Opinion Crypto

UK vs EU: what next in the DeFi arms race?

The UK can stay ahead of the crypto curve by embracing new emerging technologies, writes R3’s Alisa DiCaprio.

Jeremy Hunt

HM Treasury

The much-anticipated UK government’s Financial Services and Markets Act received royal assent in June 2023, representing a major overhaul in financial services regulation.

The UK has witnessed a downturn in fintech investment, an IPO drought and a tough macroeconomic environment over the past year. 

As a result, the pressure is on for the government to innovate the UK’s financial markets to make sure it doesn’t lag behind its peer economies.

The Financial Services and Markets Act (FSMA) represents an important milestone in accelerating this journey. It was passed into legislation in June 2023 as part of the Edinburgh reforms package. 

This act is a 346-page document that introduces far-reaching regulatory reforms that will affect almost all financial services firms across a range of markets.

Notably, the act puts distributed ledger technology (DLT) at the heart of its mission to enable enduring financial services innovation. 

Provisions such as the creation of a Financial Market Infrastructure (FMI) sandbox and digital asset regulation bring DLT into a secure, regulated environment. 

The sandbox will serve as a platform for a more collaborative, open and trusted digital economy.

With the UK government now set to implement these proposals, understanding how they will affect decentralised finance (DeFi) and the fintech community is vital.

FMI sandbox vs EU DLT pilot regime

The FMI sandbox is a key provision in the FSMA for entities in highly regulated markets. It will enable participating firms to experiment with DLT in a regulated framework by temporarily modifying certain legislation.

The sandbox has been widely dubbed the UK’s equivalent of the European Union’s DLT pilot regime. 

The pilot, which went live in March 2023, also exempts firms from existing legislation to promote the use of DLT and blockchain for the issuance and trading of tokenised stocks, bonds, and funds – including money market funds. 

Like the FMI sandbox, the objective is to assess whether to retain DLT-based market infrastructure on a permanent basis.

There are, however, several factors which differentiate the FMI sandbox from the EU’s pilot:

Participation - The FSMA facilitates far broader participation in the FMI sandbox than that of the DLT pilot regime. 

While participants in the UK sandbox can include both FMI providers (and participants in these systems) and technology companies, the EU’s pilot is limited to multilateral trading facilities and securities settlement systems.

Use-cases – In contrast to the EU pilot, which offers an exemption to only the MiFID II and CSDR regulations, the FMI sandbox will enable the dis-application of a wider range of legislation to test and experiment with DLT. 

The FMI sandbox may go one step further beyond exempting firms from current legislation to also modifying legislation in certain scenarios. This may result in more carefully targeted regulatory frameworks for different use cases.

Technology – Much of the focus has been on the use of DLT, but this is not the only technology that is tested or adopted under the sandbox. 

In contrast to the EU pilot which sets out frameworks specifically for DLT multilateral trading facilities and DLT settlement systems, the sandbox refers to the application of “developing technology” which may go beyond the scope of DLT.

Innovation through regulation

Another aspect of the FSMA is that it further establishes smarter crypto asset regulation. 

While the act had originally intended to introduce a limited regulatory framework to stablecoins, it was subsequently amended to also include regulation for crypto asset services, and the assets themselves.

Firms engaging in activities relating to stablecoins or crypto assets for payment will become subject to numerous regulatory requirements. 

This includes Financial Conduct Authority (FCA) authorisation, capital requirements, rules for ensuring the quality and safekeeping of reserve assets, insolvency requirements, anti-money laundering requirements as well as more robust risk management and governance.

This sets out a similar path to Europe’s recent Markets in Crypto Assets (MiCA) legislation passed in April, which also introduces more stringent risk management, capital reserve and disclosure requirements. 

Smart regulation will be critical in not only embedding more secure consumer safeguards within the crypto space but also in providing the required guidelines on how the underlying DLT is applied. 

Regulatory and legal certainty provide the core foundations for any emerging technology to be applied successfully, so the fact that both the UK and EU are moving to lay these foundations will help create the right environment for further innovation and integration of DLT into existing infrastructure.

Reshaping finance

The FSMA represents a significant change to the UK’s financial regulatory framework, and a huge stride forwards in the introduction of transformative DLT-based systems across financial markets. 

The implementation of the proposals outlined above will require immense effort by governments, regulators and technology providers, meaning open collaboration across both the public and private sectors and interoperability will be key to delivering these measures.

For the FSMA to have its intended impact of helping the UK remain at the forefront of financial innovation, institutions must therefore work together across their ecosystems, tapping into firms and individuals with the regulated market and technological expertise.

The views and opinions expressed are not necessarily those of AltFi.

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