CAI0033

Written evidence submitted by Association for Financial Markets in Europe (AFME)

Executive Summary

What opportunities and risks would the introduction of a Bank of England Digital Currency (BoEDC) bring?

As the Bank of England continues to assess different use cases for a BoEDC, we emphasise the importance of considering potential impacts to the existing financial ecosystem holistically, domestically and cross border, including the thorough evaluation of potential impacts on availability and cost of credit for the real economy but also on financial stability risks. BoEDC issuance cannot be considered in isolation since there will be an interplay between the role of other forms of payments used for settlement, such as: fiat currency, stablecoins, traditional and tokenised commercial bank money, or synthetic or indirect forms of central bank money, which are issued by a third party or FMI but backed by central bank money, as well as potential interoperability with synthetic CBDCs and fiat backed stablecoins. AFME members believe that different use cases may require different solutions and that there could be beneficial coexistence between settlement solutions as long as these solutions are within the appropriate regulatory perimeter.

We believe the development of a solution for central bank money settlement, payment and clearing to enable DLT-based settlement would be beneficial in wholesale markets. AFME remains supportive of broader industry aspirations to minimise credit and liquidity risk. However, it remains too early to definitively say that the development of a wholesale BoEDC is essential. Other solutions (e.g., linking DLT-based systems to existing real-time gross settlement (RTGS) systems) may prove sufficient with further analysis.

Further, we note that how the BoEDC is built (controls/protocols) will determine what it can be used for, as well as its potential use cases. GFMA’s 2022 Paper on Wholesale Central Bank Digital Currency (wCBDC)[1] sets out some important design considerations:

• Access: Limit access initially to regulated financial intermediaries that have access to central bank accounts in their respective jurisdictions. Consideration of broader access to be reserved to a later date when risks and rewards can be more effectively assessed based upon the initial implementation.
• Interoperability: as wCBDCs are expected to operate alongside legacy instruments and systems, interoperability with the broader financial market ecosystem is crucial. It is also preferred that local or regional CBDC systems and infrastructure should interoperate with each other, including in cross-border and multi-CBDC arrangements. Global standard setters will take on the role of coordinating wCBDC developments and setting common standards among central banks, partnering with the private sector to design and implement the necessary solutions for interoperability.
• Legal Status: of wCBDC must be addressed in legislative frameworks, with the goal of retaining the same classification and treatment as legacy fiat currency.
• Prudential Treatment: Prudential treatment regarding the role of wCBDCs needs to be addressed and incorporated into global standards and regional policies. It should be analogous to other central bank money, particularly with regards to capital and liquidity frameworks. To avoid unintended consequences, finance ministries, central banks, and prudential regulators should collaborate with the financial sector to ensure the design models of wCBDCs are in fact analogous to other central bank money.
• Risk Management: wCBDCs should be incorporated into existing risk management processes and solutions for clients.
• Programmability: The public and private sectors should work together to address the opportunity, challenges, and risks associated with programmable money.
• Privacy: it is important that the system complies with end-user privacy legislation.

It is important to consider potential impacts to the existing financial ecosystem holistically. As mentioned above, BoEDC issuance cannot be considered in isolation. AFME members believe that different use cases may require different solutions and that there could be a beneficial coexistence between settlement solutions as long as these solutions are within the appropriate regulatory perimeter. AFME members therefore remain interested in opportunities to expand wholesale central bank money settlement, but believe that the development of a BoEDC should not be based on it being the only allowed solution for payment and settlement purposes.

Are the Government and regulators suitably equipped to grasp the opportunities presented by crypto-assets, whilst at the same time mitigating against the risks?

In the rapidly evolving crypto-market, it is imperative that regulators actively seek to ensure that they have ample supervisory capacity, sufficient expertise, and that they employ the appropriate specialist and technical staff. We encourage regulators and supervisors to be proactive and innovative to match the pace of change. Gaps in supervisory and regulatory expertise could dampen robust implementation of regulation, which may in turn have a knock-on impact on markets and financial stability.

We believe that there is a critical need for a comprehensive, adequately balanced regulatory, legal and supervisory oversight framework; adapted to the evolving nature of the technology and its applications. For example, the ongoing work occurring across the UK including this consultation, the Law Commission consultation[2], and the FCA crypto sprints are most welcome. To grasp the opportunities presented, it will be important for these efforts to have a coordinated approach, strategic direction, and to occur in collaboration with industry and the global regulatory community.

What opportunities and risks could the use of crypto-assets—including Non-Fungible Tokens—pose for individuals, the economy, and the workings of both the public and private sectors?

DLT, as the technology underpinning crypto-assets, has the potential to bring significant benefits to market participants and consumers, including increased efficiencies at various stages of the capital markets transaction lifecycle.

DLT can also be used to increase access to certain financial products, drive financial inclusion, improve the resiliency of market infrastructure and change the way market participants interact with one another. Potential efficiencies if interoperable DLT solutions are implemented across financial services include faster settlement times, reduced trade breaks and reconciliations required (reducing counterparty and settlement risk); reduced process costs and complexity; enhanced regulatory compliance, auditability, and transparency.

There are different types of crypto-assets, which should be considered separately, that entail different rights, benefits and risks. AFME also believes that it is important to apply the principle of ‘same risk, same activity, same regulation,’ with any necessary amendments or additional guidance, and to provide additional clarification on how existing rules will apply to crypto-assets.

The regulatory frameworks for crypto-assets should be globally aligned, wherever possible, to sufficiently mitigate risks, and remain technologically neutral.

Unbacked crypto-assets

Risks related to these products arise from their high volatility and from their unregulated nature, both in terms of actors, and activities conducted in relation to those assets. Similar risks exist as in traditional markets (fraud, theft, hacks, market manipulation/abuse, etc.) and would benefit from a comprehensive regime to bring those products used for financial purposes into the perimeter of regulation. The EU’s Markets in Crypto Assets (MiCA) proposal can be an initial reference point to consider how to regulate these assets. It will, however, be important to allow regulated financial institutions to participate in this market, as they would bring liquidity and strong controls and processes. It will also be important to regulate Decentralised Finance (DeFi) activities, using similar rules to those applied to the same financial activity conducted in a centralised manner, to avoid the build-up of risks outside of the regulatory perimeter.

Stablecoins

Not all stablecoins rely on the same stabilization mechanisms to keep their value stable. Products that are akin to deposits should be treated and regulated differently than those that are more closely related to a money market fund. Consideration should be given to how those products are marketed to consumers, the rights conferred and disclosure and management of the risks involved, including KYC/AML. Regulation should address those risks and should borrow, where relevant, from existing regulations (e.g., where products are akin to deposits).

Regulation should also address conflicts of interest (risk taken by stablecoin issuer but born by stablecoin holders), custody of the reserve assets, basis price risk, convertibility issues, access to the assets at all times, the need for them to be segregated and unencumbered, appropriate HQLA composition and duration limitations, and other prudential requirements such as buffers/stress testing requirements.

Non-fungible tokens (NFTs)

Regarding the treatment of NFTs, AFME believes that the ‘same risk, same activity, same regulation’ principle should also be applied. NFTs offer significant opportunities for innovation, but if excluded from the regulatory perimeter could also create significant risks to: operational resilience; consumer protection; opportunities for arbitrage; market abuse and AML. AFME would thus encourage that NFTs are not treated differently than any other crypto assets based on the fact that they are not fungible (in fact, some can be split in parts with those parts being fungible between themselves), and evaluated in a similar manner, based on the rights conferred. NFTs used for financial purposes and traded on a secondary market should be included in the regulatory framework in a principles-based manner.

Furthermore, we believe further consideration and clarification on the status of a token that is theoretically fractionable, but has not been fractioned, is required. The same would apply to a token which has been fractioned in such a way that the fractions remain unique and non-fungible. Given these outstanding issues, and noting the rapid market developments in relation to NFTs, we would encourage further analysis accompanied by regulatory treatment that is fit for purpose and adaptable to market developments.

How can DLT be applied in the financial services sector?

As mentioned above, DLT, as the technology underpinning crypto-assets, has the potential to bring significant benefits at various stages of the capital markets transaction lifecycle, and can also be used to improve the resiliency of market infrastructures.

We recommend a technology agnostic approach, acknowledging that technology is neither “good” nor “bad”, but outcomes can vary greatly depending upon the individual use cases and specific applications.

The capital markets industry has a successful history of implementing new technology and has undertaken large change management programs with detailed risk management planning. It can apply this experience to DLT implementation in financial services, building on its expertise in technology change management to realise   the potential benefits of DLT.

AFME considers that the biggest potential efficiency improvements are likely to be on post-trade processes. These developments have prompted the financial industry to weigh the utility of having new “on or off chain” wholesale payments formats (e.g., CBDC, single-fiat linked stablecoins, etc.) which can match the programmable functionality and innovation emerging on the asset-side.

If DLT, as an underlying technology, is considered primarily as an alternative means of record-keeping and transmitting information across a network of participants, we anticipate there will likely be a greater initial impact on post trade functions, although there may be benefits from using code to automate the creation or offering of financial products or services, or the streamlining or automation of processes in markets that are highly manual and unstructured today (e.g., private capital).

For example, many DLT efficiencies may be gained in trade confirmation, clearing, settlement, custody, tax processing, corporate actions and other activities, because DLT can streamline some of the existing manual or complex processes that market participants currently perform. This streamlining may lead to the commoditisation and automation of various businesses and processes. The IMF estimate that a DeFi environment has lower marginal costs compared to traditional finance, due to the absence of labour and operational costs.[3]

While there are potential benefits for how the post trade process could be transformed, there are also important considerations and transformation challenges that may occur. The implementation of DLT will require the financial services industry to address and mitigate any new challenges that could arise from those products or services. Any post trade implementation may also have impacts on the value chain and other processes across the securities lifecycle.

Digital securities

Natively issued securities have some benefits vs traditional primary market issuance, from origination to trade confirmation or settlement. On the origination side, if interoperable DLT solutions are implemented, benefits include: faster time to market, delivery vs payment distribution, more issuer involvement in the process, automation of asset servicing, and greater scope of potential investors. Trade confirmations benefit from having a single golden record, straight through processing (STP) matching/allocation, reduction in manual operations and enhanced regulatory transparency. The ability to also program settlement, reduces the settlement cycles and helps avoiding a central point of failure risk. This in turn, allows the automation of asset servicing operations, increases investor-issuer transparency and allows direct investor access and the implementation of direct voting mechanisms or automated corporate actions execution.

Payments

DLT has the potential to impact wholesale payments, improving speed of end-to-end processing, reducing costs and challenges, and increasing transparency, as long as KYC/AML requirements are revised in light of the new transaction timeframes or international cooperation agreements, in the case of cross border payments.

Challenges

Although we expect there to be a significant uptake of this new technology, there are a also number of potential challenges that must be addressed.

There is currently a high degree of uncertainty on the regulatory and legal framework which will eventually underpin the use of this new technology. Appropriate regulation should be considered as a facilitator of DLT. Regulatory challenges could include the need for clarification on the legal-basis of settlement finality, in particular for cross-border transactions; or the distribution of functions, roles and responsibilities in an environment where regulation applies to centralized entities, such as operators of trading or settlement systems.

Interoperability and harmonisation of standards to allow industry participants, including regulatory authorities, to participate in multiple networks of new and existing technologies will also be critical to the broad adoption of DLT-based solutions.

Any DLT system based on atomic and/or close to real-time settlement would require significant changes to existing market practices, fundamentally altering liquidity and treasury management, netting processes and risk management models, and scalability through this transition (e.g. between DLT systems during the transition period).

How are Governments and regulators in other countries approaching crypto-assets, and what lessons can the UK learn from overseas?

The UK framework needs to be globally consistent and based on global standards to sufficiently mitigate risks and support the competitiveness of the UK. It is also important for the UK to leverage existing global frameworks and to rely on compatible standards, particularly for cross border purposes.

Some jurisdictional approaches the UK may look at include:

• Germany: allows e-securities for a number of products.
• France: allows for DLT issuance of certain instruments.
• Luxembourg: allows for DLT issuance of certain instruments.
• Switzerland: allows for use of DLT, to create a DLT trading facility, amends bankruptcy law to account for asset segregation and the protection of customer wallets.

Legal certainty and regulatory clarity will underpin a framework that protects consumers but also creates the foundations to attract DLT projects furthering responsible innovation.

It will be important that the UK shows its spurs on innovation by providing regulatory clarity and collaboration with the private sector, to proactively champion and drive responsible innovation.

One use case where it will be important for the UK to learn from and work cooperatively with overseas regulators would be in relation to BoEDCs. Given the breadth of the BoEDC’s potential connections, connectivity and interoperability should be considered across the following dimensions:

1. Interoperability with existing wholesale payment instruments and systems.
2. Interoperability with new payment instruments and systems.
3. Connectivity with the broader capital market ecosystem and financial market utilities.
4. Interoperability with cross-border FX systems, including other international CBDCs.
5. Interoperability between local wCBDC and any retail CBDC that may exist.
6. In the context of DLT-based CBDC infrastructure, interoperability between different DLT protocols.

By taking a principles-based approach, the UK can foster innovation and work towards its stated intention of being a “hub” for not only the crypto-assets industry, but also in its approach to digital finance in general. This approach is also applicable to data, artificial intelligence, and operational resilience policy in that it would mitigate the risk of overly prescriptive requirements that could hamper innovation, and also future-proof regulation to be agile and keep pace with new developments.

Timing is also important and to strengthen competitiveness, it is crucial for guidance and regulation to be implemented at pace. As noted, MiCA will enter into force shortly and other jurisdictions are also moving quickly. We would welcome further guidance from the UK on the expected timing of new guidance and regulation, but also clarity on the remit of individual supervisory authorities. These aspects are key when considering global interoperability, and how consistency of oversight will be implemented.

Finally, in support of the above, AFME believes that both the UK and other global regulators should strive for a competitive and level-playing field to ensure all firms involved in capital markets adhere to the principle of ‘same risk, same activity, same regulation’.

September 2022