Latest on digital finance

Alongside sustainable finance, Fintech is now a prime mover in the evolving European financial market.  It is now enshrined in the European Commission’s Digital Finance Strategy (closely aligned with their long-term Capital Markets Union).  It continues to attract significant interest from both potential investors and the financial media (and is also now under formal scrutiny from the Luxembourg financial regulator).

Accordingly – this is an area that merits our ongoing attention (on both sides of the channel) to identify emerging trends, challenges and opportunities presented in due course.

1. What is the EU Digital Finance Strategy?

The current Digital Finance Strategy (DFS) is an update of the EC’s original 2018 FinTech Action Plan.

It was published last September, together with the latest Capital Markets Union Action Plan.

The DFS outlines a package of measures enabling the EC to achieve their digital transformation strategy within the finance sector in the next four years, while regulating its risks.  This includes many complex, far-reaching legislative proposals, namely:

• Markets in Crypto-Assets Regulation (MiCA)
• Digital Operational Resilience Regulation (DORA)
• Distributed Ledger Technology Market Infrastructure Regulation (DLTR)
• Amending Directive revising key EU financial services regimes (e.g. UCITS, AIFMD and MiFID II) where necessary

While the UK has now left the single market for financial services (and is no longer bound by the EC’s legislation), a reminder that the UK Government has recently declared their rival digital finance package which will reflect much of the EU’s current strategy.

2. DORA proposals under scrutiny

The EC’s proposed DORA regulation is designed to put in place a comprehensive digital operational resilience framework applicable to all regulated financial institutions facing information and communications technology (ICT) third party service firms within the industry.

Ongoing, ICT third-party service providers deemed “critical” by financial entities will have to comply with a new EU oversight framework to mitigate the applicable risks.  The ESAs will act as “Lead Overseers” and the national competent authorities (NCA) as “enforcers” in due course.

DORA will apply to entities regulated in current AIFMD, UCITS and MiFID II regimes (in an extension of the current 2016 Network and Information Systems Security (NIS) Directive and 2019 EU Agency for Cybersecurity (ENISA) Regulation).

DORA has already generated notable media attention, following a 6-page letter sent to the EC from their European Supervisory Authorities (ESAs), who highlighted the current proposals “raise challenges on the practical functioning of the oversight framework, especially the complexity of the governance and decision-making process”; the ESAs also made a direct request for “coherence” and “adequate resources” from the EC to be able to carry out their additional tasks and responsibilities.

The EC’s adopted act is  now open for industry feedback until 11 May 2021, with scrutiny from both EU Parliament and Council to follow . After the finalised DORA legislation has been adopted and entered into force, it will begin to apply directly in EU-27 Member States after 12 months.

In the meantime – as Cloud Service Providers (CSPs) are within DORA scope – a reminder that ESMA’s recent Guidelines covering outsourcing to CSPs will apply from 31 July 2021.

3. Regulatory Framework for EU crypto-assets, DLT

 “One of the DFS identified priority areas is ensuring that the EU financial services regulatory framework is innovation-friendly and does not pose obstacles to the application of new technologies. This proposal, together with the proposal on a DLT pilot regime, represents the first concrete action within this area.” European Commission (Context c/o proposed Markets in Crypto-assets regulation).

Cryptocurrency is digital form of money that does not exist physically. Operating independently from any central bank (up until now): cryptocurrencies are instead traded across global computer networks underpinned by distributed ledger technologies (DLTs) e.g. most notably, blockchain.

You may have heard about Bitcoin recently reaching a new record market high, after Tesla revealed it had bought USD 1.5 billion of the world’s best-known cryptocurrency.

Prospective crypto-asset markets attract widespread attention, with certain fund managers citing cryptocurrency exchange traded funds as “untapped digital gold”.   However, most fund professionals still consider the largely unregulated crypto markets as high-risk gambling within an extremely fragile, volatile environment.  Up until now, it remains an area strictly out of bounds for UCITS investments.

For over 3 years, the EC has been examining the opportunities and challenges presented by crypto-assets, with ESMA supplying them with initial advice back in January 2019.

There is now a proposed  regulatory framework for markets in crypto-Assets (MiCA) to be applied in due course.  MiCA effectively creates a draft licensing regime for crypto-asset Issuers and crypto-assets service providers based in the EU (similar to MiFID II). The regulation also formally defines:

• asset-referenced tokens (referring to value of legal tender currencies and / or commodities)
• e-money tokens (a means of exchange, referring to the value of legal tender currencies)
• other crypto-assets (i.e. cryptocurrencies such as Bitcoin).

MiCA is accompanied by the EC’s draft regulation for a DLT market infrastructure  (i.e. DLTR).  This is effectively an ‘experimental’ pilot legal framework for the practical application of DLT in post-trade services, including DLT multilateral trading facilities (DLT MTFs) operated by MiFID II licensed firms.

Similar to DORA, it is likely that both proposed MiCA and DLTR regulations will face calls for extensive revision (from both the finance industry and EU Parliament & Council  within the next 18 months or so.

The finalised legislation is scheduled to enter into force by 2024 at the latest.

Meanwhile, across the channel, there are now widespread overnight media reports of the joint Bank of England / UK Treasury announcement to create a Taskforce to gauge feasibility of a Central Bank Digital Currency (CBDC).  This would be “fundamentally different” to cryptocurrencies i.e. issued in sterling, placed between cash and private payment systems (not based on DLT).

4. CSSF: Fintech unit publish DFS podcast

The CSSF’s new  Financial Innovation division recently published a podcast covering most of the topics covered above.

This follows a 15-page PDF issued last month (‘Financial Innovation: a challenge and an ambition for the CSSF’), where they outlined 3 x approaches to “embrace the major challenge… of technological innovation integration within financial services and markets”, i.e.

• a proactive open regulatory approach: to avoid hindering new opportunities and benefits by creating excessive regulatory barriers for innovation;
• a prudent risk-based regulatory approach: in order to safeguard the role of prudential supervision of the financial sector in ensuring the safety and soundness of the financial sector with a special focus on consumer protection, market confidence and AML considerations;
• a technology neutral approach: which ensures that each project presented to the CSSF is assessed on the basis of the services effectively provided, regardless of the technology used