By William Garner, partner in Financial Services & Funds at Charles Russell Speechlys
It is impossible to have any discussion involving Fintech these days, without the possibilities offered by blockchain technology popping up somewhere in the conversation.
The race is on to turn blockchain technology from a system allowing a small number of anonymous participants to deliver small quantities of crypto-currencies to each other, into a viable means of delivery and settlement for financial instruments. Alongside this, we need to think about the legal and regulatory implications of using this new technology, which is emerging into a legal and regulatory environment developed to deal with a very different world – one that contemplated a centralised ledger and a monopolistic settlement process. The central concepts of a distributed ledger and potentially open access are at odds with established systems and it is going to be difficult to reconcile them with the current regulatory landscape.
The legal issues surrounding the use of a system using blockchain technology that is governed by English law are generally positive. It is highly likely that the English Courts would fall back on the considerable body of legislation and case law in determining the validity of a commitment made, confirmed or settled through a blockchain process and the consequences of any failure in that process. It should therefore be possible to design a system using blockchain technology governed by English law that could be used to create or confirm legally binding obligations, pay or transfer money, or validly transfer title to financial instruments and other assets.
The regulatory position is very different; the application of regulation to any settlement or delivery system using blockchain technology turns on the financial instruments being committed or settled through the system and its functionality. Most post-trade activities are outside the scope of regulation and there are many suggested uses for blockchain technology that would most likely not require any regulatory approvals. Take for example, collateral management: here it would be possible to envisage a blockchain system established between a closed and defined user group such as a broker and its clients, which could be used to manage margin that (due to the efficiencies of blockchain technology) could pay and release margin virtually in real-time. Such an arrangement is unlikely to require any regulatory approval.
Nevertheless, to realise the full potential of blockchain technology in clearing and settlement, it would need to be deployed on a mass scale and as that would inevitably make such a system systemically important. This alone would attract the attention of the regulators. The most obvious potential uses for blockchain technology would be in connection with the settlement of transactions in financial instruments. Settlement is not a regulated concept, but operating as a central counterparty or clearing house is, and would therefore require the operator of the blockchain system to seek exemption under the Financial Services and Markets Act 2000. The point at which the operator of the system would need to seek exemption would depend on the nature of the financial instruments being settled through it and the functionality of the system.
Even if the operation of a system using blockchain technology did not require the operator to be recognised as a central counterparty or clearing house, they may well be undertaking a range of activities that would bring them within the scope of regulation. One of the most basic potential uses for blockchain technology is its use as a mechanism for making payments (as it currently does with crypto-currencies). Any system being used to facilitate payments is potentially within the scope of the Payment Services Directive (the Payment Services Regulations 2009, in the UK) and anyone making payments through use of a blockchain system to transfer cash would likely need to be authorised as some form of payment services provider. If the operator of the blockchain system was at any point providing liquidity into that system, they would need to carefully consider whether they were undertaking the regulated activity of issuing electronic money.
Any blockchain system being used to create or confirm commitments relating to the sale and purchase of financial instruments may well fall within the scope of a trading system, and therefore require regulation as a Multilateral Trading Facility or Systematic Internaliser. If it also went on to settle those commitments, the operator could well be involved in the regulated activity of sending dematerialised instructions.
Probably the most significant regulatory challenge for any system employing blockchain technology is the clearing requirement imposed by the Markets in Financial Instruments Directive and European Market Infrastructure Regulation, which impose an obligation on participants to transactions in various financial instruments to submit those transactions to clearing. Therefore unless (and until) these regulations are modified to allow the use of systems employing blockchain technology, the opportunities offered by it will unfortunately remain limited.