Today the Association for Financial Markets in Europe (AFME) published a paper outlining two critical steps needed to scale DLT in capital markets in the European Union. First is the urgent need for a settlement solution for tokenized assets using central bank money. Secondly, AFME wants to see tokenized securities being considered eligible as collateral when banks borrow money from their central bank.
DLT and central bank money
While the European Central Bank (ECB) already announced plans for central bank money DLT settlement in February, AFME reiterated the urgency for an interim solution.
The ECB’s plans involve an interim solution that will be available relatively quickly, and a longer term wholesale central bank digital currency (wCBDC) solution. It follows the participation of 64 institutions in wholesale DLT trials during 2024 involving three different technology solutions. Two of those linked to existing payment systems and the third was a wCBDC.
An important use case mentioned that uses these settlement solutions is intraday repo, something that the Deutsche Boerse’s Eurex is readying to launch. Related to this, AFME also requested a gradual extension of Target 2 operating hours. There was a bigger ask regarding two of the solutions. It requested that the pre-funding requirement for the TIPS settlement solution and the wCBDC be dropped as this fragments liquidity if there are many pools of cash. The alternative wasn’t outlined, but presumably involves some kind of credit or instant transfer at the point of payment.
Going a little deeper, AFME made several recommendations following last year’s DLT trials. All the solutions involved interoperability between the settlement side and the ledger holding the securities, with the aim of achieving atomic settlement, wherein either both legs fail or succeed. AFME’s focus was on issues that might threaten atomicity.
Some features were designed specifically for the trials, such as the availability of cancellation keys and default timeout management. For a production environment, the existence of cancellation keys undermines atomicity. The authors also want a more technically mature interoperability environment, again to prevent a scenario where one leg might proceed while the other fails. Finally, they requested that the ECB consult legal experts about the settlement status of transactions where only one leg has settled.
Collateral eligibility
Collateral must fulfill multiple criteria to be eligible for central bank credit. If the digital security is part of the DLT Pilot Regime, it will qualify. However, so far only two infrastructures have DLT Pilot Regime licenses and only one has launched.
The heart of the problem lies in how DLTs typically bypass central securities depositories (CSDs), yet most regulatory frameworks, including collateral eligibility rules, specifically require CSD involvement.
For example, conventional collateral eligibility requirements include that a security has to be registered by a CSD or a central bank. The vast majority of digital securities are not. Plus, eligible marketable securities have to be listed on exchanges. But the current laws prevent an exchange listing unless the security is registered with a CSD, which is currently a challenge for DLT secondary markets.
As an alternative, AFME suggests that so long as the entity operating the DLT is subject to regulatory requirements such as MiFID II or CRD/CRR, then that could suffice. And the lack of statutory settlement finality could be substituted with contractual agreements.
This regulatory approach would benefit established players, unless expanded to include other regulated entities. For instance, Germany’s crypto securities registrar concept, while less stringent than CSDs, has enabled innovation by startups approved by BaFin, though these entities fall outside MiFID II or CRD/CRR regulation.
