dematerialisation is “The issuance (or re-issuance) of securities which are not represented by a physical certificate. […]”. See UNIDROIT, Legislative guide on Intermediated Securities (2017) xxii, xxiv. 174 See William Spaulding, 'Execution, Clearing, And Settlement' (Thismatter.com, 2018) <https://thismatter.com/money/stocks/settlement-and-clearing.htm> accessed 5 April 2018. 175 'Timeline NYSE' (Web.archive.org, 2018) <https://web.archive.org/web/20100813233211/http://www.nyse.com:80/about/history/timeline_1960_1979_index.html> accessed 5 April 2018. 176 According to CSDR, starting from 2023, all new transferable securities (admitted to trading or traded to trading venue), and starting from 2025 all transferable securities, have to be represented in book-entry form. CSDR art 76 (2).

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availability of low-cost computers at the beginning of the 1980s, internet, and the possibility of processing

information in faster, safer, and more accurate way, e-trading became today’s reality even at consumers’

level.177

What emerges from this analysis is that the history of financial markets has pushed towards a natural process

of centralisation towards reliable financial institutions that have helped to reduce risks and costs of financial

transactions. This happened for payments, clearing and settlement systems. Such reliability has been built

over time, starting with an interbank monitoring system, and finishing up to a substantial, always evolving legal

framework based on international standards, which stands as the foundation of current FMIs.

However, most of blockchain’s advocates say that with the use of DLTs in payment, clearing and settlement

systems, we may assist to a total disruption of the centralised structure, and therefore intermediaries, in favour

of a permissionless decentralised one. The following Subsections debunks this statement by proposing an

alternative solution that complies with the existing PFMI and EU regulation and relies on a permissioned

decentralised network.

3.3 Regulatory framework: PFMI and EU regulation

In the aftermath of the global financial crisis of 2008 (GFC), financial markets learned an important lesson

regarding effective risk management and the importance of strong governance of FMIs together with their

oversight. In 2010, the CPSS and IOSCO began a process to review and update international standard for

FMIs to solve those challenges the GFC has brought to light. The result was a report containing twenty-four

principles (PFMI) categorised into nine broad categories178 “to support the goals of the G20 [group of 20] and

FSB [Financial Stability Board] to strengthen the safety and soundness of the financial markets, including

critical market infrastructures.”179

177 Today’s technology allows high-frequency trading thanks to algorithms that automate trading at high velocity. Other platforms provide financial advice with almost no human intervention thanks to Robo-advisor services based on mathematical rules and algorithms that analyse the market. 178 The nine categories are: (i) general organisation, (ii) credit and liquidity risk management, (iii) settlement, (iv) CSDs and exchange-of-value settlement systems, (v) default management, (vi) general business and operational risk management, (vii) access, (viii) efficiency, and (ix) transparency. 179 CPSS-IOSCO, 'Co-Chairs’ Summary Note For The CPSS-IOSCO Principles For Financial Market Infrastructures' (BIS 2012) 2 <https://www.bis.org/cpmi/publ/d101.htm> accessed 29 July 2018.

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As regarding the risk management, the report intends to address systemic risk, legal risk, operational risk,

credit risk, liquidity risk, custody and investment risk, and general business risk. This Subsection examines

operational risk (principle seventeen) as it is important to understand whether unrestricted blockchains are

suitable for the next revolution of FMIs or not. Also, the PFMI set out general organisation standards that are

minimum requirements for all kinds of risk management. In particular, principle two on the governance structure

of the FMI, and principle three on the framework for the comprehensive management of risks are relevant to

this analysis. Here below the three principles:

“Principle 2: Governance

An FMI should have governance arrangements that are clear and transparent, promote the safety and

efficiency of the FMI, and support the stability of the broader financial system, other relevant public

interest considerations, and the objectives of relevant stakeholders.

Principle 3: Framework for the comprehensive management of risks

An FMI should have a sound risk-management framework for comprehensively managing legal, credit,

liquidity, operational, and other risks.

Principle 17: Operational risk

An FMI should identify the plausible sources of operational risk, both internal and external, and mitigate

their impact through the use of appropriate systems, policies, procedures, and controls. Systems should

be designed to ensure a high degree of security and operational reliability and should have adequate,

scalable capacity. Business continuity management should aim for timely recovery of operations and

fulfilment of the FMI’s obligations, including in the event of a wide-scale or major disruption.”180

Another crucial concept is the one of governance in FMIs. According to the glossary of PFMI, governance is

“[T]he set of relationships between an FMI’s owners, board of directors (or equivalent), management, and

other relevant parties, including participants, authorities, and other stakeholders (such as participants’

customers, other interdependent FMIs, and the broader market)”.181

180 CPSS-IOSCO, PFMIs (n 94). 181 ibid Annex H, 176.

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If we look at the way public blockchains are built today, it is unlikely to think that this technology based on

open-source code run by independent software developers can comply with these three principles and, in turn,

with the European regulation based on them. In this regard, EMIR, MiFID II, and CSDR,182 together with the

related RTS issued by ESMA determine the regulatory framework for the management of operational risk and

governance. These regulations should be used as a model for restricted DLTs infrastructures.

In particular, Article 26(1) and Article 78(1) of EMIR set similar general requirements for a CCP and a TR

respectively. They “shall have robust governance arrangements, which include a clear organisational structure

with well-defined, transparent and consistent lines of responsibility, […], and adequate internal control

mechanisms, including sound administrative and accounting procedure, […].”183

As noted in Subsections 2.2 and 2.5, a blockchain-based infrastructure entails similar features of algorithmic

trading, already regulated by MiFID II, due to the automation of operational processes. To this extent, in a

similar fashion to Article 17(1), DLT systems in an FMI should “have in place effective systems and risk controls

suitable to the business it operates to ensure that its trading systems are resilient and have sufficient capacity,

are subject to appropriate trading thresholds and limits and prevent the sending of erroneous orders or the

systems otherwise functioning in a way that may create or contribute to a disorderly market.” Also, as well as

regulated markets, according to Article 48(1) of MiFID II, DLT systems in a FMI should “have in place effective

systems, procedures and arrangements to ensure its trading systems are resilient, have sufficient capacity to

deal with peak order and message volumes, are able to ensure orderly trading under conditions of severe

market stress, are fully tested to ensure such conditions are met and are subject to effective business continuity

arrangements to ensure continuity of its services if there is any failure of its trading systems.”

Moreover, similarly to Article 3 of MiFID II RTS 7 and Article 1 of MiFID II RTS 6, the overall governance and

decision-making framework of a DLT system in an FMI should ensure “a clear and formalised governance

arrangement” setting out, inter alia, “clear lines of accountability, including procedures to approve the

182 For the implications of the CSDR of FMIs, see s 4. 183 The two articles are the same except for the part in brackets. A CCP shall also have an “[…] effective processes to identify, manage, monitor and report the risks to which it is or might be exposed […]”, EMIR art 26 (1); a TR shall also “[…] prevent any disclosure of confidential information.”, EMIR art 78 (1).

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development, deployment and subsequent updates of [DLT systems] trading systems (algorithms) and to

resolve problems identified when monitoring the [DLT system] trading systems (algorithms).”184

3.4 Why is an unrestricted DLT not suitable for FMIs? A governance issue.

As noted in Section 2, unrestricted blockchains are considered immutable, based on informal democracy or

technocracy governance, totally transparent and highly resilient. However, in an FMI, immutability have to

leave some space to the possibility of a certain degree of modification in certain circumstances. Transparency

has to be mitigated because of privacy and confidentiality issues. Resilience should not impair scalability.

We also saw that, since their origins, FMIs have to deal with operational risks and transaction scalability. To

do so, a historical process led to the centralisation of the system in favour of trusted financial institutions. A

process that has been corroborated by the latest PFMI. It became evident, as stated in principle two, that a

clear and transparent governance arrangement is crucial to the stability of the financial system and “should

promote the safety and efficiency of the FMI.”

The same concepts are restated in EU regulation, as seen in section 3.3, specifying even further the need of

“formalised governance arrangements” with “clear lines of accountability” and “procedures to approve the

development, deployment and subsequent updates of” the software. While software developers may find a

solution to transparency, immutability, and scalability in the future, it is hard to imagine a solution to the informal

governance problem entailed within the nature of a public blockchain that brings additional operational risk to

the whole market infrastructure instead of diminishing it.

To this extent, it is important to mention, and elaborate further, the study of Angela Walsh regarding the open-

source operational risk of public blockchains”.185 According to her, there are three kinds of operational risks in

relation to public blockchains that arise from the same problematics open-source code has when it is initiated

and run by independent software developers: (i) the risk of impeded decision-making about changes in the

184 Trading systems refers to trading venue, Commission Delegated Regulation (EU) 2017/584 of 14 July 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying organisational requirements of trading venues [2017] OJ L 87/350, art 3 (1) (b), (MiFID II RTS 7); trading algorithms refer to investment firms, MiFID II RTS 6 art 1 (a). 185 See Lee and Deng (n 104) sub-s 11.3.

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software code”;186 (ii) the risks of software forks due to both the public availability of the source code and the

lack of legal restriction on copyrights;187 and (iii) the risk of inadequate maintenance and development of the

software due to insufficient and problematic funding.188

As stated in subsection 2.3, with an unrestricted DLT the trust regarding the right functioning of the system is

transferred from well-grounded financial institutions to certain developers. These people may take decisions

about changes in the software code through rough consensus in a technocratic-based system, or by a majority

in a democratic environment. In the latter case, if direct democracy is chosen as decision-making mechanism,

it would be like giving power to the people to decide in matters of national defence or taxation without knowing

anything about international politics or economics. In many countries, this is forbidden by constitutions. On the

other hand, representative, delegative, or proxy democracies’ mechanisms, that may solve the lack of

knowledge issue, still have a slow decision-making process that does not go well with the speed and the

contingency of financial markets. This incompatibility concerning slowness also applies to the mechanisms of

direct democracy.

With a technocratic approach, the decision is made in relation to the dominant view of the group of core

developers (rough consensus) which does not necessarily imply the majority of 51% of the group since it will

be the chair who decides whether the consent has been reached or not.189 In theory, anyone at any time can

develop the software. In practice, most of the time, the developers are concentrated in a few unknown

people.190 At the same time, anyone can step out from the developers’ team with the probability of having an

insufficient number of developers to keep the system up and running 24/7.

This would happen without any legal consequences, either for developers and for the network considered as

a legal entity, given the lack of any “official responsibility for keeping the software operational.”191 The result is

an “unacknowledged centralization of power” with no accountability or supervision on decisions.192 Moreover,

186 ibid sub-s 11.3.1. 187 ibid sub-s 11.3.3. 188 ibid sub-s 11.3.2. 189 The term “rough consensus” was used for the first time by the Internet Engineering Task Force (IETF) in describing its consensus decision-making procedures for working groups (WGs). IETF, 'Working Group Guidelines And Procedures' (1998) sub-s 3.3 <https://tools.ietf.org/html/rfc2418> accessed 5 August 2018. 190 See sub-s 1.2.2. 191 See Lee and Deng (n 104) sub-s 11.3.1.1. 192 ibid.

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since the continuity of the operation of the system is not ensured, financial markets may suffer from paralysis

periods, especially when the system is crucially important. This scenario would occur due to the interruption

of all structures and services built on top of the crashed fundamental system.

As Walsh pointed out, in an FMI, the problem “is not the centralization part, but the unacknowledged part.”

The latter “can lead to the exercise of unaccountable and unchecked power.”193 However, certain public

projects identify a clear, formalised, and transparent governance arrangement that removes the

unacknowledged part in favour of a system that is more compatible with regulations and international standards.

Nevertheless, the nature of an open-source project usually involves an ideological purpose that is related to

the core developers or promoters of the project.194 This purpose influences the decision-making leaving space

for a chance that the decision will not be accepted by the community.

In such a case, the result is a software fork, with a consequent fork of the entire network,195 that leads to one

of the following outcomes: “(a) peaceful co-existence of both old and new software [network]; (b) the old version

of the software die; (c) the new version of the software [network] die; or (d) there is a contentious co-existence

of the old and new software [network].”196 This is possible because the open-source software is available to

everyone and can be modified without legal consequence. On the other hand, the consequences of a fork in

a public blockchain related to an FMI may create serious disruption. Hence, a fork would create fragmentation

in the data structure with two version of the same ledger “undermining the technology’s service as a single,

reliable source of truth.”197

As regarding the funding problem, in general, open-source software developers compile the software code as

an altruistic or reputational activity “outside of their regular paid employment.”198 They do not receive any wage

193 ibid. 194 For instance, Vitalik Buterin is the creator of Ethereum and now leads the Ethereum’s research team shaping the future versions of the Ethereum protocol. A comparison can be made with Linus Torvalds, leader of the Linux open-source project and creator of the Linux Kernel, an open-source operating system kernel. 195 There are two main types of software fork: hard and soft. “A hard fork is a change to a protocol that renders older versions invalid. If older versions continue running, they will end up with a different protocol and with different data than the newer version. This can lead to significant confusion and possible error.” With a soft fork “[…] a protocol is changed in a way that tightens the rules, which implements a cosmetic change or that adds a function that does not affect the structure in any way, then new version blocks will be accepted by old version nodes.” See Noelle Acheson, 'Hard Fork Vs Soft Fork' (CoinDesk, 2018) <https://www.coindesk.com/information/hard-fork-vs-soft-fork/> accessed 8 August 2018. 196 See Lee and Deng (n 104) sub-s 11.3.3. 197 ibid. 198 ibid sub-s 11.3.2.

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for their work meaning that they can abandon the project at any moment increasing the likelihood that bugs

are not fixed, and the system remains out of date. However, Financial institutions may easily support any

project, public or private, if it is convenient for them. Developers may be paid by financial institutions that

benefit from this kind of projects. This would increase the level of developers’ accountability towards the paying

institution.

On the other hand, the lack and of an effective, external, and formal supervision may raise conflict of interest

problems. No one prevents a financing institution from giving directives on software development that favour

it over others. One may argue that the market would fix this issue with participants leaving the unfair

infrastructure in favour of a most reliable one. Take part in this debate exceed the scope of this study. What

can be said here is that, historically, regulations and government have always tried to prevent conflicts of

interest especially after the GFC199 stepping away from the invisible hand concept theorised by Adam Smith.

Given the current legal framework, the root problem is that financial institutions would hardly finance a long-

term public open-source project based on unrestricted DLT for creating new types of FMIs.

My additional claim is that even if the governance arrangement is efficient, transparent, and clear, with paid

developers, the problem of the accountability towards competent authorities remain. At the moment, public

blockchains are not supervised by any financial authority, and they are not considered as components of FMIs.

It would be hard to imagine a single financial supervisor for a network that is decentralised all over the world

and that may be used in different jurisdictions that are not entirely harmonised. Also, public blockchains, given

their open nature, may serve different purposes that exceed those of the financial markets. For instance, health,

supply chain, gaming, energy, and many others at the same time. I ask the reader to think how such a system

can be supervised by a competent financial authority that does not deal with any of the other sectors mentioned

above. This would create competition between financial and non-financial competent authorities on the same

system making enforceability of current laws hard if not impossible. The lack of effective accountability and

enforceability makes regulations useless including the ones against operational risks.

199 EMIR arts 28 (4), 33; MIFID II arts 18 (4), 23, 48 (1) (a); CSDR art 26 (3, 6).

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All of these scenarios do not comply with PFMI and EU regulation analysed in the Subsection 3.3. On the

contrary, they carry on additional layers of operational risks at any level. By looking at the bigger picture, the

potential implications concern not only the backbone of as FMI but also everything that is built on it. For

instance, an investment firm which needs to outsource “important operational functions” to a third party will

find it hard to comply with Article 16 (5) of MiFID II when the third party is a public blockchain. In fact, there are

no “reasonable steps to avoid” the above mentioned “undue additional operational risk” other than relying on

a centralised network or a hypothetical restricted blockchain. This would create redundancy and additional

costs by making the implementation of a public blockchain in an FMI unnecessary.

3.5 Why is a restricted DLT suitable for FMIs?

The only alternative to overcome the outlined problems is a restricted or permissioned blockchain. More

specifically, a restricted tiered arrangement200 would easily comply with all principle and regulations listed in

subsection 3.3.

First, it will be possible to have clear and transparent governance which would be able to guarantee a safe

and efficient FMI in compliance with principle two of PFMI.201 When the code is created and run by a legal

entity,202 whether it is derived by open-source code or not, it is the owner of the software that decides the sort

of the system, its updates, and how much resources should be assigned to the project.

Decisions about software changes will be driven by technical aspects rather than ideological ones so that

decision-making “Committee” would necessarily count on a technocratic, centralised, and transparent body.

This would prevent any fork in the network, and consequently, any fragmentation and redundancy issue.

Therefore, when a hard fork203 is needed due to the complete incompatibility of the new software with the old

one, the only possible outcome is that the old version of the software (and network) will die, leaving the new

version of the ledger the only source of truth, denaturalising the concept of fork itself.

Second, the owner of the software will pay software developers to fix the bugs and update the system so that

the continuity of the services is guaranteed in the long-term. Further, given the transparency of the governance

200 See sub-s 1.4. 201 CPSS-IOSCO, PFMIs (n 1) Principle 2. 202 For instance, CCPs, SSSs, CSDs, or TRs. 203 See n 195.

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arrangement, it will be easy to set up clear lines of accountability and decisional procedures to “approve the

development, deployment and subsequent updates” of DLT systems as required by MiFID II RTS 6 and 7.

Even the problem of the accountability toward competent financial authorities would be solved. Thus, if

distributed systems204 are deployed within a specific territory that shares highly harmonised jurisdictions on

FMIs, there will be no problem in identifying the competent supervisory authorities. In particular, these systems

should be only dedicated to the operation of FMIs. At the EU level, everything would remain unchanged with

the European Banking Authority (EBA), the European Supervisory Authorities (ESAs), the European System

of Central Banks (ESCB), the European Central Bank (ECB), and the European Securities and Markets

Authority (ESMA) carrying out, with a close collaboration, their specific supervisory and oversight tasks for

each FMI.

Third, the whole software governance arrangement together with restricted validation governance allow a

certain degree of modification of the ledger. A crucial aspect for statutory reconciliation procedures or when

inadvertent errors (fat fingers), or frauds may trigger a certain number of smart contracts that may result in a

snowball effect in an almost fully automated market. The validation structure of the nodes should be based on

a permissioned basis to avoid any opposition to the modification of the ledger in the cases mentioned above.

On the other hand, to avoid the problem of tampering with the ledger by 51% of the nodes,205 it is necessary

to identify a number of nodes that is adequate to the scalability of the system and, at the same time, a minimum

quorum that makes tampering impossible. A rotation assignment of the node quality to a number of

predetermined participants bound by a contractual arrangement to the owner of the FMI could help in this

regard. At the same time, the decentralised structure of the ledger theorised in Subsection 1.2.3 would

guarantee the resilience of the system avoiding any point of failure. With this kind of arrangement, the trust

would be shared between the owner of the FMI, the network, and the competent authority for the supervision

of that particular FMI.

Fourth, as regards the access to trading information and transparency, the owner of the network should provide

a tiered permissioned access according to the status of the participant, or supervisor, and always in respect

of non-discriminatory access rules to guarantee a level playing field for participants and consumers. The

204 Meaning that the system is only dedicated to the operation of an FMI. 205 51 % attack, see n 135.

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outcome would be the creation of different layers of access to information for different types of participants

and supervisory authorities. This would allow complete compliance with confidentiality requirements for CCPs,

TRs,206 and CSD,207 and with participation requirements for clearing members in a CCP,208 and for participants

in a CSD.209 Finally, the identification of participants under the supervision of a trusted body (FMIs), that

already have to comply with KYC rules, will simplify AML and CFTR procedures.

4 A case study on Central Securities Depository

4.1 Introduction

As noted in Subsection 3.2, today, the holding of securities usually involves intermediaries. This is always true

in the EU when securities are intended to be sold and traded on capital markets. In particular, securities that

are traded on a trading venue or which “are transferred following a financial collateral arrangement as defined

in point (a) of Article 2(1) of Directive 2002/47/EC”210 have to be “recorded in book-entry form in a CSD on or

before the intended settlement date.”211

This section gives an example of how a restricted DLT can be used by a CSD to carry out its notary function

and reconciliation procedures under CSDR in regard to tradeable securities.212 It is important to remember that

the existing regulatory framework provides essential safeguards for well-functioning securities markets so that

a CSD or an SSS using a DLT that perform regulated services or functions should be mindful of existing

regulations. In particular, RTS on reconciliation procedures issued by ESMA213 offers a sound basis for the

implementation of this technology at the operational level, although slight amendments are required to

guarantee the integrity of the issue and so investor protection.

206 EMIR arts 33 (5), 35 (1) (j), 64 (4). 207 CSDR art 45 (2). 208 EMIR art 37. 209 CSDR art 33. 210 ibid, art 3 (2). 211 ibid. 212 Non-tradable securities are excluded from this analysis since they are usually not subject to regulatory constraints of the CSDR or SFD unless specified otherwise by national law. 213 Commission Delegated Regulation (EU) 2017/392 of 11 November 2016 supplementing Regulation (EU) No 909/2014 of the European Parliament and of the Council with regard to regulatory technical standards on authorisation, supervisory and operational requirements for central securities depositories [2017] OJ L 65/48 (Commission Delegated Regulation (EU) 2017/392).

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4.2 DLTs and CSDs’ notary function and reconciliation procedure

The first step for trading securities on capital markets is their issuance in the primary market. The issuance

process is regulated by the lex societatis (corporate law) applicable to the issuer, or by lex contractus (the law

chosen by the issuer) for certain aspects of debt issuance.214 The EU did not harmonise these laws that remain

of national prerogatives. However, at the operational level, national CSDs, which offer notary, central

maintenance, and settlement services, are all subject to CSDR.215

The first obstacle to the implementation of an unrestricted DLT for issuance services operated by a CSD is

that, under EU regulation, the CSD has a notary function. The initial recording of securities in an issuance

account stored on a public DLT would be carried out by unidentified nodes collectively responsible for

validating the transaction.216 This means that validators may reside in different parts of the word making any

kind of accountability and enforceability difficult if not impossible.

A private DLT run by a CSD could overcome this shortcoming since the validation process is made by trusted,

identified nodes that have been admitted in the network on the base of admission requirements, and respect

of conduct rules and contractual agreements. Validators may be considered as “account operators” under

Article 64(5) of Commission Delegated Regulation (EU) 2017/392. According to this RTS, account operators

are entities that are “contracted by a CSD to record book entries into its securities accounts”, and that must

“provide the CSD with the information that the CSD deems necessary to ensure the integrity of the issue, in

particular to solve any reconciliation problems.”217 Overall, the FMI will oversight this validation process and

detain the central governance to ensure proper handling of operational risk.

On the last point, the duty of a CSD to ensure the integrity of the issue represents the second obstacle.

According to Article 37 of CSDR, a CSD must take appropriate reconciliation measures to verify that the

number of securities debited on the issuance account is equal to the sum of securities recorded on the

securities accounts of investors or participants of the SSS operated by the CSD. Once again, with a public

DLT, this procedure would be carried out by unidentified nodes so that no legal entity would bear responsibility

214 See AMI-SeCo (n 128) sub-s 3.1.1. 215 The core services of CSDs are: “1. Initial recording of securities in a book-entry system (‘notary service’); 2. Providing and maintaining securities accounts at the top tier level (‘central maintenance service’); 3. Operating a securities settlement system (‘settlement service’).” CSDR Annex, s A. 216 See AMI-SeCo (n 128) sub-s 3.2. 217 Commission Delegated Regulation (EU) 2017/392.

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for it. Moreover, a public arrangement presents all drawbacks examined in section 3.4 regarding the

immutability of the ledger so that “the private key to modify the number of assets in circulation in the DLT

network would need to remain under the control of the operator [issuer CSD].”218

It should be noted that immutability (or truthfulness) of the data is one of the main benefits of DLT and that

some DLTs use single-entry bookkeeping with cryptographic linkages instead of double-entry bookkeeping. In

this case, notary checks on the correspondence between the number of securities in the issuance and

securities accounts (reconciliation) are guaranteed by proper cryptographic algorithms that link those accounts

without letting “anything to get in or out of the network after its content has been determined by the operator.”219

In order for a DLT to be implemented in a CSD system, ESMA should update its current RTS regarding

reconciliation measures.220 In particular, the third subparagraph of Article 59(1) should include the possibility

to use single-entry accounting based on cryptographic algorithms, besides the double-entry system.

Moreover, a fifth paragraph should be inserted to guarantee the truthfulness of the ledger in case the

reconciliation procedures specified in Articles 59, 60, 61, 62, and 63 are carried out with a single-entry

accounting system. This amendment should provide that every change made by a CSD and occurred in the

ledger following the reconciliation procedures shall be traceable. Such traceability should be implemented at

the software level, and the part of the code should be disclosed to the competent authority. In this way, a smart

contract can automatically create a report of any correction that can be automatically sent to “participants,

competent authority, relevant authorities and the other entities involved in the reconciliation process that are

referred to in Articles 61, 62 and 63” as provided by Article 65 of the same RTS. Also, such an arrangement

would add additional layers of security, transparency, and trust over the ledger fostering investor protection.

5 Challenges

218 See AMI-SeCo (n 128) sub-s 3.3. 219 ibid sub-s 3.3.2. 220 Commission Delegated Regulation (EU) 2017/392.

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5.1 Introduction

Regardless of the type of DLT, the implementation of such a technology in an FMI gives rise to certain

challenges both at the regulatory level and operational level. This section examines five of them being aware

that they are not the only ones. The aim is to demonstrate that despite the congruence of restricted DLTs with

many aspects of FMIs, their possible large-scale implementation in the medium-term is impossible without

progress in both regulatory harmonisation and technical solution.

Subsection 5.2 deals with the need for harmonisation of the securities issuance process at national level.

Subsection 5.3 faces the problem of lack of interoperability between SSS and payment systems in DvP

procedures. Subsection 5.4 analyses the same problem of interoperability from an external perspective

between FMIs’ DLTs and other external participants’ systems. Subsection 5.5 considers the incompatibility of

DLTs with SFD and CSDR in relation to the opening of insolvency proceedings against participants. Finally,

Subsection 5.6 points out the problem of the nature of the asset registered on a DLT in relation to collateral

management.

5.2 Harmonisation of the issuance process

As noted in subsection 3.2, the issuance process is regulated by national corporate law that is not harmonised

at the EU level. It is for the applicable national law to determine whether securities can be issued by using a

DLT network. For instance, in Germany, the establishment of securities requires the creation of a physical

certificate preventing the full digitalisation of securities with DLTs. 221 Harmonisation over the securities

issuance to foster full digitalisation would help the deployment of DTLs in FMIs.

5.3 SSS and payment systems interoperability in DvP

Even if a restricted DLT is implemented for the issuance of securities and SSS, Article 39(7) of the CSDR

requires that “all securities transactions against cash between direct participants in a securities settlement

221 See ESMA (n 94) 105.

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system operated by a CSD and settled in that securities settlement system shall be settled on a DvP222 basis”.

Under current regulations,223 the cash leg of the securities settlement shall be settled in central bank money

(CeBM) where practical and available to avoid credit and liquidity risks, or in commercial bank money (CoBM)

if CeBM is not used. This creates a challenge regarding the interoperability of SIPS and DLT systems deployed

for securities settlement. Whether cash is directly represented in the ledger, or in a separate DLT through a

potential central bank virtual currency, or whether the DLT interacts with non-DLT system exceed the scope

of this study.224 However, interoperability and harmonisation between different technologies or different DLT

systems is conditional to the delivery and yet to be implemented.

5.4 FMIs and external systems interoperability

Interoperability is also crucial for different aspects of the whole FMI. For instance, in the post-TARGET2-

Securities environment, issuer or issuer’s agents can have a distribution account in one CSD that is different

from the issued CSD so that they can pool their distribution activities with one CSD while issuing securities in

different markets.225 Further, according to national law, an issuance process or reconciliation process may

involve other actors such as custodians, registrars, national numbering agencies, and others. New DLT system

should be arranged by taking into consideration both harmonisation and interoperability with all relevant

systems.

5.5 Settlement finality in insolvency proceedings

Articles 3(1)(2), and 6(1) of SFD set up the regulatory framework regarding the challenge of settlement finality

in insolvency proceedings with a DLT. However, to better understand the issue CSDR and ESMA guidelines

on this matter offer a clearer example. CSDR requires CSDs to “have effective and clearly defined rules and

222 “DvP is settlement mechanism that links a securities transfer and a funds transfer in such a way as to ensure that delivery occurs if and only if the corresponding funds transfer occurs.” See CPSS-IOSCO, PFMIs (n 94) 152. 223 See CPSS-IOSCO, PFMIs (n 94) Principle 9; CSDR Art 40(1), Recital 44; Regulation of the European Central Bank (EU) No 795/2014 of 3 July 2014 on oversight requirements for systemically important payment systems (ECB/2014/28) [2014] OJ L 217/16. 224 On this matter, see AMI-SeCo (n 128) sub-s 4.2; IPOL (n 153) s 3. 225 See ECB – Eurosystem, 'Topic 6: Issuance Practice – Draft' (2012) ch 2.1.2, para 6-11 <https://www.ecb.europa.eu/paym/t2s/progress/pdf/subadapt/minicon1/2012-06-27_Solution_Outline_Issuance_practices.pdf?532ac522c0c40ae1af41614a5c687631> accessed 13 August 2018.

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procedures to manage the default of one or more of its participants.”226 According to ESMA guidelines, a CSD

shall have the ability to suspend or terminate its participants’ access to its SSS when participants are defaulting,

and the default has been identified.227 A real-time or near-real-time settlement in a DLT solution would give no

time to the CSD to suspend access to defaulting participants right after the opening of the insolvency

proceedings against them. This result in the possibility for defaulting participants to enter a significant amount

of transfer order instructions into the system, with the consequent settlement, before the operator is able to

suspend the access. Such a scenario would pose a threat to the compliance with settlement finality rules and

so increase systemic risk.228

5.6 Nature of the asset in DLTs and collateral management

Even though restricted DLT may offer potential advantages for collateral management in FMIs,229 in terms of

nature of the assets recorded on the ledger, there is no “certainty on whether a position in the ledger constitutes

full title or another form of entitlement. In addition, these positions in the DLT network would need to be

recognised as collateral under the applicable law.”230 Once again, national law is not harmonised on this matter.

Therefore, a harmonised regulation is required at EU level.

Conclusions

This paper examined the implementation of restricted DLTs in EU FMIs instead of unrestricted ones. Although

advocates of public or unrestricted DLTs promote the implementation of such arrangements for FMIs due to

their main characteristics, a trade-off that loosens them is necessary for the arrangement to comply with current

regulatory framework. This trade-off can be easily met with a restricted DLT.

226 CSDR art 41 (1). 227 See ESMA, 'Guidelines On Participant Default Rules And Procedures Under Regulation (EU) No 909/2014' (2017) ch 3, para 31 <https://www.esma.europa.eu/regulation/post-trading/settlement> accessed 13 August 2018. 228 See AMI-SeCo (n 128) sub-ss 5.2.2, 5.2.3. 229 ibid sub-ss 8.2.1, 8.2.2, 8.2.3. 230 ibid sub-s 8.2.3.

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In particular, immutability should compete with governance and operational procedures that allow a certain

degree of modification of the ledger to correct inadvertent errors, restore the situation after frauds, or to carry

out statutory reconciliation procedures. This is only possible with a restricted DLT.

Trusting only the network is not sufficient to guarantee investor protection and prevention of systemic risks. In

fact, it is hard for a financial supervisory authority to supervise a public network. Trust should be shared

between the owner of the FMI, the network, and the competent authority for the supervision of that particular

FMI. This is only possible with a restricted DLT.

The transparency provided by unrestricted DLTs is important to achieve more accurate assets’ prices,

reduction of settlement risk and help to reduce costs related to mandatory disclosure regulations, mandatory

reporting requirements for post-trade transparency and, traceability for compliance with KYC, AML and CFTR.

However, transparency and traceability should compete against privacy and the need to keep certain

information confidential. This can be achieved only with a restricted DLT where participants have different

layers of access to information.

Smart contracts can drastically reduce costs of clearing and settlement procedures and reporting processes.

However, due to their capacity to automate processes and cyber risks attached to them, they may trigger

systemic event in a similar fashion of algorithmic trading. For this reason, regulators should take into

consideration MiFID II and MiFID II RTSs on algorithmic trading in regulating DLTs. The same conclusion on

immutability regarding governance also applies to automation.

Resilience is crucial for FMIs, and DLTs may contribute to render the whole financial market more resilient.

However, the arrangement should be set up in such a way as not to decrease the scalability and, at the same

time, to keep the database safe and tamper-proof. Only a restricted DLT can meet such requirements.

The historical evolution of the centralisation of FMIs is important to understand the reasons why today’s

regulations require FMIs to have formal governance arrangement to manage risks. Unrestricted DLTs struggle

to meet any requirement on this matter. This happens regardless of the implementation of democratic or

technocratic governance models. On the other hand, a restricted DLT with a technocratic governance

arrangement subject to supervisory financial authority would have no problem to manage risks.

Restricted DLTs can easily meet the almost all the requirements for a CSD to carry out its notary function and

reconciliation procedures as required by CSDR. However, slight amendments are required to guarantee the

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integrity of the issue and so investor protection. In particular, RTS regarding reconciliation measures should

include the possibility of a CSD to use single-entry accounting based on cryptographic algorithms, besides the

double-entry system. Moreover, the truthfulness of the ledger should be guaranteed by adding a provision that

ensures traceability and reporting requirements of any correction made by the CSD on the database.

The need of harmonisation of the securities issuance process at national level, the lack of interoperability

between SSS and payment systems in DvP procedures, the lack of interoperability between FMIs’ DLTs and

other external participants’ systems, the incompatibility of DLTs with SFD and CSDR in relation to the opening

of insolvency proceedings against participants, and the problem of the nature of the asset registered on a DLT

in relation to collateral management represent, inter alia, some of the challenges that have to be solved in

order to allow restricted DLT to be deployed on a large scale.

List of abbreviations

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AMI-SeCo

AML

BIS

CCP

CCS

CFTC

CFTR

CPMI

CPSS

CSD

CSDR

DAO

DLT

DTC

DvP

EMIR

ESMA

EU

FMI

FSB

G20

GDPR

GFC

IETF

IOSCO

IPOL

KYC

MiFID II

MiFIR

NIS

NYSE

PFMI

RTGS

RTS

SFD

SIPS

SSS

TR

Advisory Group on Market Infrastructures for Securities and Collateral

anti-money laundering

Bank of International Settlement

Central Counterparties

Central Securities Services

Commodity Futures Trading Commission

Counter-Terrorist Financing Regulations

Committee on Payments and Market Infrastructure

Committee on Payment and Settlement Systems

Central Securities Depository

Central Securities Depository Regulation

Decentralised Autonomous Organisation

Distributed Ledger Technology

Depository Trust Company

Delivery versus Payment

European Market Infrastructure Regulation

European Securities and Markets Authority

European Union

Financial Market Infrastructure

Financial Stability Board

Group of 20

General Data Protection Regulation

Global Financial Crisis

Internet Engineering Task Force

International Organization of Securities Commissions

Policy Department for Economic, Scientific and Quality of Life

Know Your Customer

Markets in Financial Instruments Directive II

Markets in Financial Instruments Regulation

Network and Information Security directive

New York Stock Exchange

Principles of Financial Market Infrastructure

Real Time Gross Settlement

Regulatory Technical Standard

Settlement Finality Directive

Systemically Important Payment Systems

Securities Settlement Systems

Trade Repositories

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Distributed Ledger Technology and Asset

Securitisation: an analysis of the benefits and the regulatory challenge to this framework

Victor Da Silveira Vieira

ABSTRACT

Within the current framework of financial technologies, the rise of distributed ledgers appears as a promising

component to the improvement of this innovative field. Despite being commonly related to virtual currencies,

the global financial markets are currently directing their attention to distributed ledger technology (‘DLT’) and

realising that its application to financial services may provide significant benefits to investors and potentially

reshape the way financial markets are known. In this context, the asset securitisation industry is being

considered as one of the fields that could mostly benefit from distributed ledgers. This is because DLT is

deemed to have the capacity to address the problems highlighted by the Global Financial Crisis of 2008 which

have tarnished the securitisation industry. However, the paper considers that regulatory uncertainty remains

as a challenging obstacle to this new framework. As at the present day no legal framework covers the use of

DLT in financial activities, there is no certainty whether regulators will allow the application of this technology

to securitisation or, especially, how would be the approach taken by them to deal with this innovation. Thus,

the aim of this paper is to clarify if there are consistent legal grounds for regulators to embrace DLT and

securitisation and, mainly, to suggest the most adequate regulatory strategy that regulators should take to

consider this framework. To this purpose, the paper provides an explanation of the main concepts of DLT and

demonstrates how securitisation could benefit from this technology. In this way, the paper critically evaluates

the possible approaches that could be taken by regulators to deal with the application of DLT to financial

activities as securitisation and proposes that there are consistent legal grounds to support the use of DLT in

securitisation, considering the higher degree of transparency that it could provide for the benefit of investors

protection. The research brings proposals of the most suitable approach that should be taken by regulators to

cope with this innovation.

Keywords: asset securitisation – distributed ledger technology – Global Financial Crisis – regulation –

innovation – transparency – securities laws

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TABLE OF CONTENTS

INTRODUCTION

1. DISTRIBUTED LEDGER TECHNOLOGY AND ITS

IMPACT TO THE GLOBAL FINANCIAL MARKETS

1.1. Blockchain: A New Trend in the Market

1.2 The Rise of a New Financial Infrastructure

2. DLT AND THE CASE FOR ASSET SECURITISATION

2.1 Securitisation as a ‘Causa Proxima’ of the Crisis

2.2 Securitisation and DLT: A New Hope for the Industry?

3. REGULATORS AND THEIR APPROACHES TO

FINANCIAL INNOVATION

3.1 Regulatory Uncertainty: A Challenge to be Addressed

3.2 Regulation and DLT: Possible Approaches by

Regulators

3.2.1 Wait and See Approach

3.2.2 Issuance of New Regulation

4. DLT AND SECURITISATION: ACHIEVING THE AIM OF

SECURITIES LAWS AND A REGULATORY MODEL TO BE

FOLLOWED

4.1 Why regulators should embrace DLT and

Securitisation?

4.2 Regulatory Sandboxes: A Do no Harm Proposal for DLT

and Securitisation

CONCLUSIONS

BIBLIOGRAPHY

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Introduction

During the recent decades, technology could be considered as one of the main drivers for humans`

development. Society has been witnessing a constant growth of new technological improvements which are

affecting the way citizens interact with each other.231 Following this trend, importance is currently being posed

to the impact of technologies on financial services, giving rise to a new field of interest known as ‘Fintech’.232

In a report conducted by the UK Treasury, Fintech was defined as ‘high-growth organisations combining

innovative business models and technology to enable, enhance and disrupt financial services’.233 In this

context, at the present moment, the eyes of financial markets participants are mostly turned into distributed

ledger technology (‘DLT’), an innovative system famously known for underpinning the virtual currency

Bitcoin234 and deemed to have the potential to dramatically revolutionise the way capital markets function.235

As one of the most relevant components of the Fintech revolution, DLT is considered to be a shared

platform where information could be stored through cryptography and accessed by all their members, creating

an environment based on transparency and safety. 236 Thus, there are many institutions and market

participants that are directing their efforts to the possible implementation of DLT to financial services,

supporting that this technology could, in fact, redesign the future of the financial infrastructure.237 In this way,

it is widely discussed that one of the promising areas which could benefit from DLT is asset securitisation.238

The issuance of asset-backed securities (‘ABS’) is considered to be one of the factors that contributed to the

collapse of the global markets during the global financial crisis of 2008 (‘Crisis’).239 Indeed, the facts occurred

during the Crisis brought into light weaknesses identified in the process of structuring ABS which are mostly

related to the lack of proper information that was given to investors and the overreliance on credit rating

agencies` assessments.240 Considering this problematic framework, there are commentators who propose

that DLT could efficiently address these problems.241 This is because, by implementing DLT through all the

231 See Steve Woolgar, Virtual Society? Technology, Cyberbole, Reality (2th edn, Oxford University Press, 2002) 1-2. 232 See George A Walker, ‘Financial Technology Law: A New Beginning and a New Future’ (2017) Volume 34, Number 3 GPSolo Magazine 76. 233 See UK Treasury, ‘UK FinTech – On the cutting edge. An evaluation of the international FinTech sector’ (2015) 21 <https://www.ey.com/Publication/vwLUAssets/EY-UK-FinTech-On-the-cutting-edge/%24FILE/EY-UK-FinTech-On-the-cutting-edge.pdf> accessed 29 March 2018. 234 For the definition of virtual currencies, see the one proposed by the Financial Action Task Force, which defines virtual currency as ‘a digital representation of value that can be digitally traded and functions as: (1) a medium of exchange; and/or (2) a unit of account; and/or (3) a store of value, but does not have legal tender status (i.e. when tendered to a creditor, is a valid and legal offer of payment) in any jurisdiction.’ In this way, see FATF, ‘FATF Report Virtual Currencies Key Definitions and Potential AML/CFT Risks’ (2014) available at <http://www.fatf-gafi.org/media/fatf/documents/reports/Virtual-currency-key-definitions-and-potential-aml-cft-risks.pdf> accessed 15 July 2018. 235 See generally World Economic Forum, ‘The future of financial infrastructure: An ambitious look at how blockchain can reshape financial services’ (2016), <http://www3.weforum.org/docs/WEF_The_future_of_financial_infrastructure.pdf> accessed 29 March 2018. 236 See UK Government Office for Science, ‘Distributed Ledger Technology: beyond block chain’ (2016) 5-8, <https://www.gov.uk/government/news/distributed-ledger-technology-beyond-block-chain> accessed 29 March 2018. 237 See generally WEF (n 5). 238 See generally Lewis Rinaudo Cohen, Lee Samuelson and Hali Katz, ‘How Securitization can benefit from Blockchain Technology’ (2017) Volume 23 The Journal of Structured Finance. 239 ibid; see also American Securities Exchange Commission, ‘Asset-Backed Securities Disclosure and Registration’ (2014) 12, <https://www.sec.gov/rules/final/2014/33-9638.pdf> accessed 29 March 2018. 240 ibid 10. 241 See generally Cohen, Samuelson and Katz (n 8); and Deloitte & Touche LLP, Structured Finance Industry Group and the Chamber of Digital Commerce, ‘Applying blockchain in securitization: opportunities for reinvention’ (2017) available at <https://www2.deloitte.com/us/en/pages/regulatory/articles/applying-blockchain-in-securitization.html> accessed 29 March 2018.

https://www.ey.com/Publication/vwLUAssets/EY-UK-FinTech-On-the-cutting-edge/%24FILE/EY-UK-FinTech-On-the-cutting-edge.pdf

http://www.fatf-gafi.org/media/fatf/documents/reports/Virtual-currency-key-definitions-and-potential-aml-cft-risks.pdf

http://www3.weforum.org/docs/WEF_The_future_of_financial_infrastructure.pdf

https://www.gov.uk/government/news/distributed-ledger-technology-beyond-block-chain

https://www.sec.gov/rules/final/2014/33-9638.pdf

https://www2.deloitte.com/us/en/pages/regulatory/articles/applying-blockchain-in-securitization.html

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stages of a securitisation transaction, this technology might provide a higher degree of transparency to this

market and, consequently, bring confidence back to ABS` investors.242

Despite the benefits that DLT may offer to asset securitisation, legal issues appear as

challenging obstacles to this new framework. It can be observed that one legal consideration is related to the

approach that regulators may take with respect to the use of DLT in securitisation. That is to say, as there is

still no consistent legal framework that covers DLT, questions remain whether regulators will allow the use of

this technology in financial activities, such as securitisation, or which approach will be taken by them to deal

with this innovation.243 Following this uncertain scenario, the aim of this paper is to consider the potential

application of DLT to securitisation and if there are legal grounds for regulators to embrace the use of this

technology and, mainly, to evaluate which should be considered the most suitable approach to be taken by

them to deal with this innovation. To this purpose, firstly, Section 1 briefly explains the key components of DLT

and its potential impact on the global financial markets. Thereafter, Section 2 provides an explanation of the

problems linked to securitisation highlighted by the Crisis and demonstrates the benefits that DLT could provide

to these transactions. Furthermore, in Section 3, this paper clarifies that regulatory uncertainty may hinder the

referred implementation and critically analyses the possible approaches that could be taken by regulators to

deal with this innovation. In Section 4, this paper considers the legal reasons that might support the application

of DLT to securitisation and, finally, seeks to suggest an adequate regulatory model for regulators to follow in

order to embrace this proposed framework and address the current regulatory challenge.

242 ibid. 243 See Harold Primm, ‘Regulating the Blockchain Revolution: A Financial Industry Transformation’ (2016) Volume 36 Review of Banking & Financial Law 84-85; and Deloitte, SFIG and CDC (n 11) 21.

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Section 1 – Distributed Ledger Technology and its Impact to the

Global Financial Markets

1.1. Blockchain: A New Trend in the Market

Considering the disruptive framework brought by Fintech, DLT has been broadly claimed as one of

the most promising technologies of this field and, therefore, defining its key concepts seems to be pertinent

for the purpose of this paper. In this regard, it appears vital to consider the DLT`s definition given by the UK

Treasury which has defined this technology as ‘an asset database that can be shared across a network of

multiple site, geographies or institutions’.244 Thus, what could be understood by this definition is that DLT

provides digital ledgers where assets, transactions or information can be stored in a historical order and be

widely available to their members (commonly known as nodes).245 In this way, it seems that the real disruptive

feature of this technology relies on its distributed essence.246 To clarify this, different from a centralised

structure, the information kept on a distributed ledger (including past records) is available to each of its

members who can directly access it at their own discretion, mitigating the need for a central entity to control

information.247 Therefore, this outlines that there is a clear degree of disintermediation within the objectives

of distributed ledgers, a feature that could challenge the common centralised system as the one applied by

banks for example.

Explained the distributed characteristic of DLT, the provision of a complete picture of this technology

must also cover a famous term belonged to this framework: the blockchain. In simple words, blockchain is one

of the different kinds of DLT and, probably, have its popularity linked to the heated world of virtual currencies,

since it is the system that underpins Bitcoin.248 On this path, what differs blockchain from other types of

distributed ledgers is the fact that it is a ‘database that takes a number of records and puts them in a block’.249

Put it simply, each transaction included in a blockchain is collected into a block and linked to the next block

through cryptography, hence, the information bundled in this system remains securely protected by computer

code encryption.250 Furthermore, it is worth mentioning that the immutability of the information stored on a

blockchain is also a crucial advantage of this technology. This is because, by connecting the blocks with

cryptography, it might be impossible to change information of one block without revalidating the data of the

previous blocks which seems to result in the creation of an immutable environment.251 Lastly, there is also

244 See UK Government (n 6) 5. 245 See Dion Blummont, ‘Blocking the Future? The Regulation of Distributed Ledgers’ (2017) Victoria University of Wellington Legal Research Paper, Student/Alumni Paper No 37/2017 2-3 available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3016210> accessed 29 March 2018. 246 See European Securities and Markets Authority, ‘The Distributed Ledger Technology Applied to Securities Markets’ (2017) 4 available at <https://www.esma.europa.eu/system/files_force/library/dlt_report_-_esma50-1121423017-285.pdf> accessed 29 March 2018. 247 See International Swap & Derivatives Association and Linklaters, ‘Whitepaper Smart Contracts and Distributed Ledger – A Legal Perspective’ (2017) 7 available at <https://www.isda.org/a/6EKDE/smart-contracts-and-distributed-ledger-a-legal-perspective.pdf> accessed 29 March 2018. 248 ibid 7; see UK Government (n 6) 5. 249 See UK Government (n 6) 17. 250 ibid; see Michèle Finck, ‘Blockchain Regulation’ (2017) Max Planck Institute for Innovation & Competition Research Paper No 17-13 4 available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3014641> accessed 29 March 2018. 251 See Deloitte, SFIG and CDC (n 11) 3.

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noteworthy importance to classify distributed ledgers into two different categories. The first one is represented

by the ‘permissionless’ or public ledgers, a type of DLT that does not impose any restrictions to their

participants (i.e. everyone may freely enter the system and access information), since no central intermediary

manages the network.252 The Bitcoin’s blockchain is deemed to be the most famous public DLT, providing a

peer-to-peer network based on full disintermediation.253 On the other side, in ‘permissioned’ or private

distributed ledgers, there are one or more agents who act as administrators of the ledger, holding powers to

discretionary restrict the entry of new members and to maintain privacy to some information when

necessary.254 Despite having a degree of centralisation, a private blockchain may avoid the entry of dishonest

parties, therefore, it is being currently used by some of the major financial institutions as Goldman Sachs and

Barclays.255 Thus, this explanation of the key aspects related to DLT leads this paper to provide a brief

description of the smart contracts` framework, since these tools are normally considered together with DLT.256

Since its initial proposal, there is no unquestioned definition of a smart contract.257 However, this paper

adopts the concept proposed by Alexander Savelyev who defines smart contract as a: ‘a piece of software

code, implemented on Blockchain platform, which ensures self-enforcing and autonomous nature of its terms

triggered by conditions defined in advance and applied to Blockchain- titled assets.’258 From this concept, it

could be understood that a smart contract seems to be a computer tool that formalises contractual terms

agreed between parties into a digital coded form.259 Therefore, parties may have a platform where agreed

provisions could be implemented into software codes which might, as a consequence, bring certainty to

contract law. 260 Furthermore, as a smart contract is designed through computer codes, its execution is

completely automated, hence, the obligations are exclusively performed through the running of the codes,

independently from any human intervention.261 This automation of smart contracts outlines its importance to

DLT, since distributed ledgers might provide an appropriate environment to this self-execution.262 In this

context, institutions are recognising the benefits that smart contracts could bring to financial activities. For

instance, the International Swap & Derivatives Association (‘ISDA’) is currently considering the use of smart

contracts in derivatives transactions by integrating them into the ISDA documentation framework.263 Thus, vital

importance is being posed to the potential application of smart contracts and DLT to financial activities as will

be further addressed by this paper.

252 See ISDA and Linklaters (n 17) 8. 253 See Satoshi Nakamoto, ‘Bitcoin: A Peer-to-Peer Electronic Cash System’, available at <https://bitcoin.org/bitcoin.pdf> accessed 29 March 2018. Bitcoin is a virtual currency designed by an unknown person or group of persons called Satoshi Nakamoto. 254 See Deloitte, SFIG and CDC (n 11) 5 255 See Jean Bacon, Johan David Michels, Christopher Millard and Jatinder Singh, ‘Blockchain Demystified’ (2017) Queen Mary School of Law Legal Studies Paper No 268/2017 19; and Kadhim Shubber, ‘Blockchain initiative pulls in another 13 banks’ (Financial Times, September 2015), available at <https://www.ft.com/content/72ffd222-66be-11e5-97d0-1456a776a4f5> accessed 29 March 2018. 256 See ISDA and Linklaters (n 17) 8. 257 See Alexander Savelyev, ‘Contract Law 2.0: «Smart» Contracts as the Beginning of the End of Classic Contract Law’ (2016) Basic Research Program Working Papers Series Law at the National Research University Higher School of Economics (HSE) 7 available at <https://wp.hse.ru/data/2016/12/14/1111743800/71LAW2016.pdf> accessed 29 March 2018. 258 ibid 15. 259 See Savelyev (n 27) 12. 260 ibid; see Max Raskin, ‘The Law and Legality of Smart Contracts’ (2017) Georgetown Law Technology Review 305 309. 261 ibid; Savelyev (n 27) 15. 262 ibid 314; see ISDA and Linklaters (n 17) 8. 263 See generally ISDA and Linklaters (n 17).

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1.2. The Rise of a New Financial Infrastructure

Technology is changing the way that businesses are undertaken, Airbnb in the housing sector

and Uber in cars are just a few examples of innovative companies disrupting their respective markets.264

Following this trend, financial markets actors and international organisations are conceiving the potential

application of DLT to financial services, a tendency that promises to redesign the structure of the current

markets.265 It is widely claimed that DLT`s platforms could have the potential to disrupt the foundations of the

global capital markets, mainly because of the new framework based on disintermediation.266 Therefore, apart

from the virtual currencies, it has been argued that DLT could broaden their application to other assets traded

on financial markets.267 For example, this technology may promote a place where securities could be settled

and cleared on a DLT platform268 between parties without the need for a third intermediary.269 In the same

trend, the Foreign Exchange Market (‘FX Market’) is also a promising case for the use of DLT, since it seems

that this technology may provide a higher degree of transparency to this market through the storage of foreign

currency prices on a common decentralised ledger as blockchain.270 Following this tendency, it is argued that

securitisation is one the fields that could significantly benefit from DLT, since this technology appears to have

the capacity to address many of the problems highlighted by the Crisis which have tarnished the securitisation

industry. Thus, this proposed issue will be further discussed by this paper.

264 See Goldman Sachs, ‘Profiles in Innovation Blockchain Putting Theory into Practice’ (2016) 13 available at <https://msenterprise.global.ssl.fastly.net/wordpress/2017/07/Goldman-Sachs-Blockchain-putting-theory-to-practice.pdf> accessed 29 March 2018. 265 See generally WEF (n 6). 266 ibid. 267 See Philipp Paech, ‘The Governance of Blockchain Financial Networks’ (2017) Modern Law Review LSE Legal Studies Working Paper No 16/2017 3 available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2875487> accessed 29 March 2018. 268 ibid 3-4. 269 ibid 8; see also Blummont (n 15) 11. 270 See Jason Leinwand, ‘How blockchain technology could change FX’ (Banking Exchange, 2017), available at <http://www.bankingexchange.com/news-feed/item/7211-how-blockchain-technology-could-change-fx> accessed 18 June 2018.

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Section 2 – DLT and the Case for Asset Securitisation

2.1. Securitisation as a ‘Causa Proxima’271 of the Crisis

The events following the Crisis have demonstrated significant flaws in the securitisation process

which seem to have contributed to the collapse of the global markets. However, before explaining the role

played by securitisation to the Crisis, it appears relevant to mention the main features of this kind of financial

transaction. To precisely explain, an asset securitisation transaction can be defined as the ‘issuance of bonds

backed by a pool of receivables or other assets (hence ‘asset-backed securities’ or ‘ABS’) rather than by a

corporate credit’.272 Put it simply, this structured finance transaction involves the selling of assets (for example

housing mortgages or consumer receivables) by their owner (originator) to a new special purpose vehicle

(‘SPV’) which will fund the purchase of the assets by the issuance of ABS to capital markets` investors.273 In

relation to the purchase of the securities by the investors, credit rating agencies (‘CRA’) will rate the bonds in

accordance with their risk assessment.274 On this basis, considerable importance is normally given to the

quality of the asset portfolio that underlines the securities, since the proceeds derived from the receivables are

the ones that will pay interests and principal of the bonds.275 In this way, in order to provide a degree of safety

to investors, one of the most important risk mitigators is the undertaking of careful due diligence of the portfolio,

including commercial matters (potential occurrence of debtors` default) and legal concerns (good title of the

receivables).276 Therefore, securitisation provides benefits for both the originator who accesses new sources

of financing and for the investors who can purchase high rated securities by CRA.277

Recognised the main features of securitisation, it seems pertinent to explain the arguments that

confirm the contribution of this practice to the Crisis. During the years before the Crisis, the securitisation

industry was experiencing a moment of bonanza with many investors purchasing high rated products backed

by housing mortgages.278 However, as already discussed by many commentators, these complex securities

seem to have been overvalued by CRA, since a significant amount of them were, actually, underlined by

subprime mortgages, assets with poor cash flow performance and high risk of default.279 This circumstance

has subsequently resulted in the downgrade of the bonds with the decrease in their performance280 and

damages to investors who purchased these securities. For these reasons, the complex framework of

271 See Rosa M. Lastra and Geoffrey Wood, ‘The Crisis of 2007-09: Nature, Causes, and Reactions’ (2010) Volume 13 Issue 3 Journal of International Economic Law 16. 272 See Marke Raines and Fanny Lau, ‘UK Securitisation’ Volume 1 Number 2 Bankers` Law 23. 273 See Philip Wood, Law and Practice of International Finance (Sweet & Maxwell Limited, 2008) 450-454. 274 See Andrew Mcknight, The Law of International Finance (OUP, 2008) 699. 275 ibid; see Wood (n 43) 450. 276 ibid. 277 See Wood (n 43) 450-456. 278 See Orkun Akseli, ‘Securitisation, the Financial Crisis and the Need for Effective Risk Retention’ (2013) European Organization Law Review 14 7-9; and International Monetary Fund, ‘Securitization: Lessons Learned and the Road Ahead’ (2013) 8-9 available at <https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Securitization-Lessons-Learned-and-the-Road-Ahead-41153> accessed 19 June 2018. 279 See Merritt B. Fox, ‘Due Diligence with Residential Mortgage Backed Securities’ (2013) Columbia Law School Working Paper No 462 60 available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2359679> accessed 19 June 2018; and Kenneth E. Scott and John Taylor, ‘Why Toxic Assets Are so Hard to Clean Up’ (The Wall Street Journal, 21 July 2009) available at <https://www.wsj.com/articles/SB124804469056163533> accessed 19 June 2018. 280 See SEC, ‘Summary Report of Issues Identified in the Commission Staff’s Examination of Select Credit Rating Agencies’ (2008) 2 available at <https://www.sec.gov/news/studies/2008/craexamination070808.pdf> accessed 19 June 2018.

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securitisation is commonly blamed to have played the most important role to the Crisis, however, as supported

by some commentators, securitisation could be considered a ‘causa proxima’ of the Crisis, but not the

exclusive cause of the Crisis.281 On this account, the analysis which supports securitisation as a ‘causa

proxima’ of the Crisis seems to be mostly based on a relevant flaw identified in the securitisation framework:

the overreliance by investors on CRA` ratings in place of the conduction of effective due diligence of the

underlying assets.282

As above mentioned, the Crisis has highlighted a lack of proper due diligence of the pool of

assets securitised by investors who have purchased the products on the exclusive reliance on CRA` ratings283

(which proved to be contestable in subsequent time). 284 However, it appears crucial to mention that

undertaking proper due diligence was not a simple procedure. This is because, there were significant

difficulties related to the quantity and the content of the information of the assets securitised which were

available to investors.285 Firstly, the amount of data available to investors, as provided by the issuers of the

securities in accordance with regulatory requirements, seemed not to be sufficient to correctly understand the

risks of the pool of assets (and in many cases was almost impossible to obtain).286 Moreover, the data, in

some circumstances, was not reliable, since a significant amount of the underlying assets` documentation

omitted information of the debtors` conditions or was based on false statements.287 In this way, it could be

observed that this problematic issue might have its grounds on the structure of the housing mortgage industry

where originators maintained (and still maintains) most of the mortgage documentation on paper and, as a

consequence, could have contributed to the due diligence failures.288

Therefore, the Crisis seems to have clarified a considerable inefficiency in the securitisation process

linked to the lack of proper disclosure and transparency to investors which may have damaged the risk

assessment of the underlying assets by investors. With this respect, in addition to the difficulties liked to due

diligence procedures, there are commentators who argue that the inherent complexity of a securitisation

transaction may also bring difficulties to effectively assess the risks of the transactions.289 Following this

argument, the complex structure involved in these bonds might consequently decrease a desirable level of

transparency to investors.290 Hence, considering the failures in due diligence procedures and the consequent

lack of transparency related to information, it seems that investors remained with little option rather than to rely

on the CRA.291 In response to this circumstance, regulators in different jurisdictions have addressed many of

these issues by imposing new rules to strengthen due diligence and information disclosure requirements of

ABS.292 In the United States, the Dodd-Frank Act has suffered significant statutory reforms and the American

281 See Lastra and Wood (n 41) 16-17. 282 ibid. 283 See Rosa M. Lastra, International Financial and Monetary Law (2th edn, OUP, 2015) 190. 284 See SEC (n 50) 2. 285 See Fox (n 49) 60-64. 286 ibid. 287 ibid. 288 See Deloitte, SFIG and CDC (n 11) 10. 289 See Steven L. Schwarcz, ‘Disclosure`s Failure in the Subprime Mortgage Crisis’ (2008) Utah Law Review 1113-1114. 290 ibid. 291 See Cohen, Samuelson and Katz (n 8) 53. 292 See Fox (n 49) 72.

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Securities Exchange Commission (‘SEC’) has issued new rules to enhance the provision of data related to

ABS to investors.293 On this point, there are commentators who support that the disclosure requirements

imposed by the current regulation have, in fact, improved transparency to ABS` investors, however, they also

argue that this level of information might not be still sufficient to empower investors with an optimal degree of

information to consider risks of these bonds.294 Following this circumstance, it has been considered that

technologies as DLT might be viewed as an allied to address these issues that may still hinder the complete

recovery of the securitisation industry after the Crisis.295 Hence, this paper advocates for this potential

application and argues that DLT could be a promising tool to enhance transparency in the ABS market as will

be further discussed.

2.2. Securitisation and DLT: A New Hope for the Industry?

Considering the deficiencies in the securitisation process, this paper aims to suggest that DLT

may have the potential to deal with these failures, bringing significant benefits to this industry. In this sense, it

could be argued that DLT provides an environment where digitalised data would be commonly available to

their participants and, as a consequence, potentially solve the pitfalls within a securitisation transaction.296

To better explain this, through the storage of the underlying assets and all relevant information related to ABS

on a DLT platform, investors would have the possibility to directly access reliable information, enhancing their

assessment of risks and the conduction of proper due diligence and, therefore, reducing the necessity to

exclusively rely on CRA.297 In order to sustain the proposed assumption, it appears relevant to mention that

this industry is currently considering the use of DLT to improve the structuring of ABS. In this way, important

to mention the work of the Structured Finance Industry Group, one of the main global institutions that aims to

strengthen the securitisation market,298 which has already considered the improvements that DLT could bring

to the whole securitisation process.299 For instance, this institution has supported that DLT and smart

contracts enable a ‘chronological and immutable audit trail of all transactions’.300 In this way, the information

related to the pool of assets virtually stored on a blockchain would be uniform, reliable and accessible to

investors who participate in the network, avoiding problems derived from the content of information and

increasing transparency in this framework.301 However, in order to clearly understand the benefits that DLT

could bring, the paper will briefly explain how this technology could be applied to the entire process of

structuring ABS.

Considering the new framework proposed by this paper, DLT may have the potential to change

all the relevant stages of securitisation, such as: (1) origination of the pool of assets; (2) structuring the

293 ibid 72-73. 294 See Cohen, Samuelson and Katz (n 8) 53. 295 See generally Deloitte, SFIG and CDC (n 11). 296 See Cohen, Samuelson and Katz (n 8) 53. 297 ibid. 298 See SFIG, ‘SFIG´s website’ <http://www.sfindustry.org/about> accessed 20 June 2018. 299 See generally Deloitte, SFIG and CDC (n 11). 300 ibid 8. 301 ibid.

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securities; and (3) monitoring and trading.302 In the first stage, using the most known example of the

securitisation of housing mortgages, it can be noticed that the conclusion of a mortgage loan still may involve

a significant amount of time and is mostly based on huge amount of papers, which could increase the possibility

of errors with the information and also bring costs to access the data.303 Thus, it is suggested that DLT,

through the use of smart contracts, would enable that assets, such as real estate mortgages, to be digitalised

and registered on a DLT`s platform.304 In this scenario, all the relevant data concerned to these assets could

be directly and easily accessible by all the parties of a securitisation transaction, such as originators, services,

CRA and the proper investors.305 Given this context, it could be claimed that this new feature within

registration might provide a higher degree of transparency and safety to investors in case of structuring ABS

underlined by assets recorded on a blockchain. This is because ABS` investors could participate in this

blockchain network and thus have straight access to reliable information, since, once stored on a DLT`s

platform, data is digital identified and immutable (with all the historical chronology and current status of the

asset), reducing the risks of errors or fraud within the assets` documentation.306 Thus, this paper proposes

that DLT could facilitate the process of due diligence (reduction of time and costs) by offering a tool that could

empower investors with ‘accurate, real-time loan-level data about the assets compromising the relevant

pool’,307 and consequently avoiding the need to exclusively rely on CRA` assessment. Furthermore, this tool

could also bring efficiency to the structuring procedure of the securities by making the compliance with

regulation simpler.308 To exemplify this, once the assets are shared to the participants of the network, ABS

could have their underlying receivables previously selected automatically in accordance with regulatory

requisites.309

To complement the benefits above indicated, DLT and, especially, smart contracts might also

provide advantages to the monitoring and trading of ABS. On this account, it has been claimed that the use of

smart contracts could provide automation to the process of monitoring the performance of the ABS and their

respective underlying assets.310 That is to say that, due to the automated execution of smart contracts, they

can report ABS` investors with real-time information of the underlying portfolio, such as due payments or

eventual debtors` defaults.311 For instance, in case of any non-payments by borrowers or the non-compliance

by the issuer of specific obligations of the documentation, investors would be immediately informed by smart

contracts, which could, consequently, lessen the importance of trustees or servicers.312 In this way, investors

302 See Lewis R. Cohen and David C. Tyler, ‘Blockchain´s three capital markets innovations explained’ (Lexology, 15 July 2016) <https://www.lexology.com/library/detail.aspx?g=4d290bb0-6b6f-4868-8b49-92838a755b57> accessed 20 June 2018. 303 See Alex Lielacher, ‘How Blockchain can Disrupt the Mortgage Market’ (Nasdaq, 21 September 2017) <https://www.nasdaq.com/article/how-blockchains-can-disrupt-the-mortgage-market-cm848889> accessed 20 June 2018. 304 See Deloitte, SFIG and CDC (n 11) 11. 305 See Jennifer Hongbo, ‘How much does trust cost?: Analysis of the Consensus Mechanism of Distributed Ledger Technology and Use-Cases in Securitization’ (2017) Sloan School of Management 38 available at <https://dspace.mit.edu/handle/1721.1/111454> accessed 20 June 2018. 306 See Deloitte, SFIG and CDC (n 11) 11. 307 See Cohen and Tyler (n 72). 308 See Deloitte, SFIG and CDC (n 11) 14-15. 309 ibid. 310 Ivan Zone, ‘Loan Securitization Using Smart Contracts’ (Medium, 28 February 2018), available at <https://medium.com/@_ivan_zone/loan-securitization-using-smart-contracts-34cc7a146914> accessed 21 June 2018. 311 See Deloitte, SFIG and CDC (n 11) 17. 312 See Cohen and Tyler (n 72).

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may gain a proper tool to better monitor the performance of the underlying assets, a kind of innovation that

could have been useful during the Crisis in order to efficiently track the payments of the ABS. Finally, it is

suggested that DLT could be also used in the trading of the ABS. To support this proposition, recognised

institutions as the Australian Securities Exchange,313 JPMorgan Chase, Credit Suisse, BNP Paribas, and

Citigroup314 are currently considering the development of DLT-based clearing and settlement systems to

trade securities which may have the potential to decrease the role and costs with intermediaries and, at the

same time, increase transparency and price accuracy.315

Thus, it seems convenient to propose that DLT and smart contracts could, in fact, empower investors

with useful tools to improve all the stages of the securitisation procedure. In this sense, this paper argues that

there is a strong case for the use of DLT within securitisation. This is especially because this technology may

have the potential to increase transparency, safety and efficiency of ABS transactions,316 providing investors

with access to reliable information, diminishing the importance of CRA and, as a result, addressing some of

the weaknesses identified during the Crisis. However, it seems that legal issues remain as one of the main

obstacles to the application of DLT to securitisation. For instance, the law governing smart contracts,

considerations about data security and privacy are just a few examples of legal concerns that commentators

highlight.317 That said, this paper aims to specifically address a relevant legal challenge to the use of DLT in

financial transactions as securitisation: the current regulatory uncertainty in relation to this framework.

Considering the dichotomy between regulation and innovation, this paper will provide a critical analysis of the

approaches that could be taken by regulators to deal with this innovation as will be further discussed.

313 See David Floyd, ‘ASX Exchange Targets 2020 for DLT Settlement System’ (Coindesk, 21 September 2017) available at <https://www.coindesk.com/australian-securities-exchange-eyes-end-2020-dlt-rollout/> accessed 21 June 2018. 314 See Maria Terekhova, ‘Bank behemoths test distributed ledger technology solution for equity swaps’ (Business Insider, 22 November 2017) available at <http://uk.businessinsider.com/jpmorgan-citi-credit-suisse-test-distributed-ledger-technology-solution-2017-11?r=US&IR=T> accessed 21 June 2018. 315 See Deloitte, SFIG and CDC (n 11) 18. 316 ibid 8. 317 ibid 20-21.

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Section 3 – Regulators and their Approaches to Financial Innovation

3.1. Regulatory Uncertainty: A Challenge to be Addressed

Within the current framework of DLT and its relation with the law, regulatory uncertainty is

considered to be a significant obstruction to allow the use of DLT in financial transactions as asset

securitisation. 318 That is to say, given the absence of a clear consistent regulatory framework that

comprehends DLT and financial activities, questions about the acceptance of this technology by regulators

and, especially, how they will treat this potential use, whether, for example, by the issuance of new regulation,

or by applying current legislation.319 In this sense, there are commentators who argue that the mentioned

indecision by regulators could in fact harm or stifle the potential use of DLT in financial services.320 They

consider that current regulation might be ill-suited to address new legal circumstances brought by DLT and,

therefore, firms that develop DLT` solutions could be uncertain about which laws are applied or if regulators

will indeed accept it.321 In addition, regulatory uncertainty may also lead to ‘negative externalities’, since firms

that aim to apply DLT to their business could have increased burden expenses in order to clearly define their

legal status.322 As DLT is a technology in a beginning stage, regulators are still analysing the best legal

strategy to embrace this technology, adopting different approaches to deal with it in many jurisdictions.323

While in countries like Switzerland, regulators tend to promote an innovation-friendly environment, being

currently opened to embrace DLT within financial markets, other regulators in countries as Brazil are still

treating innovations as DLT and virtual currencies with cautious.324 In this way, it could be argued that this

divergent framework among national jurisdictions could bring difficulties to innovative firms to observe each

national approach (which may vary in their severity) and, as result, harming the development of innovations

as the use of DLT in securitisation.325 Therefore, regulatory uncertainty remains as a significant obstacle to

the application of DLT to financial activities as securitisation, since, in order to allow the use of this technology

in financial practice, regulators will have to embrace it by providing an adequate regulatory strategy. However,

to fully consider the allowance of this innovative proposal, it seems crucial to reflect on the approaches that

could be taken by regulators to deal with financial innovation, leading this paper to the recurring discussion

linked to the relationship between regulation and innovation.

Law and regulators are continuously ‘running’ to address technological innovations that may

arise in the market.326 In this context, it seems clear that innovations as DLT could bring relevant benefits to

318 See Primm (n 13) 84-85. 319 See Deloitte, SFIG and CDC (n 11) 21; and generally Finck (n 20). 320 See Primm (n 13) 84-85. 321 ibid. 322 See Finck (n 20) 21. 323 ibid 11; see Chris Brummer & Yesha Yadav, ‘Fintech and the Innovation Trilemma’ (2017) Georgetown Law Journal, 2018 Forthcoming 44, available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3054770> accessed 21 June 2018. 324 See Alvaro Rivero, ‘Distributed Ledger Technology and Token Offering Regulation’ (2018) available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3134428>; see also Reuters Staff, ‘Brazil regulator bans funds from buying cryptocurrencies’ (Reuters, 12 January 2018), available at <https://www.reuters.com/article/brazil-bitcoin/brazil-regulator-bans-funds-from-buying-cryptocurrencies-idUSL1N1P71DV> accessed 24 June 2018. 325 See Brummer & Yadav (n 93) 60-61. 326 See Lyria Bennett Moses, ‘Agents of Change: How the Law Copes with Technological Change’ (2011) 20 Griffith Law Review 763.



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the financial practice. For instance, legal scholars constantly claim that financial innovation can be historically

seen as an accelerator of financial markets and the economy as a whole.327 These improvements are mostly

related to the capability of financial innovation to potentially increase efficiency and minimise costs of

transactions, as well to address recurrent market problems (for example, lack of transparency that might harm

investors` investment decision).328 On this basis, it could be argued that the use of a DLT platform in the

securitisation process might be considered an example of financial innovation improving market efficiency. On

the other hand, legal academy also teaches that financial innovation may also be the genesis of risks and

harmful circumstances, such as was observed during the Crisis with the proper structured finance industry.329

Considering the above mentioned, in order to respond to problematic issues derived from financial

innovation (for example, new forms of risks), a recurrent approach taken by regulators is to strengthen the

regulatory oversight to financial innovation.330 Nevertheless, strictly regulating financial innovation might, at

the same time, hinder its development due to the increased burdens that intrusive regulation could bring.331

To clarify this, it is constantly claimed that there is a clear trade-off between regulation and innovation, since,

when focusing on providing strict regulation, regulators may restrain innovative tools as DLT.332 On the

opposite, by taking a more permissive approach to financial innovation, regulators could threat the integrity of

the market considering eventual risks derived from new financial tools,333 and, consequently compromising

the objectives of financial regulation. Following this stance, Christine Lagarde, managing director of the

International Monetary Fund (‘IMF’), has already highlighted the importance of defining a suitable regulatory

approach to Fintech innovations, as well as the difficulties to achieve this aim.334 The director claims that

regulators must find an adequate approach that preserves innovation without its restraint and, at the same

time, meets the objectives of regulation as investor protection and market integrity.335 Thus, it seems clear

the importance of regulators to address eventual regulatory uncertainty related to DLT and financial

transactions with an appropriate regulatory model that should face this issue by not compromising innovation

or the objectives of financial regulation. On this account, in order to propose this suitable approach to address

regulatory uncertainty that hinders the application of DLT to financial activities as securitisation, this paper will

provide a critical analysis of the possible strategies conducted by regulators that could be used to deal with

this new framework.

327 See Emilios Avgouleas, ‘Regulating Financial Innovation’ in Niamh Moloney, Eilis Ferran and Jennifer Payne (eds), The Oxford Handbook of Financial Regulation (1th edn, OUP, 2015) 667. 328 See Dirk A. Zetzsche, Ross P. Buckley, Douglas W. Arner and Janos Nathan Barberis, ‘Regulating a Revolution: From Regulatory Sandboxes to Smart Regulation’ (2017) Fordham Journal of Corporate and Financial Law 6. 329 Zetzsche and others (n 98) 6 emphasize that new kinds of derivatives products like Collateral Debt Obligations and Credit Default Swaps were relevant to the rise of the problems observed during the Crisis. 330 See Brummer & Yadav (n 93) 26-27. 331 ibid. 332 ibid 6. 333 ibid. 334 See Christine Lagarde, ‘A Regulatory Approach to Fintech’ (2018) Finance and Development 9-10. 335 ibid.

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3.2. Regulation and DLT: Possible Approaches by Regulators

In light of the above discussed, it seems that regulatory uncertainty persists as a difficult barrier to

allow the use of DLT in securitisation, especially considering the difficulties to define an approach that properly

embrace this innovation. Therefore, providing a critical evaluation of the approaches that could be taken by

regulators appears as a crucial task for the purpose of this paper. Therefore, in the following part, this research

will examine the regulatory strategies normally used by regulators when facing financial innovations like DLT:

(i) the Wait and See Approach, and (ii) the Issuance of New Regulation.

3.2.1. Wait and See Approach

In order to address the regulatory uncertainty challenge to the use of DLT in financial activities

as securitisation, one possible approach that could be taken by regulators is the commonly known ‘Wait and

See’336 approach (‘Wait and See Approach’). This regulatory strategy is popular within regulators and

supported by some academics in view of specific benefits that it could bring to the development of financial

innovation.337 To put it simply, the Wait and See Approach is based on the use by authorities of existing laws

to deal with financial innovation without the issuance of new regulation that could suppress the development

of this technology by bringing new costs to firms.338 Therefore, this seems to clarify the clear advantages of

this approach and the reasons why some regulators adopt it to deal with DLT.339 There are commentators

who support that the Wait and See Approach might provide time to the industry to develop DLT solutions (as

its use in securitisation) without difficulties derived from new regulation, while, at the same time, allow

regulators to learn more about this innovation.340 For these reasons, this approach is commonly based on

the assumption of ‘educate, don’t regulate’,341 since regulators may have a period to engage with the industry

to better understand the complex framework of DLT and effectively assess the necessity or not to provide new

laws, allowing this innovation to flourish.342 Thus, it appears that the Wait and See Approach is being widely

used to deal with DLT. For instance, this is the strategy taken by the European Securities and Markets Authority

(‘ESMA’), which has already recognised that DLT may improve securities transactions, however, the body

understands that it seems early to consider a new regulatory framework to this technology, emphasizing that

current EU laws could attend its initial use in financial transactions.343 To reinforce the arguments of the

proponents of the Wait and See Approach, it could also be effective to provide a parallel with the strategies

concerned with virtual currencies. On this point, there is a current tendency by regulators to adopt a Wait and

See Approach in dealing with the issuance of virtual currencies, applying prevailing laws to these emissions

336 See Finck (20) 12. 337 ibid; see Douglas W. Arner, Jànos Barberis and Ross P. Buckley, ‘The Evolution of Fintech A New Post-Crisis Paradigm?’ (2015) University of Hong Kong Faculty of Law Research Paper No 2015/047 33, <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2676553> accessed 24 June 2018. 338 See Finck (20) 12. 339 See Osborne Clarke, ‘An introduction to Blockchain: the key legal issues’ (11 August 2017), available at <http://www.osborneclarke.com/insights/an-introduction-to-blockchain-the-key-legal-issues/> accessed 12 July 2018. 340 See Finck (20) 12. 341 ibid. 342 ibid. 343 See generally ESMA, ‘Report the Distributed Ledger Technology Applied to Securities Markets’ (2017), <https://www.esma.europa.eu/system/files_force/library/dlt_report_-_esma50-1121423017-285.pdf> accessed 12 July 2018.



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and, as a result, not harming the development of these innovative products.344 In this way, the SEC is

currently aligned with this tendency, since the American regulator is applying the provisions of the Securities

Exchange Act 1934 to certain emissions of virtual currencies.345

Despite the above presented, one may argue that a Wait and See Approach might fail to entirely

address regulatory uncertainty, since, in order to define which existing laws are applied to DLT`s innovations,

legally defining this technology can be a barrier to this strategy.346 In other words, it seems that, until there is

a clear legal definition of the technology and by which regulation it is submitted, firms that aim to implement

DLT to securitisation might be restricted due to the lack of certainty of which laws to observe.347 Hence, one

possible solution to this issue is to complement the Wait and See Approach with the provision of informal

guidance by regulators.348 This means that regulators might informally express their view of which laws

should be applied to innovations in the markets (as the case of DLT) without the issue of new formal

regulation.349 Therefore, the arguments previously indicated could sustain this strategy to deal with DLT`s

solutions to securitisation and, in this way, address the discussed regulatory uncertainty challenge.

Nevertheless, this paper identifies some failures in the pure application of the Wait and See Approach which

might undermine its use.

In spite of the arguments above presented, this paper contests the use of a Wait and See Approach,

arguing that the exclusive application of this strategy could not be suitable to address the regulatory uncertainty

challenge that hinders DLT and ABS transactions. This assumption stems from the following arguments: (i) a

remaining lack of legal certainty; and (ii) the timing related to this approach. With respect to the first argument,

it can be observed that the Wait and See Approach might indeed not harm the development of DLT`s

innovations, however, it seems reasonable to argue that it may fail to entirely provide a high degree of legal

certainty. To support this statement, it could be argued that existing regulation might be ill-suited to address

all the new legal issues brought by DLT or, even if they fully achieve the DLT framework, laws are in constant

change and may rapidly become outdated, which might demand that regulation ‘to be adapted, or that entirely

new laws will need to be implemented, to cater for blockchain’.350 Furthermore, as previously indicated, the

lack of a legal classification in relation to DLT, as well as the inexistence of a clear legal framework could harm

innovators with legal uncertainty.351 As above observed, there are commentators who advocate for the use

of informal guidance as a way to provide legal certainty to innovators.352 However, it is argued by this paper

that informal guidance might not entirely solve this problem. As these statements are not empowered with

344 See Rosa M. Lastra and Jason G. Allen, ‘Virtual Currencies in the Eurosystem: challenges ahead’ (2018) European Parliament Monetary Dialogue 32-33, available at <http://www.sipotra.it/wp-content/uploads/2018/07/Virtual-currencies-in-the-Eurosystem-challenges-ahead.pdf> accessed 12 July 2018. 345 See SEC, ‘SEC Issues Investigate Report Concluding DAO Tokens, a Digital Asset, were Securities’ (25 July 2017), <https://www.sec.gov/news/press-release/2017-131> accessed 12 July 2018, where the regulator states that some virtual currencies could be classified as securities and therefore subjected to securities laws. 346 See Finck (20) 13. 347 ibid. 348 See Brummer & Yesha Yadav (n 93) 44. 349 See Finck (20) 13. 350 See Osborne Clarke (n 109). 351 See Finck (20) 13; and Primm (n 13) 84-85. 352 See Brummer & Yesha Yadav (n 93) 44.

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binding effects, courts could have the prerogative to dismiss these informal instructions and, as result, firms

that wish to create DLT` solutions to securitisation could still have concerns related to which laws to observe

(i.e. legal uncertainty).353 In relation to the second argument, timing could also be seen as a disadvantage of

the Wait and See Approach. Regulators may take considerable time with the referred approach to better

understand DLT` proposals, without providing a clear new legal framework to the industry.354 During this time,

DLT may quickly grow (as normally grow technologies) and creates eventual new circumstances and risks not

foreseen by existing laws,355 remaining innovators with incompatible regulations. For these reasons, this

paper argues that regulators applying an isolated Wait and See Approach seem not to be considered the most

suitable regulatory response to the application of DLT to securitisation, especially given its failure to entirely

provide legal certainty and the length of time that it could take. Following these arguments, it could be

recognised the incapacity of the pure use of the Wait and See Approach to properly cope with DLT and financial

activities as securitisation, which could therefore lead to the support of a different approach to face regulatory

uncertainty: the issuance of new regulation.356

3.2.2. Issuance of New Regulation

Taking into account the argued flaws of a sole Wait and See Approach to cover the potential

application of DLT to securitisation, one strategy that could be conducted by regulators is to issue new

legislation that would specifically address DLT.357 In this sense, there are supporters who advocate for the

necessary enactment of specific regulation in order to allow financial transactions to be performed on a DLT

platform.358 On the basis of this proposition, it appears that this could be the same interpretation given to the

case of DLT and securitisation, since, to securitise assets recorded on a blockchain or issue ABS in a DLT

platform, regulators would have to address this issue by separate new regulation. Following this proposal, it

appears relevant to briefly bring into the consideration the goals of financial regulation.

In order to comprehend if a regulatory strategy is indeed suitable (including, their suitability to deal

with financial innovation), there are commentators who highlight the importance of clearly defining the

objectives of financial regulation.359 In this way, they consider the following goals of financial regulation: (i)

investors protection; (ii) retail investor protection; (iii) safeguard of financial stability; (iv) safeguard of market

efficiency; (v) market competition; and (vi) prevention of financial crime.360 That said, given the goals of

investors protection and financial stability, they are deemed to be critical concerns by regulators, since financial

regulation is essential to protect investors from fraudulent practices, to avoid them to take disproportionate

353 Concerning the dismissal by courts of informal guidelines, see Finck (20) 14 who observes that ‘this happened in the context of the platform economy where the European Court of Justice`s Advocate General Szpunar has been unimpressed by the European Commission`s guidelines on whether a platform should be considered as a mere intermediary or as also providing the underlying service’. 354 See Dr. Julie A. Maupin, ‘Mapping the Global Legal Landscape of Blockchain and other Distributed Ledger Technologies’ (2017) 6, available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2930077> accessed 13 July 2018. 355 ibid. 356 See Paech (37) 25-26. 357 See Finck (20) 16. 358 See generally Paech (37). 359 See John Armour and others, Principles of Financial Regulation (OUP, 2016) 61. 360 ibid 61-69.


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risks and to guarantee the stability of the system.361 In this regard, it is widely argued that the use of DLT to

store or trade assets (as in the proposed case of securitisation) may pose significant threat to financial

stability.362 There are commentators who sustain that, as DLT is based on virtually and interconnected

platforms between their participants, financial transactions stored on a blockchain, if reach an expressive

amount of value or participants in this network, might have the potential to be a risk to the stability of the

system.363 Following this assumption, due to existing borders between digital platforms and the real markets,

problems in the digital environment can be expanded and spread to many institutions, eventually harming the

financial system as a whole.364 Therefore, these circumstances may legitimate the regulation of DLT as a

way to ensure financial stability and investors protection (i.e. objectives of financial regulation).

Complementing the arguments that may endorse the issuance of new rules to DLT` proposals, one

may also argue that this approach might also provide legal certainty to innovators that seek to implement DLT

to their financial activities.365 To put it simply, the referred proposition states that, by providing a clear legal

framework to DLT, regulated participants of the market could safely know which rules are applied to their DLT`s

experimentations and, as a result, reduce the costs by innovators with regulatory compliance.366 In this

context, it seems that regulators that take this kind of approach aim to create an authentic ‘blockchain-friendly

venue’367 and, therefore, be attractive to firms that wish to innovate with DLT.368 For example, it could be

cited the cases of Gibraltar and Malta. In the first case, the Gibraltar Financial Services Commission has

recently issued the Financial Services (Distributed Ledger Technology Providers) Regulations 2017,369 a

legislation that establishes a specific DLT framework for firms that seek to use DLT into their activities.370

Secondly, the Malta Digital Innovation Authority Act, the Innovative Technological Arrangement and the Virtual

Financial Assets Bill are recent laws designed by Maltese authorities that cover the regulation of DLT and

virtual currencies.371 By enacting this new legislation, it seems that the Maltese regulator intends to create a

regulatory framework which will encourage the development of innovations and achieve the goals of financial

regulation (such as financial stability and investors protection).372 Therefore, according to the arguments of

this proposition, the use of DLT in securitisation should be dealt by regulators with the issuance of new

legislation to embrace this framework. However, even though there are clear benefits that regulation may bring,

this paper questions some issues related to the adoption of this approach, especially due to its inefficiency to

adequately address the trade-off between regulation and innovation.

361 ibid 62-65. 362 See Paech (37) 16. 363 ibid 17. 364 See Lastra and Allen (n 114) 32-33. 365 See Finck (20) 16-17. 366 ibid 16; see Nathan Cortez, ‘Regulating Disruptive Innovation’ (2014) Berkeley Technology Law Journal Volume 29 Issue 1 203-204. 367 See Finck (20) 17. 368 ibid. 369 See Gibraltar Gazette No 4401 12 October 2017. 370 See Gibraltar Financial Services Commission, ‘Distributed Ledger Technology Regulatory Framework (DLT Framework)’, <http://www.gfsc.gi/dlt> accessed 17 July 2018. 371 See Ana Alexandre, ‘Malta Passes Blockchain Bills Into Law, ‘Confirming Malta as the Blockchain Island (Cointelegraph, 05 July 2018), <https://cointelegraph.com/news/malta-passes-blockchain-bills-into-law-confirming-malta-as-the-blockchain-island> accessed 17 July 2018. 372 See Lastra and Allen (n 114) 27.

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Despite the advantages of new DLT regulation, this paper identifies some flaws in this approach,

since the content of new rules could be seen as a barrier that may refrain DLT. In this way, distinguished

academics as Charles Goodhart have already pointed out the downsides that detailed regulation may create,

such as imposing firms more expensive forms to comply with rules and, therefore, harming the development

of innovation.373 This means that new regulation might have the risk to be highly complex or rigorous and

impose new costs on firms that could stifle the implementation of DLT to securitisation.374 With this respect,

it has been argued that, in order to comply with strict requirements established by new laws, firms (especially

small sized ones) may have their costs significantly increased and, as a result, inhibiting the development of

DLT proposals to financial practices.375 Thus, this paper claims that new regulation to DLT could have the

adverse effect of refraining this technology by imposing new expenses to innovators and, therefore, might not

fully observe the trade-off between regulation and innovation. This is because, on one side, it could attend the

objectives of financial regulation, however, on the other side, the content of regulation can impose highly

complex and burdensome requirements that might undermine the development of DLT` solutions to financial

markets.376

Reinforcing the above argued, it seems that the time that regulators establish new rules also

appears as a relevant issue to be considered in order to analyse the convenience of the discussed regulatory

approach. To put it simply, premature regulation could also have the negative result of harming the financial

innovation.377 For this reason, the timing that authorities legislate new activities (as the use of DLT in

securitisation) might be essential to preserve innovation. In this context, it has been claimed that premature

regulation of financial innovation ‘may quickly be avoided or become obsolete’,378 since, at an initial stage of

a technology, regulators tend to fail to comprehend all the risks that could be derived from an innovation,379

or if the financial markets will indeed embrace it,380 which may entail on early ill-suited laws. In relation to

DLT and its use in financial transactions, it has been considered that this technology is still not entirely tested,

therefore, innovators and regulators are monitoring and understanding its potential use to financial

activities.381 In this way, it is argued by this paper that the issuance of specific DLT regulation, at the present

moment, seems not to be the most suitable approach to be taken in order to address the regulatory uncertainty

challenge to allow the application of DLT to securitisation, especially considering its early stage of development.

To sustain this, it could be cited the successful case of e-banking, an activity that began to be developed a

significant time before its regulation, which might have resulted in the positive outcomes within this industry.382

373 See Charles Goodhart and others, Financial Regulation Why, how and where now? (Routledge, 1998) 2. 374 See Jacques Pelkmans and Andrea Renda, ‘Does EU Regulation Hinder or Stimulate Innovation?’ (2014) CEPS Special Report No 96 10-11, available at <https://www.ceps.eu/system/files/No%2096%20EU%20Legislation%20and%20Innovation.pdf> accessed 17 July 2018. 375 ibid; see Finck (20) 18. 376 ibid. 377 ibid. 378 See Iris H-Y Chiu, ‘A Rational Regulatory Strategy for Governing Financial Innovation’ (2017) European Journal of Risk Regulation, Forthcoming 758 available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3032712> accessed 17 July 2018. 379 ibid. 380 See Arner, Barberis and Buckley (n 107) 32. 381 See Deloitte, SFIG and CDC (n 11) 21; and ESMA (n 113) 18. 382 See Arner, Barberis and Buckley (n 107) 32.

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Hence, given the arguments above presented, this regulatory strategy might have the risk to stifle DLT (not

attending the innovation-regulation trade-off) and to provide premature and ineffective rules by virtue of the

necessity to confirm its actual embracement by the market and to clarify the exact legal issues that regulators

may have to address in prospective legislation.

Therefore, until this point, this paper has provided an analysis of the possible approaches that

regulators may take to address the regulatory uncertainty challenge in order to allow the application of DLT to

securitisation. Considering this examination, it seems that both the Wait and See Approach and the issuance

of new regulation may bring benefits to the DLT framework, however, this paper identifies flaws in these

strategies that undermine their use by regulators to cover DLT and securitisation. Recognised this statement,

the research will subsequently provide the legal arguments that could support the embracement by regulators

of DLT and securitisation and, finally, will propose a convenient regulatory approach to properly address this

framework.

SECTION 4 – DLT AND SECURITISATION: ACHIEVING THE AIM OF SECURITIES

LAWS AND A REGULATORY MODEL TO BE FOLLOWED

4.1 Why regulators should embrace DLT and Securitisation?

Before suggesting the most suitable approach to address the discussed regulatory challenge, it seems

critical for the aim of this paper to firstly clarify the legal arguments that could sustain the embracement by

regulators of the application of DLT to the ABS market. As explained in Section 2, securitisation is a kind of

financial transaction that uses a pool of receivables to underline the issuance of securities.383 For this reason,

these financial assets are considered as proper securities and, therefore, their issuances are submitted to the

rules prescribed by securities laws.384 The regulation applied to the issuance of securities is commonly

defined as the legislative material that ‘compromises the regulation of public issuers of securities, secondary

markets, asset management products and market intermediaries’, 385 and has their proper particular

objectives. Among those, investor protection appears as one of the most relevant goals that regulators aim to

achieve with securities laws.386 On this account, scholars as John Armour explain that investor protection is

a rationale which is widely adopted by national securities laws and basically provided by rules of mandatory

disclosure.387 In other words, this academic standing considers that securities laws are mostly based on the

mandatory disclosure by issuers of the relevant information necessary for investors to evaluate the risks

derived from the securities and, therefore, to have the capacity to make an informed investment decision.388

In this way, it seems that securities regulation aims to empower investors with the relevant information to allow

383 See Wood (n 43). 384 See Alastair Hudson, Securities Laws (Sweet & Maxwell, 2008) 14. 385 See International Monetary Fund, ‘Strengths and Weaknesses in Securities Market Regulation Market Regulation: A Global Analysis’ (2007) IMF Working Paper WP/07/259 6 available at <https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Strengths-and-Weaknesses-in-Securities-Market-Regulation-A-Global-Analysis-21428> accessed 17 July 2018. 386 See Armour and others (n 129) 62. 387 ibid. 388 ibid.

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them to conduct a rational analysis before purchasing securities and, as a consequence, to increase

transparency in the market.389 In this context, it should be also highlighted that there are commentators who

question the capacity of investors to deal with an excessive amount of complex information, which may

undermine the role of disclosure to investor protection.390 In spite of these arguments, the current securities

regulation`s framework is still based on a disclosure-regime as supported by the International Organization of

Securities Commissions (‘IOSCO’),391 which prescribes as the objectives of securities laws: ‘the protection of

investors; ensuring that markets are fair, efficient and transparent and the reduction of systemic risk’.392

According to these objectives, the referred organisation emphasises the importance of full disclosure as the

most relevant way for securities laws to provide the protection of investors in capital markets.393 That said, it

could be understood that securities laws have as their aim the provision of investor protection by disclosure of

information, creating a more transparent and safer capital market.

Given the above considered, it seems relevant to observe that this disclosure-based approach was

embraced by current regulation that specifically deals with securitisation. As highlighted in Section 2, the Crisis

has shown considerable flaws in the securitisation stages which seem to have failed in ensuring investors with

relevant information of the ABS.394 Thus, one of the main responses by regulators to face this problematic

circumstance was to strengthen due diligence and disclosure obligations in compliance with the transparency

objective of securities regulation.395 Following this tendency, it could be cited current regulation in the US and

the European Union. In the first case, the commonly known Regulation AB, as amended by Regulation AB II,

is clear with its intention to ‘to provide investors with timely and sufficient information, reduce the likelihood of

undue reliance on credit ratings’396 and, as a consequence, enhance investor protection.397 This law sets

out an array of disclosure requirements to issuers as, for example, the obligations prescribed by item 1111 of

Regulation AB linked to the disclosure of the characteristics of the underlying assets.398 On the same path,

the European Parliament has recently released the Regulation (EU) 2017/2402 which also intends to create

within the European Union`s capital market a ‘specific framework for simple, transparent and standardised

securitisation’,399 imposing new disclosure requirements to allow investors to make informed decisions in the

389 See Luca Enrique and Sergio Gilotta, ‘Disclosure and Financial Markets Regulation’ in Niamh Moloney, Eilis Ferran and Jennifer Payne (eds), The Oxford Handbook of Financial Regulation (1th edn, OUP, 2015) 514-515; and Paul Latimer, ‘Securities Regulation Laws – Their Aims and How to Achieve Them’ (2012) 3, available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2460220> accessed 23 July 2018. 390 For a detailed analysis of the arguments which support the ineffective of the mandatory disclosure system, see the literature of Troy Paredes, ‘Blinded by the Light: Information Overload and its Consequences for Securities Regulation’ (2003) 81 Washington University Law Quarterly forthcoming 417, <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=413180>, accessed 23 July 2018. On this account, the academic suggests that the overload of information problem might be addressed by regulation through the prescription of a higher degree of standardization and less complexity. 391 IOSCO is an international authority that aims to provide standards for global securities laws. See IOSCO, ‘IOSCO´s website’ <https://www.iosco.org/about/?subsection=about_iosco> accessed 23 July 2018. 392 See IOSCO, ‘Objectives and Principles of Securities Regulation’ (2003). 393 ibid. 394 See Fox (n 49) 60-64. 395 See Steven L. Schwarcz, ‘Securitization and Post-Crisis Financial Regulation’ (2016) Cornell Law Review Online 118-121. 396 Asset-Backed Securities Disclosure and Registration, SEC Release Nos. 33-9638, 34-72982, 79 Fed. Reg. 57184 (2014) 16. 397 ibid. 398 Asset-Backed Securities, SEC Release Nos. 33-8518, 34-50905, File No. S7-21-04 (2005). 399 Regulation (EU) 2017/2402 of 12 December 2017.



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securitisation market. 400 That said, it seems that securities regulation mainly aims to provide investor

protection by ensuring a transparent framework based on disclosure obligations as reflected by national laws,

including the ones that address securitisation. Therefore, this paper considers that this assumption might

clarify the reasons for regulators to embrace DLT and securitisation, since the benefits of this technology seem

to match with the objectives of securities laws.

In Section 2, this paper has explored the potential benefits that DLT might bring to securitisation by

functioning as a tool to increase transparency in this market, a new framework that seems to be in line with

the aim of securities regulation. By recording the underlined assets of ABS on a DLT platform, investors could

have direct access to digitalised and more reliable information of the securities before their purchase, as well

as during their entire lifecycle.401 These benefits may indeed increase transparency in the securitisation

process, since investors would be empowered with real-time data and issuers a more efficient platform to

comply with information disclosure requirements imposed by laws.402 Therefore, this assumption clarifies the

legal reasons for regulators to allow the use of DLT in securitisation. This is because, this paper argues that

the increase of reliable information disclosure and transparency among ABS transactions seems to be in line

with the aim of securities laws. To this support this stance, as above clarified, one of the objectives of securities

regulation is to pursue investor protection by mandatory disclosure and consequently to create a more

transparent environment for investors.403 Following this objective, by implementing DLT to securitisation,

regulators might allow the use of a tool that has the potential to create a more informed market and, hence, to

strengthen investors protection as prescribed by securities legislation`s goals. Furthermore, DLT might be also

useful for the regulatory authorities, especially considering the advantages brought by the commonly known

Regulatory Technology (‘Regtech’).404 In this sense, regulators could be given access to the shared DLT

platform, where the underlined assets of a securitisation transaction would be stored and, in this way, they

might be provided with straight monitoring of the performance of the securities, as well as the compliance of

obligations by the parties.405 In the latter suggestion, it is claimed that, at the time of the events of the Crisis,

if regulators had a technology as DLT to monitor the performance of the structured products (identifying the

decrease on the underlined repayments), they might have taken earlier actions to prevent the significant

damages occurred.406

Given the above explained, this paper argues that there is a strong legal case for regulators to allow

the use of DLT in the securitisation framework. To justify this statement, it is claimed that regulators have

consistent legal grounds to embrace DLT and securitisation, since, by doing so, they are complying with the

400 Article 7 of the Regulation (EU) 2017/2402 establishes an extensive list of information that issuers and originators must make available to investors. 401 See generally Deloitte, SFIG and CDC (n 11). 402 ibid 8. 403 See Armour and others (n 129) 62. 404 For the definition of Regtech, see the one proposed by Lastra and Allen (n 114) 48, who define Regtech as ‘the use of new Information and Communications Technology (‘ICT’) in monitoring, reporting and compliance.’ In this sense, Regtech is defined as a framework where technology is used to improve regulatory supervision. 405 See Deloitte, SFIG and CDC (n 11) 5-19. 406 See J. Christopher Giancarlo, ‘Special Address of CFTC Commissioner J. Christopher Giancarlo Before the Depository Trust & Clearing Corporation 2016 Blockchain Symposium’ (US Commodity Futures Trading Commission, 29 March 2016), available at <https://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-13> accessed 26 July 2018.

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objectives of securities regulation (investor protection by market disclosure), ensuring a higher degree of

transparency to the securitisation market.407 As DLT is seen as a tool that could create a more transparent

environment for investors,408 it is argued that the use of this technology meets the aim of securities laws by

enhancing the disclosure of reliable information and, in this way, providing higher protection for investors. In

addition, the benefits that this technology may create to regulators` supervision (the above case of Regtech)

is also considered by this paper as an argument that supports the regulatory allowance of DLT to securitisation.

Hence, this paper sustains the adoption by regulators of this new framework, since this proposal seems to be

in line with the aim of securities regulation. Recognised these legal arguments to support this possibility, this

paper will, at this moment, answer the central question proposed by this research: defining the regulatory

model for regulators to deal with DLT and securitisation.

4.2 Regulatory Sandboxes: A Do no Harm Proposal for DLT and Securitisation

Clarified the reasons why regulators should consider the use of DLT in securitisation, in this

part, this paper suggests a suitable approach to address the current regulatory uncertainty that refrains this

new framework. As previously argued, flaws can be identified in the traditional strategies taken by regulators

in dealing with financial innovation (Wait and See Approach and the issuance of new regulation). Following

this analysis, this paper highlights the ideas proposed by the Chairman of the American Commodity Futures

Trading Commission (‘CFTC’), J. Christopher Giancarlo, who has strongly supported the use of a do no harm

approach by regulators to deal with DLT and its use in financial markets.409 To clarify this, this do no harm

strategy would be based on the assumption that regulators should provide a flexible legal framework that must

not stifle innovation, avoiding strict application of existing or premature new regulation.410 In the words of

Chairman Giancarlo, the principle of the do no harm prescribes that ‘governments and regulators should avoid

undue restrictions, support a predictable, consistent and simple legal environment and respect the bottom-up

nature of the technology and its development in a global marketplace’.411 This seems that this strategy

focuses on providing a clear room for innovation to naturally evolve without burdens derived from new

regulation or ill-suited existing laws. On this path, there are commentators who state that this approach was

successfully used by regulators during the rise of the Internet in the US and it was crucial to its

consolidation.412 It is constantly argued that this do no harm proposal has allowed the Internet to grow,

because it was overseen by a flexible legal framework proposed by regulators which seems to have stimulated

investments in this technology.413 Following this explanation, despite also aiming to do not stifle innovation

407 See Armour and others (n 129) 62. 408 See generally Deloitte, SFIG and CDC (n 11). 409 See Giancarlo (n 176). 410 ibid; see Blummont (n 15) 25-26. 411 ibid. 412 ibid; see Marco Dell’Erba, ‘Initial Coin Offerings. A primer. The first response of regulatory authorities’ (2017) 14-15, available at <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3063536> accessed 17 July 2018. 413 See Giancarlo (n 176) who strongly emphasizes that, during the governing of this approach, expressive amount of capital was invested in the development of Internet, for instance, ‘investors deployed $90 billion into the cross-continental fiber-optic broadband network, and broadband reached homes and smaller businesses, while large businesses built their own dedicated data connections.’


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and promote its development,414 this paper considers that the mentioned Wait and See Approach appears

not to be completely in line with the concepts of do no harm proposed by Chairman Giancarlo. This is because,

the Wait and See Approach seems to exclusively relies on existing legislation that, in some cases, could be

ill-suited to address DLT`s innovations415 and, therefore, potentially not providing legal certainty (possibly

outlining a less active approach).416 On the other hand, this idea of do no harm proposed by Chairman

Giancarlo additionally comprehends the actual creation by regulators of a clear legal framework based on

‘uniform principles in an effort to encourage DLT investment and innovation’,417 which might succeed in

providing legal certainty to market participants418 (possibly highlighting a more active approach). To better

explain the design of this framework, this paper sustains the case of regulatory sandboxes as an example of

the use by regulators of the do no harm concepts.419

As already stated by some commentators, the creation of regulatory sandboxes could be

considered a proposal in line with the do no harm suggestions proposed by Chairman Giancarlo and, therefore,

a suitable new strategy to deal with the use of DLT in financial transactions as securitisation.420 A regulatory

sandbox is widely defined as an environment created and under supervision by regulators which allows firms

to test their financial innovations (including technologies as DLT) without having to comply with all strict

regulation421 that normally stifles the development of new market products. In other words, a sandbox is a

‘safe space’422 based on the idea of experimentation, where regulators allow firms to test their financial

experiments through the application of specific flexible rules or by the grant of exemptions to comply with the

current regulation.423 To better explain how functions a regulatory sandbox, firms could be allowed to

experiment the structuring of securitisation transactions using DLT inside this space, where they will be

subjected to flexible rules under the regulator`s monitoring.424 In order to avoid risks that could be derived

from the technology and ensure investors protection, during this process, regulators may impose some

conditions to allow these tests inside the sandbox.425 For example, these conditions could comprehend

limitation of time, kind of consumers available to purchase the products and the value of the transactions.426

Once successfully tested, this new product could be carried to the actual financial markets.427 Therefore, this

could be the same approach applied by regulators to DLT and securitisation by experimenting the use of this

technology through the stages of a ABS transaction inside the inside sandbox. Within the testing period,

regulators could confirm the actual benefits that DLT may bring to securitisation, as well the necessity to

414 See Finck (20) 12. 415 See Osborne Clarke (n 109). 416 ibid. 417 See Giancarlo (n 176). 418 ibid. 419 See Blummont (n 15) 26. 420 ibid. 421 See Finck (n 20) 14. 422 See Zetzsche and others (n 98) 26. 423 ibid; see also Finck (n 20) 14; and Brummer & Yadav (n 93) 51. 424 ibid. 425 See Lev Bromberg, Andrew Godwin and Ian Ramsay, ‘Fintech Sandboxes: Achieving a Balance between Regulation and Innovation’ (2017) Journal of Banking and Finance Law and Practice, Vol. 28, No 4 4. 426 See Zetzsche and others (n 98) 3-37, who indicate the conditions normally applied by regulators to firms that participate in sandboxes. 427 ibid.

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change current regulation or to design eventual new laws to properly address this framework.428 At the current

stage, some regulators have already taken the path to create regulatory sandboxes.429 However, it seems

crucial to highlight the case of the United Kingdom regulator, the Financial Conduct Authority (‘FCA’), which

was the pioneer in providing a regulatory sandbox focused on Fintech`s innovations as DLT.430 The FCA`s

sandbox is currently conducting its fourth round of experimentations and has already provided an array of tests

with technologies as DLT, smart contracts, artificial intelligence and peer-to-peer lending.431 Therefore, this

paper states that regulatory sandboxes, as an example of the do no harm concepts, should be considered the

regulatory model to be followed to address the regulatory uncertainty challenge that hinders the application of

DLT to securitisation, especially considering the arguments that will be below provided by this research.

Given the above explained, this paper argues that the implementation of regulatory sandboxes

in line with the principles of do no harm as proposed by Chairman Giancarlo is the most suitable approach for

regulators to deal with the discussed regulatory uncertainty challenge and embrace the case of DLT and

securitisation. To sustain this stance, this paper stems from two main arguments: this strategy could (i) better

satisfy the innovation-regulation trade-off; and (ii) correct the flaws identified in the Wait and See Approach

and the issuance of new regulation. In relation to the first argument, it is argued that regulators adopting

regulatory sandboxes could indeed encourage the development of innovation without its harm (first side of the

trade-off). To support this, the establishment of a sandbox could provide an environment where firms might,

for instance, develop DLT solutions to securitisation with fewer burdens derived from existing regulation,

considering the provision of a flexible legal framework inside the sandbox.432 Therefore, this paper states that,

by allowing this possibility, regulators are taking active actions to promote innovation, since the compliance

with the entire rigid conditions prescribed by laws may stifle the development of DLT, especially in the case of

small-sized firms.433 On the other side of the trade-off, it is also argued that the discussed approach could

observe the objectives of financial regulation. This is because, during the tests inside sandboxes, regulators

must ensure the protection of consumers that participate in this space and the system as a whole434 by

imposing conditions to avoid eventual risks that could rise.435 For instance, the FCA demands firms that aim

to apply to the sandbox to make a proposal for the regulator explaining the means how they will mitigate and

compensate eventual harm to consumers,436 as well as that they consider that the tests must not entail on

harm to the system as a whole.437 Therefore, it seems that these conditions clarify the concern of the UK

regulator with its sandbox to match the stimulation of innovation with the safeguards of consumers and the

428 See Brummer & Yadav (n 93) 54. 429 According to Zetzsche and others (n 98) 26, in August 2017, 14 countries have already created their own sandboxes: the United Kingdom, Hong Kong, Malaysia, Singapore, Abu Dhabi, Australia, Mauritius, Netherlands, Indonesia, Brunei-Darussalam, Canada, Thailand, Bahrain and Switzerland. 430 See Bromberg, Godwin and Ramsay (n 195) 5. 431 See FCA, ‘FCA´s website’ <https://www.fca.org.uk/firms/regulatory-sandbox> accessed 02 August 2018. 432 See Bromberg, Godwin and Ramsay (n 195) 4. 433 See Chiu (n 148) 748. 434 See FCA, ‘Regulatory Sandbox’ (2015) 3, where the FCA recommends that the regulatory sandbox`s structure should provide a flexible framework to firms, but also to ensure that investors are protected. Available at <https://www.fca.org.uk/publication/research/regulatory-sandbox.pdf> accessed 02 August 2018. 435 See Bromberg, Godwin and Ramsay (n 195) 12. 436 See FCA (n 204) 21. 437 ibid 10.

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markets. For these reasons, this paper considers that the do no harm proposal438 based on sandboxing could

better mitigate the trade-off between regulation and innovation.

In addition to the above argued, the potential correction of flaws identified in the Wait and See

Approach and the issuance of new regulation could also justify the thesis of classifying regulatory sandboxing

as an adequate approach for the case of DLT and securitisation. As considered in Section 3, new rigid

regulation that covers DLT, at the current time, could be deemed as an ineffective action that might stifle this

innovation due to the early stage of this technology.439 Thus, it is argued that the use of sandboxes could

provide, at the present time, a framework for innovators and regulators to experiment DLT`s proposals to the

securitisation industry confirming their benefits in order to furtherly verify the necessity or not to change existing

regulation or to issue new legislation in order to embrace this framework.440 In this way, sandboxing could, in

fact, provide flexible rules to DLT and securitisation without harming its development as could occur in the

case of strictly regulating this framework at the present time.441 Secondly, in relation to the Wait and See

Approach, it was previously considered that this approach might fail to provide a higher degree of legal

certainty and to stifle innovation in case of excessive time with this approach.442 Therefore, this paper

supports that regulatory sandboxes could also provide solutions to these failures. This is because the sandbox

approach is based on the establishment of a flexible, but clear legal rules that might be followed by firms that

participate in this environment.443 Put it simply, firms might, in fact, know which requirements to attend in

order to experiment DLT`s innovations to ABS transactions and, in this way, promoting legal certainty to this

environment.444 Moreover, with the exclusive use of a Wait and See Approach, regulators may take time to

provide a clear legal framework to address DLT and securitisation, eventually using ill-suited laws and as a

result harming this innovation.445 To deal with this flaw, it is argued that regulators that take the sandboxing

approach could have time and a space to better understand DLT and their potential application to

securitisation,446 while, simultaneously providing flexible rules that may properly fit the development of

DLT447 and, therefore, timely keep pace with eventual changes and novelties that might arise with this

technology. Hence, from the arguments above proposed, this research sustains that the use of regulatory

sandboxes based on the principles of do no harm is the appropriate regulatory approach to deal with the

application of DLT to securitisation and to address the current regulatory uncertainty. However, this paper

suggests further recommendations linked to the need for international regulatory coordination to complement

the proposed thesis.

Once consistently argued how the do no harm sandboxing could provide a response to the

question proposed by this paper, it seems also relevant to recommend that this strategy might be

438 See Giancarlo (n 176). 439 See Arner, Barberis and Buckley (n 107) 32; see also Deloitte, SFIG and CDC (n 11) 21; and ESMA (n 113) 18. 440 See Brummer & Yadav (n 93) 54. 441 ibid 51. 442 See Finck (20) 13; and Maupin (n 124) 6. 443 See Zetzsche and others (n 98) 26; see also Finck (n 20) 14, Brummer & Yadav (n 93) 51, and Blummont (n 15) 26. 444 See Finck (n 20) 16; and Blummont (n 15) 26. 445 See Maupin (n 124) 6; and Osborne Clarke (n 109). 446 See Finck (n 20) 16. 447 See Zetzsche and others (n 98) 26; see also Finck (n 20) 14; Brummer & Yadav (n 93) 51; and Blummont (n 15) 26.

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complemented with international coordination by regulators in order to fully achieve its purpose. To this end, it

is worth to point out that with respect to new technologies brought by Fintech (as DLT), regulators are taking

different approaches to deal with these innovations.448 However, this lack of international convergence might

weaken eventual actions of national regulators by stimulating circumstances as regulatory arbitrage449 or

hindering innovators that aim to develop DLT financial products in different jurisdictions.450 Additionally, this

situation could also be aggravated by virtue of the nature of Fintech technologies, as well as the current

organisation of regulatory sandboxes. To support this, as a digital platform, DLT is deemed to be a technology

that functions in a global and cross-border form,451 while approaches by regulators are usually provided on

national scale.452 Secondly, the structure of the current sandboxes is limited by their national reach and,

therefore, their rules may vary from jurisdiction to jurisdiction.453 Thus, considering this lack of convergence

and the intrinsic transnational nature of DLT and sandboxes, it is constantly argued that these circumstances

may ask for international regulatory coordination454 between regulators in order to provide an appropriate

framework to embrace the use of DLT in financial activities as securitisation. In this sense, this paper follows

the proposal suggested by Chairman Giancarlo who has already advocated for the promotion of global

regulatory coordination in relation to DLT and financial services through the harmonisation of laws.455 In this

opportunity, he suggested that this coordination process might be performed through the issuance of principles

based on the do no harm approach that should be implemented by authorities into their national, providing

‘flexibility, certainty and harmonisation necessary’456 to allow the DLT framework.457 Once harmonised by

authorities, these principles would provide a worldwide environment for firms to innovate with flexible rules that

could promote innovation in a global scale.458 Thus, in consonance with the proposal of Chairman Giancarlo,

this paper recommends that international organisations as IOSCO should consider the issuance of principles

based on the do no harm, prescribing a flexible legal framework459 to financial innovation (as, for instance,

the one proposed by regulatory sandboxes) in order to provide international coordination. In this context,

through harmonisation of these principles, regulators may allow the creation of a coordinated international

legal framework that could properly embrace DLT and its use in securitisation.

Given the arguments presented in this Section 4, this paper supports the view that there is a

strong legal case for regulators to embrace DLT and securitisation. DLT is a technology that could bring clear

448 See IMF, ‘Fintech and Financial Services: Initial Considerations’ Staff Discussion Notes No 17/05 (2017) 18, <https://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2017/06/16/Fintech-and-Financial-Services-Initial-Considerations-44985> accessed 29 March 2018. 449 ibid. For the definition of regulatory arbitrage, see Armour and others (n 129) 565, who define regulatory arbitrage as a tendency by firms to search for jurisdictions with relaxed regulations to provide their activities. 450 See Lev Bromberg, Andrew Godwin and Ian Ramsay, ‘Cross-Border Cooperation in Financial Regulation: Crossing the Fintech Bridge’ (2018) Capital Markets Law Journal Vol. 13, No 1 12. 451 See Finck (n 20) 21; and IMF (n 218) 18. 452 See IOSCO, ‘IOSCO Research Report on Financial Technologies’ (2017) 70, <https://www.iosco.org/library/pubdocs/pdf/IOSCOPD554.pdf> accessed 08 August 2018. 453 See Finck (20) 16; and Brummer & Yadav (n 93) 61. 454 See Bromberg, Godwin and Ramsay (n 220) 2; and IMF (n 218) 18. 455 See Giancarlo (n 176). 456 ibid. 457 ibid. 458 ibid. 459 As supporters of this soft law recommendation, Brummer & Yadav (n 93) 61 suggest that eventual international standards related to Fintech activities could be achieved by an international forum between national authorities.

https://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2017/06/16/Fintech-and-Financial-Services-Initial-Considerations-44985


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benefits to the issuance of ABS by providing a higher degree of transparency to this framework.460 As above

argued, these benefits may directly comply with the aim of securities regulation,461 and, therefore, it seems

evident that regulators have indeed consistent legal grounds to consider this technology to securitisation.

Therefore, in order to address regulatory uncertainty related to DLT, it is claimed by this paper that regulators

should take an active approach by working closely with market participants to promote the evolvement of

DLT462 and to better understand how this technology could attend some demands of the securitisation market.

To this end, this paper argues that a desirable regulatory model to allow DLT and the case for asset

securitisation would be based on (1) the principles of do no harm approach, (2) the creation of regulatory

sandboxes, and aligned with (3) regulatory international coordination. Thus, by taking this innovation-friendly,

regulators could provide a more transparent and safer environment for ABS investors and, as a consequence,

give a new hope for the securitisation industry.

460 See generally Deloitte, SFIG and CDC (n 11). 461 See Armour and others (n 129) 62. 462 See Bromberg, Godwin and Ramsay (n 195) 5

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Conclusions

Considering the above argued, this research concludes that there is a strong legal case for

regulators to consider the use of DLT in securitisation. On this point, it is supported by this paper that the use

of regulatory sandboxes based on the do no harm principles, as proposed by Chairman Giancarlo, should be

considered the model that properly addresses the current regulatory uncertainty that hinders this DLT`s

proposal to securitisation.463 This statement stems from the fact that, with this strategy, regulators could better

cope with the trade-off between innovation and regulation464 and provide corrections of the flaws identified in

possible regulatory approaches.465 In summary, in Section 1, this research has described the main features

of DLT and has explained how this technology is currently being considered to redesign the global financial

markets.466 Following this part, Section 2 has demonstrated that inefficiencies in the securitisation process

(lack of proper due diligence and overreliance on CRA) are deemed to be reasons that qualify this kind of

transaction as a ‘causa proxima’ of the Crisis.467 In this way, Section 2 has also elucidated how DLT could

propose solutions to these problematic issues by allowing a more transparent and safer framework for ABS

investors.468 Subsequently, Section 3 has explored the analysis of regulatory uncertainty (i.e. questions if or

how regulators may properly deal with DLT) as a relevant challenge to permit this new environment to

securitisation.469 In this context, Section 3 has critically evaluated possible approaches taken by regulators

to cope with DLT and has concluded that the issuance of new regulation to DLT, at this moment, could harm

its development to financial transactions,470 while the Wait and See Approach fails to provide an optimal

degree of legal certainty.471 In order to answer the question presented by this research, Section 4 proposes

the thesis that the benefits that DLT may bring to securitisation (provision of a more transparent and protected

environment for investors) seem to be in line with the aim of securities regulation and, hence, clarifies the

consistent legal grounds for regulators to accept this technology. Finally, Section 4 concludes that the use of

regulatory sandboxes based on the do no harm principles is considered the most suitable approach to embrace

DLT and securitisation. To fully provide this innovation-friendly proposal, this paper recommends that

organisations as IOSCO to issue principles based on the do no harm concepts in order to harmonise national

laws and to move in the direction of international coordination in order to reach a worldwide environment to

receive DLT and financial transactions.472 Therefore, given the extensively considered by this paper, it

appears that DLT is a promising technology that could dramatically restructure financial activities as known

today,473 including the asset securitisation practice. By allowing this new framework with a flexible approach,

463 See Giancarlo (n 176). 464 See Chiu (n 148) 748. 465 This paper has considered the Wait and See Approach and the issuance of new regulation. 466 See generally WEF (n 5). 467 See Lastra and Wood (n 41) 16-17. 468 See Deloitte, SFIG and CDC (n 11) 18. 469 ibid 21. 470 See Finck (20) 18. 471 ibid. 472 This recommendation is in line with the one proposed by Giancarlo (n 176). 473 See generally WEF (n 5).

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regulators could indeed act as a real ‘partner’ of the market, helping to recover confidence to the securitisation

industry, a financial activity that is recognised to be important to provide funds to the economy as a whole.474

This situation clarifies how technologies of the Fintech field are a reality that could bring significant benefits to

the markets and, consequently, the society as a whole. Thus, regulators might realise that technology is a real

modern phenomenon that must inevitably to be taken into consideration, because the society seems to be in

front of the rise of a new infrastructure that may not only model the future of the global markets, but also, as

commented by the IMF Director Christine Lagarde, because of its ‘potential to improve our lives’.475

474 See Deloitte, SFIG and CDC (n 11) 28; and SFIG (n 68). 475 See Lagarde (n 104) 10.

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