Onwards, into a new digital finance world
The European Commission (EC) has issued an ambitious Digital Finance Package, which aims to set up a harmonized, secured, and innovative regulatory framework for the issuance, distribution, and servicing of crypto assets.
Laurent Collet - Partner - Strategy Regulatory & Corporate Finance - Deloitte
Benoit Sauvage - Director - Risk Advisory - Deloitte
Published on 15 April 2021
Five years after the blockchain boom, the financial world has changed and matured. While we once talked about blockchain as likely as pigs caught flying, today we have a better understanding of what cryptocurrencies, distributed ledger (DLT), and other digital technologies can achieve. Different solutions and applications leveraging these new technologies have been launched, with varying degrees of success.
One of the first lessons learned was that blockchain is unlikely to completely disrupt the way financial markets are regulated and organized. However, it is clear that this technology can provide more efficient and transparent issuance, distribution, and asset servicing methods.
So far, we have produced more papers and studies about blockchain and DLT than actual projects; but what entity would reasonably play and invest in the digital marketplace without first knowing the rules of the game? Clearly, a legal and regulatory framework was the missing piece of the digitalization puzzle; a framework which appears shortly to be implemented.
Recently, we have seen a convergence of key trends, including private cryptocurrency and asset initiatives (for example, Libra and investment bank stablecoins), China’s blossoming digital finance market, and the acceleration of digital adoption due to the COVID-19 crisis. Combined, these developments have forced regulators to examine the digital finance question.
Central banks in Europe and the United States (US) have begun to assess the business opportunities of developing both retail and wholesale central bank digital currencies. And, the European Commission (EC) has issued an ambitious Digital Finance Package, which aims to set up a harmonized, secured, and innovative regulatory framework for the issuance, distribution, and servicing of crypto assets.
This Digital Finance Package comprises of digital finance and retail payment strategies, as well as two regulations:
i) The Markets in Crypto Assets (MiCA) and ii) The Digital Operational Resilience Act (DoRA).
The EC will also implement a pilot regime, which would enable market infrastructures to propose new and innovative DLT solutions within a secured and regulated environment.
These new regulations are a key milestone in the development of innovative crypto asset solutions and will also link and harmonize the various local laws on the subject (in France, Germany, and Luxembourg, to name but a few). They also aim to regulate dark or grey areas where no proper legal framework for crypto assets or crypto services exist.
It is worth noting that the qualification and definition of crypto assets as financial instruments or e-payments in the current regulatory framework means their use is more applicable than ever. They are covered by the Markets in Financial Instruments Directive (MiFID II), the Central Securities Depositories Regulation (CSDR), the Market Abuse Regulation (MAR) and the Electronic Money Directive, as long as the digital assets share similar characteristics to their more regular versions.
However, the Digital Finance Package is much more than just a new set of requirements for governance and operations. We also view MiCA and the pilot regime as a clear opportunity for the development of new products and services in the financial industry landscape. The target operating model is also subject to transformation, such as providing broader access to platforms, better-integrated trade/post-trade value chains, and new ways to safe-keep assets.
So, are we finally ready for take-off?
In a nutshell, yes! This legal framework will bridge any gaps by introducing new regulations and reaffirming the current framework, while also creating a legal certainty around crypto assets that all stakeholders will no longer be able to ignore. Crypto assets will be part of the future financial eco-system the same way the market is today issuing, distributing, registering, and safe-keeping financial instruments.
We highlight in this article what the financial services landscape could look like under the new MiCA/pilot regime. We do not expect to see a major disruption of the environment, which the initial emergence of blockchain suggested; it is more likely that legacy and fintech stakeholders will work together to develop new crypto asset issuance, distribution, and servicing models, which will co-habit with existing models.
What is the new Digital Finance Package?
Since blockchain technology first emerged, we have seen several crypto assets and digital currencies launch, of which Bitcoin is the most well-known.
The high volatility of these instruments has led to regulators issuing warnings to protect investors. As a result, more stable forms of digital currencies have emerged, such as stablecoins and central bank digital currencies (CBDCs) that are supported by the main central banks, the European Central Bank (ECB) and the Bank for International Settlement (BIS). The digitalization of markets and the use of crypto assets as security tokens have also boomed in the last few months, not only on the alternative fund side, but also in traditional debt and equity. In light of this, the EC has set out an ambitious new regulatory framework to encourage responsible innovation, within a single EU market, to benefit consumers and businesses. The EC’s Digital Finance Package covers these key topics:
- A digital finance strategy to make Europe’s financial services more digital-friendly and to stimulate responsible innovation and competition. It will ensure that the EU’s financial services rules are fit for the digital age and can be applied to technologies such as artificial intelligence (AI), data management, and blockchain.
- A retail payment strategy for a fully integrated retail payment system within the EU, with a specific focus on instant cross-border-payment solutions.
- The MiCA regulation, which aims to provide a harmonized EU framework for the issuance and provision of services related to crypto assets, exchanges, and trading platforms, while mitigating risks for investors and addressing financial stability and monetary policy risks.
- A pilot regime for market infrastructures, which aims to trade and settle transactions in financial instruments in crypto asset form and gain experience in the use of DLT.
- The DoRA regulation, which aims to ensure that all financial service players have the necessary safeguards in place to mitigate cyberattacks and other risks.
To answer the question of how the financial services landscape could look under the new MiCA/pilot regime, let us start by defining the crypto asset concept. Usually, crypto assets are defined as a digital representation of value or rights, which may be transferred and stored electronically by using distributed ledger or similar technologies.
There are three main types of crypto assets:
1. Exchange tokens
2. Utility tokens
3. Security tokens
These are meant to function as a medium of exchange, a unit of account, or a store of value. They aim to facilitate the payment of goods or services via a DLT platform and are akin to fiat currency. MiCA adds the following concepts to the definition of exchange tokens:
- E-money tokens, which are used as a means of exchange and purports to maintain a stable value by being denominated in (units of) fiat currency. Issuers must grant a claim to redeem the token at any moment and at par value with the fiat currency referenced.
- Asset-referenced tokens, which are used as a means of exchange and maintain a stable value by referring to the value of several fiat currencies, one or several commodities, one or several crypto-assets, or a combination of these assets.
These provide investors with access to a specific product/function (for example, data storage) that is directly provided by the token issuer. These tokens can provide right of access, use of a service or product, or participation in an event, similar to a voucher.
These offer an investment dimension; they are more like a financial instrument than a currency. These tokens should be considered as assets that provide rights, such as ownership, a payment of a specific sum of money (dividend), or entitlement to a share in future profits or cash flows. Interestingly, security tokens may be qualified as transferable securities or financial instruments under the EU’s MiFID II. Similar to how depository receipts were certificates representing securities, security tokens are a digital representation in DLT of existing securities like equity, debt instruments, funds, etc.
It is important to highlight that crypto assets can already been issued and distributed under a legal and regulatory framework as far as they qualify as financial instruments.
Tomorrow’s digital finance ecosystem
When designing tomorrow’s digital finance model, it is important to first define the business requirements and then apply the relevant technology to answer these needs, and not the other way around.
To fully leverage DLT and crypto asset opportunities, we cannot view DLT as just a new type of “database” or spreadsheet. Instead, it is a revolutionary way to re-organize the entire value chain—issuance, exchange, post-trade, custody, and asset servicing. This out-of-the-box thinking is clearly one of the main challenges we are facing,
as we will need to break away from the sequential and centralized value chain model and instead embrace an instantaneous distributed ledger model, where participants can access the same information at the same time.
The Digital Finance Package and its pilot regime will integrate the unique traits and impact of DLT and crypto assets into the current regulatory framework. The pilot regime specifically aims to adapt the current regime to allow for new, innovative models.
The new regime will introduce the following concepts to reshape the current market infrastructure and custody business model:
- A DLT platform that can be potentially accessed by retail investors.
- A new global DLT platform that combines the initial recording of, the settlement of transactions in, and the safekeeping of DLT transferable securities.
- Settlement (delivery versus payment) in CBDC or, when CBCD is not practical or available, through commercial bank money (e-money token).
- Crypto asset servicing, including custody wallet private cryptographic keys and smart contract operations.
The new pilot regime’s DLT platform will focus on instruments (transferable securities) that have low liquidity today. This could help create not only a secondary market, but also help manage liquidity and collateral, which would ultimately and most likely positively affect the entire industry.
However, to add a dose of realism to the proceedings, the Digital Finance Package has just been released—a go-live date may still be some years off. In the meantime, several countries and financial institutions are already working on creating and implementing crypto asset solutions, including new digital currencies and security token instruments.
Today, investment firms and issuers can already issue instruments and leverage DLT to improve efficiency, enhance risk management, and distribute their products to a larger range of investors. This is because current legislation already allows crypto assets to be issued, distributed, and registered—notably the case for crypto assets that are based on existing financial instruments such as equities issuances.
Private initiatives are not only issuing quasi-classical financial instruments but also issuing digital money, which can often be volatile.
These initiatives are now joined by central banks who are considering issuing CBDC—with a claim on the fiat currency of reference—addressed to wholesale or even retail users.
Both the Digital Finance Package and the existing local crypto asset legislations will provide for new issuance and distribution models. While DLT will reshape some business processes, this will be achieved in the short- and medium-term and in parallel with existing models. We may also see certain stakeholders—investment firms, market infrastructures, custodian and asset servicers—play an active role in this transformation, with the support of new fintech companies providing crypto asset, tokenization, and digital-enabler solutions.
These new regulatory and legal frameworks are likely to hasten the development of crypto asset solutions, setting out the definition and scope of crypto assets in existing regulations and sharpening the view of what can and cannot be done across the entire EU.
While these regulations will lead to broader use of DLT or digital technologies, there are still some technical issues that must be resolved, such as the capability of DLT to manage large volumes of transactions and payments, and its robustness to cyberattacks. Last but not least, the security, anti-money laundering/know your customer capabilities and risk management of these new models will be paramount, as regulators will not allow the use of business models that do not fully integrate these considerations.
A new world of crypto asset opportunities under a regulated framework
We are on the cusp of a new global securities and payment environment; the pilot regime’s new DLT platform aims to support new payment models that re-organize the issuance, distribution, and servicing of assets, affecting wholesale and retail stakeholders alike.
Currently, we do not expect all securities transactions and payments to suddenly shift to their digital forms. Crypto assets and digitalization are best applied to new market opportunities or underserviced assets with limited automation; for example, “smart contracts” that would automatically trigger dividend or interest payments. The application of these new technologies could also help transform other illiquid assets into more liquid ones and, by transforming lengthy processes into instantaneous ones,
could also optimize exchange processes (collateral, margining, etc.), providing indirect benefits to a large segment of the industry.
The new DLT securities and payment environment will be built in phases, first focusing on instruments or processes that need and/or wish to benefit from:
- Mobilization and exchange of money and/or assets on an (intraday) real-time basis.
- Reduction of counterparty risks and settlement fails.
- Easier access to instruments and enhanced exchange/distribution opportunities.
- Reduction of risks and administrative workload related to issuance and corporate action processes.
From a stakeholder’s point of view, we see the following business opportunities of this new DLT environment:
Private markets and alternative assets
Many private market and alternative asset players are looking to expand their footprint and reach more mainstream investors. To help achieve this goal, new DLT and digital enabler tools have emerged. Crypto assets allow tangible assets to be fragmented into several token assets, allowing market players to reach a larger range of investors. Digital assets, compared to previous initiatives, will integrate the entire market into a single and relatively easy-to-manage environment.
Environmental, social, and corporate governance (ESG) and green bonds/short- and/or mid-term instruments
Several investment banks have developed proofs of concept demonstrating the issuance and settlement of bonds versus CDBCs. There are clear opportunities in bond issuances, as bonds do not tend to be highly liquid due to the relatively large size of trade. With ESG/green bonds set to boom, firms could leverage DLT and the new regulatory framework to reach a larger spectrum of investors, improve their cost and resilience, and answer specific ESG needs and requirements like traceability, smart contracting, and enhanced issuance processes.
Asset managers, via DLT platforms and crypto assets, may benefit from a reduced settlement in time and risk exposure. For custodians, this would remove any potential pressure on cash and collateral, which could be used for more favorable purposes. Asset managers will be able to optimize their portfolio management during the day and enhance the liquidity of some instruments. And, digital financial transactions, in CBDC or e-money for example, can benefit from reduced settlement fails and securities and payment reconciliation issues. Digitalization could also help asset managers create any required secondary markets that are tailored to their requirements.
Asset servicers will need to adapt to these new forms of instruments and payments, by acquiring new technologies that are potentially supported by ESG approaches, and hiring and training staff. In return, this digital transformation will bring new business opportunities, such as safeguarding crypto assets, providing custody wallets for private cryptographic keys to protect the integrity of digital assets, and managing and executing smart contracts. And, in the case of digitalizing existing illiquid instruments, asset services will hold the assets’ original copies.
DLT platforms—new market infrastructures
Existing market infrastructures have the opportunity to design, implement and re-shape business models under digital platforms that can instantaneously trade, post- trade, issue, and safe-keep crypto assets under a single DLT environment. These new platforms will coexist with current regulated multilateral trading facility (MTF) and central securities depository (CSD) offerings. Under the new EU framework, we could also see new fintech companies collaborating with legacy infrastructures or leveraging new regulations to enter the marketplace, as these fintechs will be able to withstand similar levels of scrutiny as legacy financial institutions.
This digital journey could be launched today by mixing local and EU-level regulation—this would prepare the market for the EU’s upcoming digital and DLT asset framework. Combined with the upcoming AI regulations, EU markets and stakeholders of all types are embarking on an intense journey that offers many opportunities and few pitfalls.
At a time when financial organizations are defending their core business while developing tomorrow’s business solutions, it has never made more sense to leverage the opportunities of DLT, digital currencies, and security tokens.
- European Commission (EC) has issued an ambitious Digital Finance Package, which aims to set up a harmonized, secured and innovative regulatory framework for the issuance, distribution and servicing of crypto assets.
- These new regulations are a key milestone in the development of innovative crypto-asset solutions and will also link and harmonize the various local laws on the subject (in France, Germany and Luxembourg, to name a few). They also aim to regulate dark or grey areas where no proper legal framework for crypto assets or crypto services exists.
- We are on the cusp of a new global securities and payment environment with new processes along the issuance, distribution and servicing of assets, affecting wholesale and retail stakeholders alike.
- We do not expect all securities transactions and payments to suddenly shift to their digital forms. Crypto assets and digitalization are best applied to new market opportunities or underserviced assets with limited automation or illiquid assets
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