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Crypto, Digital & Resilience, Digital Transformation, Operational Resilience


BANKS SHOULD DIVE INTO NEW DLT SANDBOX

Alisa DiCaprio

August 8, 2023

Image via Bloomberg Mercury


UK BANKS CAN EXPERIMENT MORE FREELY WITH DISTRIBUTED LEDGER TECHNOLOGY UNDER NEW
LAWS DESIGNED TO MODERNISE FINANCIAL SERVICES. THEY SHOULD EMBRACE THIS
OPPORTUNITY TO STAY AT THE FOREFRONT OF INNOVATION.

The UK government’s Financial Services and Markets Act received royal assent in
June, representing an overhaul in financial services regulation.  

The FSMA puts DLT at the heart of its mission to enable enduring financial
services innovation in three ways: by creating a sandbox, enabling better
regulation and reshaping banking.

Distributed ledger technology — which allows secure real-time access, validation
and record updating across a networked database — has emerged as a core
technology that banks are experimenting with to future-proof their operations. 

It is estimated that more than four in ten banks (43%) are engaged in either DLT
proofs-of-concept or production implementation, according to a report in January
from global tech firm Appinventiv. The recent confidence crisis in banking has
only accelerated this journey. With balance sheet management now at the top of
banks’ agendas, many are exploring how to harness technologies such as DLT to
better manage intraday risk.

Sandbox: moving to ‘next-generation systems’

The Financial Markets Infrastructure sandbox — a key provision of the FSMA — has
been widely dubbed the UK’s equivalent of the EU’s DLT pilot regime. The EU
regime, which went live in March, exempts firms from existing legislation. Banks
in the bloc can now experiment with DLT and blockchain for the issuance and
trading of tokenised stocks, bonds, and funds, including money market funds, to
see if a DLT-based market infrastructure has a future.

The UK’s sandbox operates in a similar vein. Banks can harness the sandbox and
DLT as a means of digitising asset management processes and preparing for
upcoming settlement updates. These include:

 * Real Time Gross Settlement Renewal Programme. This Bank of England
   infrastructure, which holds accounts for banks and settles interbank
   payments, is being upgraded in June 2024. Banks can safely tap into the
   sandbox to test and implement the updates.
 * Tokenisation. This has the potential to unlock faster settlement times and
   lower costs; it is estimated by research and brokerage firm Bernstein that
   $5tn in assets could be tokenised on DLT over the next five years. 
 * Smart contracts. These can speed up transactions by going one step beyond
   keeping an immutable record of financial transactions to automatically
   implementing the terms of multi-party agreements.  

Innovation through regulation

The FSMA also further establishes smarter crypto asset regulation. Firms
engaging in activities relating to stablecoins or crypto assets for payment will
become subject to numerous regulatory requirements.

This includes: authorisation by the Financial Conduct Authority; capital,
insolvency and money laundering requirements; rules for ensuring the quality and
safekeeping of reserve assets; and more robust risk management and governance.

This sets out a similar path to Europe’s Markets in Crypto Assets legislation,
which also introduces more stringent risk management and requirements on capital
reserve and disclosures.

Regulatory measures will be critical in potentially bridging the gap between
banking and crypto asset services. This gap is currently quite wide in the UK;
concerns around volatility and fraud mean that almost half of major UK banks do
not allow transfers and withdrawals from crypto exchanges.

The introduction of smart regulation will not only help embed greater consumer
safeguards into crypto, but also serve as a platform on how the underlying
technology is applied. 

Reshaping banking

The banking ecosystem faces multiple challenges, from settlement risk to siloed
legacy systems and rising operating costs. Permissioned distributed ledgers can
help by providing real-time verification of transactions, removing time- and
cost-consuming reconciliation while also maintaining security and scalability.

For banks, the FSMA is both an opportunity and necessity. It will not only help
them adapt to future regulations, but also stay at the forefront of innovation
as global competition rises.



Alisa DiCaprio, chief economist at distributed technology firm R3


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