Regulators Must Consider Crypto’s Impact on Market Structure


Sir Jon Cunliffe, Deputy Governor for Financial Stability at the Bank of England, said regulators will need assurances that distributed ledger technology platforms can operate in different contexts and on a large scale given the systemic nature of capital markets.

Cunliffe spoke at the AFME Operations, Post-Trade, Technology & Innovation 2022 (OPTIC) conference in London. He said the regulator’s view that crypto assets and platforms carry major risks, but do not yet pose risks to the broader financial system, was confirmed by the absence of larger impacts. broads of collapsing crypto valuations.

However, crypto grew very rapidly and began to develop greater interconnectedness with the conventional financial system, which raised concerns about consumer protection and the need to think about systemic consequences.

“Regulators need to start extending existing standards and regulatory regimes to crypto before – not after – it becomes systemically important,” Cunliffe added. “We also need to think about the potentially disruptive impact of crypto technologies on the market infrastructure, trading, clearing, settlement and custody mechanisms that enable global capital markets.”

For example, traditional financial applications based on cryptographic technologies include Onyx Digital Assets, JPMorgan’s blockchain-based network for trading digital assets; Distributed ledger technology platform HQLAᵡ for securities lending and repo, SDX, SIX Digital Exchange for trading, settlement and custody of digital assets; and DTCC’s Project Ion for equity settlement using DLT. Additionally, native crypto businesses offer token real asset forms, such as FTX US which is expanding into stock trading.

Cunliffe admitted that post-trade and client onboarding processes are still often manual and duplicated, so there is room to leverage innovation in trading, clearing and settlement of crypto assets.

“At the heart of this is the exchange of symbolic representations of money and securities traded in the traditional financial sector today, such as stocks and debt securities,” he added. “Bringing the two components of commerce together on a single ledger facilitates near-instantaneous settlement of transactions and, leveraging modern cryptography, atomic settlement.”

This could potentially lead to significant cost reductions through the consolidation of trading and back office functions using smart contracts; eliminate settlement risk with instant settlement; and allowing splitting.

“The benefits could be particularly significant for illiquid markets (e.g. leveraged loans) that currently do not benefit from a central securities depository,” Cunliffe said. “As such, we would expect the potential benefits of tokenization/distributed ledger technology to be most pronounced in these areas.”

However, there are also risks, and Cunliffe said the operational resilience of DLT-based systems must be proven over time.

“Given the systemic nature of major capital markets, we will need assurance that DLT-based systems can work in different contexts and at different scale,” he added.

Instant settlement requires all trades to be pre-funded with the necessary cash and securities and finality can also pose challenges for risk management as there is no time to identify or rectify errors before they occur. are not executed. Therefore, regulators may not want fully instantaneous trading and settlement in all markets. Markets could also fragment if DLT platforms are not interoperable, including with traditional systems.

Sir Jon Cunliffe, Bank of England

The UK has set up a Financial Markets Infrastructure (FMI) sandbox, which the Bank of England, Financial Conduct Authority and HM Treasury plan to launch in 2023 to allow testing of new technologies and practices while disapplying or temporarily modifying certain legislations for specific purposes. . The focus will initially be on companies that want to implement DLT securities settlement systems integrated with trading platforms.

Cunliffe said: “While there are benefits to consolidating functions, as outlined above, and there are arguments for decentralization, it is very difficult to see how the risks can be managed at the good level without a legal entity responsible for the services provided and responsible for the proper functioning of the system.

He also stressed that it is essential that legal structures evolve to ensure clarity of their application as technologies for trade and post-trade services evolve.

“The technological innovation we have seen in crypto markets at least offers the possibility of a major transformation of financial market infrastructure – and one that could bring significant benefits,” he added. “It is also clear that for this to happen there are significant risks that will need to be managed and areas where public infrastructure will need to evolve. »

Solene Khy, head of product management, commodities, stocks, currencies and cryptocurrency derivatives at technology provider Murex, told a panel at the AFME conference that the crash of the crypto would lead to clean market infrastructure.

“Some of the existing crypto native businesses are going to collapse and there is going to be consolidation,” she added.

Angus Fletcher, chief executive of Fnality UK, a consortium building an “on-chain” payment system, agreed that cash and digital assets should reside on the same platform to avoid fragmentation of liquidity. As a result, the industry has the opportunity to develop standards for interoperability between technology platforms and business models.

During the conference panel, Fletcher said he hopes Fnality will be one of the main digital rails for delivery-versus-payment transactions.

“There will be greater integration between traditional markets and new markets as well as TradFi versus DeFi,” Fletcher added. “I think players who can drive will perform the best.”

He believes there is an opportunity for incumbents in the crypto space as they understand how to operate under tight regulatory scrutiny.

Angus Fletcher, Fality

“Regulation is coming into this space whether people like it or not, and bringing that expertise to the table is important,” Fletcher said. “What’s going to be important is who they partner with, so they can enable the technology alongside their expertise.”

Montserrat Farina, executive director, regulatory affairs, corporate and investment banking at JPMorgan, agreed during the panel that crypto will be regulated and a safer market will allow everyone to participate.

“I think incumbents have a lot of experience to bring in risk management,” she said. “They have a lot of experience in cybersecurity, and even private key management, because that underpins the whole flow we have in the SWIFT payment system.”

Etay Katz, a partner at law firm Ashurst, predicted during the panel that digital origination, registration, settlement, trading and post-trade platforms will have emerged in five years and expects to that fixed income securities are the first asset class to move. For example, in April 2021, the European Investment Bank issued its first digital bond on a public blockchain.

“I think the next five years are super exciting for creating this paradigm,” he said.

Pierre Pourquery, a partner at professional services provider EY, predicted during the panel that a regulatory regime will be in place for crypto in five years, so traditional banks will be much more active in this market.

“Some crypto-native businesses will need to reinvent themselves to be profitable and regulated,” he added.


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