Building the next generation of capital markets
Market participants have been talking about using distributed ledger technology as a tool to improve capital markets infrastructure for at least a decade. But despite numerous pilots and experiments, few distributed ledger technology-based capital markets systems have reached production-grade scale. If these systems are really as promising as they seem, what’s taking so long, asked panellists and participants at the Digital money summit hosted by OMFIF in London last month.
Reducing settlement times is generally agreed among market participants to reduce risk and improve capital efficiency. Whether DLT can provide a safe and compliant means of doing so is being put to the test.
Financial markets are regulated spaces, so while building the technology is important, convincing regulators of its soundness is at least equally so. To their credit, regulators are providing the opportunity to conduct the necessary tests under their supervision. In 2023, the European Union began the blockchain pilot regime, providing the legal framework for the trading and settlement of transactions with financial instruments as tokenised assets, aiming to preserve ‘investor protection, market integrity, financial stability and transparency, while avoiding regulatory arbitrage and loopholes’.
The Bank of England and the Financial Conduct Authority set out to introduce the Digital Securities Sandbox that will enable firms to issue, trade and settle securities using DLT and other developing technologies. The sandbox would provide the regulators with the opportunity to ‘design a permanent technology-friendly regime for the securities market’.
Technical barriers
Participants across different panels highlighted technical interoperability as a key problem. On account of the many players, their infrastructures are not sufficient in linking up the various systems.
Interoperability is important for avoiding fragmentation. It can ensure a seamless flow of data while upholding trust and security across the different systems. The ecosystem players will need to consider factors such as whether interoperability would occur within the same technical stack but with different applications, or as full interoperability among different applications and different technical stacks. These include other technical factors such as data storage and how these systems communicate with each other.
If these systems are not interoperable, they run the risk of liquidity fragmentation, creating ‘digital islands’ where the system can only function within itself. New systems will need to consider access to established payment rails, and to each other, to prevent this from happening.
Both the pilot regime and the DSS impose strict limits on the volume of assets that can be transacted. Scaling up for a full marketplace, however, may not simply be a question of removing these limits.
Scalability is a technical challenge. Though some in the industry believe they have solved it, demonstrating that a system that worked for a few assets in a sandbox can also work for trillions of euros of financial instruments will be an important prerequisite before advancing to widespread adoption.
Governance and regulatory hurdles
Capital markets should operate as close to globally as possible for maximum efficiency and liquidity. Frictions across borders may be important for policy reasons regarding the flow of capital and funds. But new form factors should not introduce new constraints. For this to be so requires globally cohesive regulatory frameworks. Working on these projects on a national basis makes sense initially, but for these markets to function internationally requires collaboration on operating standards.
During the summit, panellists raised the issue of shifting responsibilities of settlement from intermediaries and custodians to platforms, addressing questions like: could platforms be held accountable in the same way as current financial market infrastructure?
While some 73% of the summit audience believed that settlement would take place on DLT rails in the future, they were split on whether these rails will be operated by CSDs (43%) or if DLT would make those institutions redundant (30%).
The blockchain pilot regime and DSS are exploring whether central securities depositories will be needed with DLT infrastructure. Part of the work now will involve deciding on which roles market participants will play in these new ecosystems.
Katerina Liu is Research Analyst, Digital Monetary Institute, OMFIF.
