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The EU’s DLT pilot regime has gone live: what does it mean for banks?


Amidst growing scrutiny of the banking sector, Alisa DiCaprio, Chief Economist at R3, discusses how the EU’s DLT pilot regime offers an opportunity for banks to innovate and future-proof their finance-function against an evolving regulatory landscape.

The collapse of Silicon Valley Bank, UBS’s takeover of Credit Suisse and more recently, JP Morgan’s purchase of First Republic, has shone a light on many of the vulnerabilities in the banking sector. Principal amongst these is the importance of capital and liquidity requirements, with recent turbulence across the banking sector pushing balance and sheet management to the top of the agenda for finance functions across the board. Many banks are now exploring how to harness modern technology to manage intra-day risk more effectively.

The European Union’s (EU) distributed ledger technology (DLT) pilot regime, launched in March 2023 as part of the European Commission’s digital finance strategy, offers one of the biggest opportunities for banks looking to innovate whilst mitigating risk in a controlled environment.  The regime allows banks and financial market infrastructures (FMIs) to test DLT for the issuance, trading, and settlement of tokenised financial instruments by offering exemptions from different legislations such as MiFID II and CSDR.

It is backed by the European Parliament (EP) and the European Securities and Markets Authority (ESMA), with the recent go-live marking a landmark moment in leveraging DLT in a real-life setting to enhance efficiency across capital markets.

As scrutiny and pressure mounts on the banking industry, now is the time to assess how banks can use the pilot programme to optimise workflow and innovate in a controlled and risk-free manner.

Innovating through collaboration

Open participation and collaboration have been consistent themes as regulated market participants work towards a common goal, and the regime is a well-received addition to this critical cooperation.

The pilot allows market participants to connect their private placement and internal assets to a regulated secondary market. Buy-and-sell-side participants have identified opportunities with workflow optimisation, strategic positioning, and cost benefit analysis.

Banks can tap into the pilot regime for the launch of the Eurosystem Collateral Management System (ECMS), whose go-live was recently rescheduled by the Governing Council of the European Central Bank from 20 November 2023 to 8 April 2024 to help mitigate the impact of the rescheduled T2 launch. The ECMS aims to set out a unified system for managing assets used as collateral in Eurosystem credit operations and will replace the existing individual systems of the euro area national central banks.

On top of this, the RTGS renewal programme and subsequent changes to mandatory clearing obligations create an opportunity to futureproof financial markets by offering wider interoperability, improved user functionality and strengthened end-to-end risk management of the UK’s High Value Payment System. Innovation must be undertaken with caution, which is why the regime acts as a useful safety net when implementing these updates.

To stay ahead of competition and on top of the impending collateral management changes, banks need to look at the overall digitisation of asset management, settlement processes and the acceleration of payments.

DLT and the pilot regime can act as critical cogs in optimising a total digitisation process across banking ecosystems. Encrypted distributed ledgers provide real-time verification of transactions, removing time and cost-consuming reconciliation. This ensures processes that typically take a few days can be completed in a matter of minutes.

The move to next-generation systems

Capital markets are about networks and standards, and therefore to be successful, these networks need to interoperate with existing processes and systems in a standardised form.

This requires a heavy lift in making sure there’s a successful balance between the implementation of new models and integrating to current systems. These networks also need to be complementary to one another and without total disruption to day-to-day processes.

Existing stakeholders in capital markets rely on the trust and resiliency of the market, needing to consistently meet standardised levels of security and trust. This is a key feature that banks cannot forget amidst innovation, moving from legacy to next-generation systems.

To maintain these levels of security and trust, permissioned distributed ledgers can help capital markets meet these demands. With permissioned structures, all data is verifiable using secure cryptography and digitally-verifiable signatures for upmost security and resiliency. These ledgers are also tokenless to offer higher performance for timelier transactions.

Keeping up with global competition

There has been a recent uptick in global competition to harness new technologies with the aim of creating a successful digital economy.  The recent banking crisis will undoubtedly accelerate this transition, with many financial institutions turning to regulatory environments like the EU DLT pilot to futureproof their finance function and enhance their operational efficiency. 

The EU is not the only jurisdiction to begin experimenting with DLT at scale in financial services. The UK Government, for example, has established its FMI Sandbox, which is expected to be up and running in 2023 and will enable firms to experiment with DLT in areas that underpin financial markets such as securities settlement.

Overall, if FMIs want to benefit from the EU’s DLT pilot regime, they must take banks and other financial institutions along for the journey. For banks, this is both an opportunity and a necessity. The pilot can not only give them an opportunity to influence regulations, but also stay at the forefront of financial innovation as global competition rises.

Story provided by Alisa DiCaprio, Chief Economist at R3

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