Regulation – if developed appropriately – can be the catalyst that propels nascent technologies into the mainstream, especially in the complex world of financial services. And the European Commission (EC) has just confirmed its place at the forefront of fostering fintech innovation, writes Isabelle Corbett, Head of Regulatory Affairs at R3.

Last month, the EC announced its intention to deliver a legal framework for digital finance – providing the clarity and legal certainty required for sustainable innovation and adoption in areas such as digital currencies and crypto-assets. 

The EC’s proposals have four main priorities: removing fragmentation in the digital single market; adapting the EU regulatory framework to facilitate digital innovation; promoting data-driven finance, and; addressing the challenges and risks with digital transformation, including enhancing the digital operational resilience of the financial system.

While these proposals still have a significant journey to go on before they come into regulatory effect, this is a major step forward for the digital transformation of finance in Europe, and further proof of the EC’s continued push to be a leader in embracing emerging technologies. 

The EC’s move has undoubtedly been nudged along by the economic challenges of the COVID-19 pandemic, and the accelerated shift to all things digital in both the consumer and B2B spaces.  Commission Executive Vice President Valdis Dombrovskis even commented that the EC had been driven by how, during the lockdown, people were only able to get access to critical financial services thanks to digital technologies such as online banking and new fintech solutions and apps. 

By providing the standardisation required for a digital single market, the EC’s package could be a key part of Europe’s economic recovery from the pandemic. Technologies such as blockchain and AI, and new methods of value transfer such as digital currencies and tokens, can provide the basis for new financial products for consumers and new funding channels for companies at a time when they need them the most. 

Given the inherent ability of technology such as blockchain to provide frictionless cross-border services in areas such as payments, it requires a standardised regulatory framework that will not impede its ability to connect consumers and businesses in different countries and, in fact, will allow for the greatest advantages.  

By providing a pan-European framework, the EC’s package also has the potential to enhance financial market integration in the banking union and the capital markets union, and thereby strengthen Europe’s economic and monetary union. This is no small promise and is testament to the potential of these powerful digital technologies. 

Regulating digital assets

Previously unregulated crypto-assets, including ‘stablecoins’, are a major focus of the EC’s package and an area in which it proposes a bespoke regime with strict requirements for crypto-asset issuers and service providers seeking to offer their services in the single market.

The areas highlighted by the EC are ones which R3 has considered closely as part of our digital assets strategy. Regulators around the world are grappling with the creation and deployment of crypto-assets. It is critical that as part of that exploration, all regulators follow the EC’s example and examine and understand the underlying technology and the conduct of the platforms which trade these new assets. 

Digital assets offer the promise of a new, lower friction method of asset and capital formation. Such tokens, if developed appropriately and for enterprise usage, can automate or simplify much of the asset origination, issuance, execution, and secondary trading processes that make up much of banking today. Issuers of securities everywhere see the value in a more efficient, effective connection to those looking to allocate capital, all in a safe, regulated, and automated environment.

Naturally, it is critical that such token issuance and the lifecycle of the token be conducted in a secure and regulated manner. The EC’s package reflects this priority and raises crucial areas for consideration. 

Safeguards proposed by the EC include capital requirements, custody of assets, a mandatory compliant holder procedure available to investors, and rights of the investor against the issuer. Issuers of significant asset-backed crypto-assets would be subject to more stringent capital requirements, liquidity management and interoperability requirements. 

We believe achieving these safeguards is reliant on the use of open, permissioned blockchain platforms with well-defined governance, settlement finality and strong identity management capabilities. 

Modernising market infrastructure

The EC is also proposing a pilot programme for market infrastructures for financial instruments such as crypto-assets, based on blockchain technology. 

This new programme will provide a controlled environment for experimentation, or ‘sandbox’ – an approach that R3 has pioneered since its inception. This collaborative digital workspace will allow temporary derogations from existing rules so that regulators can gain experience on the use of blockchain technology in market infrastructures, while ensuring that they can deal with risks to investor protection, market integrity and financial stability. 

This is a very promising move that has the potential to provide legal certainty to the enterprise blockchain community and support further innovation in this space. The fact that the EC is embracing blockchain in this manner and nurturing its development reflects the increasingly widespread adoption that the technology has experienced in recent times. 

The coming years will be pivotal for the evolution of blockchain technology in the financial services space, and the pace of digitisation will only continue ramping up as the world adapts to new ways of transacting and doing business in the wake of the pandemic.

Regulators, technology firms and market participants must continue to work together as we strive towards the shared goal of digitising finance. Forward-thinking regulation must be developed to support purpose-built technology that allows for appropriate data confidentiality controls, scales to bank transaction volumes and throughput, and supports an information security design that is compatible with the financial services industry’s high standards. This unique combination holds the key to unlocking the future of finance.