The European Securities and Markets Authority (ESMA) has gathered general views from central securities depositories (CSDs) on the industry’s appetite for innovative financial technologies such as distributed ledger technologies (DLT), smart contracts, cloud computing, artificial intelligence (AI)/machine learning, the Internet of Things (IoT), biometrics and quantum computing.
Some of these technologies seem relatively widespread (e.g. cloud computing and AI), while others are less deployed despite their disruptive potential (e.g. DLT, smart contracts, quantum computing). ESMA has also gathered concrete experiences on the use of these fintechs and their application for core and non-core CSD services and activities.
AI and cloud
AI is used by some CSDs mainly for operational processes such as investors’ onboarding and AML/KYC checks (rather than core services) while others are planning to implement solutions based on AI in the near future (i.e. 1 to 5 years from now). In both cases, CSDs’ responses seem to indicate that AI is or would be used to strengthen operational processes.
Cloud computing is also either currently being used by several CSDs or should be used in the near future by some others. It seems to be used for administrative functions or when developing new projects or products due to the system’s flexibility, its cost-effectiveness and ease of use. It is worth noting though that a group of CSDs has explicitly mentioned the compliance with ESMA Guidelines on outsourcing to cloud service providers as well as the General Data Protection Regulation (GDPR) as potential challenges for the implementation of cloud computing.
DLT and smart contracts
Until now only one CSD authorized under CSDR, ID2S, uses DLT to provide notary services and central maintenance services to keep record of every change resulting from transactions settled through T2S. The CSD expressed its intention to extend progressively the use of DLT, in particular through the integration of smart contracts which should allow it to extend the asset servicing model over the entire life cycle of a debt instrument.
According to ID2S, integrating smart contracts has the potential to increase transparency to investors, regulators, and other interested parties, reduce or eliminate reconciliation issues and drive down costs associated with asset servicing, among others. The CSD highlights the flexibility offered by the DLT to develop new products and services as the main benefit of using this technology. The use of DLT by this CSD is limited to notary services and central maintenance services to keep record of every change resulting from transactions settled through T2S.
One of the CSDs among those planning to use DLT and smart contracts has highlighted that there are many challenges at this stage with regards to the use of these innovative technologies. The challenges mentioned include the uncertainty regarding advanced DLT features such as advanced cryptography, the tokenization of cash, the creation of digital assets and the reluctance of some participants to change business processes due to the impacts suffered by traditional models.
Furthermore, this same CSD indicated that the use of DLT does not come without risk, as potential new custody or other types of risks can arise from new features of this technology. Furthermore, the lack of regulatory guidelines at this stage might also represent a risk for CSDs.
Fintech partnerships
More than half of the responding CSDs have established partnerships with start-ups and other third parties for the development and use of fintech. The type of partnership varies significantly, ranging from bilateral agreements between a CSD and a start-up or a joint venture created with the support of different market players.
Examples include:
- LiquidShare : In July 2017 several market players, including Euroclear, announced the creation of the non-CSD LiquidShare, a suite of services based on a private and restricted blockchain network that issuers and infrastructures can use in the context of the issuance, holding and transfer of securities. This platform became operational in June 2020. The entirety of the issuance can be registered onto LiquidShare’s blockchain and accounted for via an issuance smart contract that keeps track of the total number of securities for each issuance.
- Deutsche Börse and HQLAX: In March 2018, Deutsche Börse Group and HQLAX announced a partnership for the creation of a new securities lending & collateral management operating model based on a blockchain platform developed by the software firm R3. The securities are issued in a conventional environment and grouped in the form of baskets of securities. For the purpose of DvD (Delivery versus Delivery), the ownership of baskets is tokenised, (i.e. represented on distributed ledgers by tokens) and exchanged on the HQLAX platform (the Digital Collateral Registry). It aims to facilitate more efficient collateral management of high-quality liquid assets (HQLAs) across a fragmented securities eco-system. Further investments into this project have been announced by the Deutsche Börse Group in early 2021.
- FundsDLT: Clearstream, together with other partners announced in March 2020 a Series A investment in FundsDLT to develop a decentralized technology platform to facilitate the distribution of funds based on DLT. FundsDLT is built using permissioned blockchain technology based on Ethereum.
- Euroclear and Algomi: Euroclear’s data and information business, Euroclear Information Solutions, announced in July 2018 investing in the fintech company Algomi, which is a software company that provides technology to bond market participants.
ESMA recommends
Generally speaking, the current level of deployment of fintech by CSDs in the EU is low. Certain innovative technologies such as AI or cloud computing seem to be already used. No specific barrier within the framework of CSDR has been brought to the attention of ESMA with regards to technologies such as cloud computing, AI/ machine learning, Internet of Things (IoT) or quantum computing.
Concerning DLT, while CSDs generally recognize its disruptive potential in the field of CSD services, its deployment is extremely limited at this stage. Indeed, other than the use of DLT by ID2S, presently CSDs are not using DLT but rather investigating its use and planning to use it in the coming years.
ESMA’s main recommendations to the European Commission on CSDR (central securities depositories regulation) are issues related to: settlement of securities and of cash in a DLT environment; settlement finality; securities accounts, credits, debits, segregation requirements and reconciliation requirements; and operationa requirements. ESMA also noted it will give further consideration to instances where Level 2 requirements might be incompatible with the use of DLT and would require some targeted amendments.