Decentralized Financial Market Infrastructures: Do They Even Exist Under Applicable Law?

Transcript

so our next session uh is going to focus Less on Europe and MAA and more on decentralized finance the name of this panel discussion is rather long I'll save it until the end because it's a mouthful but the people who will join us for the panel discussion for sure have plenty to say about it and you may have an opportunity this time since you are lucky enough to still be with us here ask a few questions that may be to your benefit so the four experts that will join us now for the next panel are

Clemens Emanuel gfer from Clifford chance Ariel Ben hatar from lensen Stalin Katrina linger from MLL and Ronald kogens from mme some of the panelists know each other rather well I think Ronald and Katrina perhaps in particular know each other well and their topic will be decentralized Financial Market infrastructure do they even exist under a political law and if so when is true decentralization given I am very very interested to see how many insights we can have on this seemingly very broad

topic okay so welcome everybody to this panel and thanks for staying here because it's going to be a very interesting panel I'm pretty sure and a very interesting topic um so I think the web 3 Industry will soon face one of its biggest challenges because Regulators are gearing up and they are start scrutinizing in particular Defi infrastructures and they basically test whether they exist whether they should exist or not we have recently seen that in the US um the SEC has sent a weals notice to Unis swap Unis swap responded and they argued for example that Unis

swap is an autonomous protocol on ethereum it's not controlled by anyone it's just a pure piece of software they also argued that Unis swap Labs is a Innovative software development company nothing else and that there is no group organization or Association that is operating the protocol because it's it's autonomous now jumping into this topic I'm very happy to have very well-known speakers here so on the one hand we have Emy from Clifford Johns he's a financial Market lawyer and Capital Market lawyer in Europe and the UK and then we have

Katrina L singer a very experienced traditional Financial Market lawyer but also in the the new web 3 Industry um from MLL and then we also have Ariel from lensen stallin a capital markets and financial Market lawyer also very active in the cmta the tokenization standards organization so I'm very happy to have you here and I think I would like to start um with the first question that I would like to um ask each one of you that what do you think do decentralized Financial Market infrastructure exist and if so when is De centralization given and now Katrina do you want to start the very good question

because I mean we're talking about the blockchain which is per se decentralized it's one of the key criterias so defining when an when we actually have an autonomous organization versus a an organization which has a centralized element um has to has I think has to be looked at in its entirety and decentralization comes on so many different layers so you have the first level blockchains you have the applications on the first level blockchains as you said Unis swap for example working on ethereum um for me the question really is what is the purpose what is the core

purpose and first level blockchains have um a different purpose when looking looking at it from a financial Market regulation than actually providing Financial Market services that is not their core um reason for being so from a from a regulatory point of view I think it can only be actual applications geared towards providing something which from an activity point of view is equal to the what a financial market organization would do so I think there are are actual um decentralized organizations which should not be regulated but how to carve them out

that's going to be part of our discussion Amy what what are you thought question so um first of all um thank you very much I think um this topic is really um really interesting and really topical as you said um and I think especially from a UK and EU perspective there has been a little bit of confusion about the topic um especially from a regulatory perspective say um I um in particularly because um recently there have been a couple of um policy papers um from the bank of England there was a policy paper focusing on the financial stability risk also from esma there was a policy paper again focusing on the financial stability risk where we

talk we usually have um policy people from The Regulators looking at um at Def fmis and assessing them and when I read all of these policy papers the first thing that I think is this was not written by lawyer which is a good thing because it's very interesting to read but also um the the problem is that the analysis is not is not um carried out from a legal perspective so from a legal perspective um I would say the first thing to bear in mind is that um under UK and EU law fmis are not activity triggered so you don't become an FMI a couple of exceptions but um you usually don't become a CCP by carrying

on CCP activities um fmis are usually recognition or designation triggered I think that's the first point to remember the first um the second point to remember is that underlying you still have regulated activity regimes which are activity activity triggered and I think that's the level that the analysis the legal and Regulatory analysis should take place it's the activity based um analysis and there we have depending on the relevant asset um for Securities we have miid for crypto assets we have MAA and that's that's the analysis that I think we should look at and and I think the outcome is exactly the same as Katrina said um it depends on what the

activity is it depends on what the relevant FMI is doing if the FMI is doing something that under from a traditional regulatory perspective is a regulated activity then I think um Regulators will enforce and will will um um pursue these entities and so that's where um the analysis should lie but in summary I think from a pure regulatory perspective I don't think decentralized fmis as such exist at the moment it's the activities that we need to look at more than the concept of an FMI and and I would agree and I would agree with that I think Regulators have been highly skeptical that there are such things as

decentralized Financial Market infrastructures probably also because they understand that what at least some are trying to do with this is to say this is so decentralized that it cannot be regulated and and as you said Emy I think the The Regulators will are likely to see it differently and look at the activity and because in a in a country governed by the rule of law such as Switzerland if if we have decided that operating a a trading venue is an activity that requires a license the fact that you have structured this in a way that you have burned the keys to control this infrastructure I mean is it really right

that this sort of alleviates any regulatory burden from you I don't think Regulators would would would agree with that and I think this is we are in this situation also because there is some times a bit too literal a reading of the rules which says you know you have if you have a financial Market infrastructure it has an operator and you sometimes see at least I see sometimes in my practice uh project project teams that will say well but we're not the operator so how can we regulate it and I think in Switzerland at least this this literal reading of the rules it might maybe work in the US but I I'm I I don't think it works in

Switzerland because we're looking at this from an anti- circumvention perspective and from the really the the point of what is actually going to be done as part of this project I think this anti um circumvention is is a key element because what the financial Market Authority does is basically look at who is gaining from setting up such a decent centralized organization and in particular in the financial Market you will in most cases you will not have a situation where there is not somebody who has benefited from the sale of

tokens from service fees or something else and that is where the financial Market would go and first of all try and find the uh the starting point for regulation and and only if you would do it for totally altruistic purposes you would be setting up a um a financial Market infrastructure would not take any money and would allow a peer-to-peer situation would it really I think start to be a uh truly autonomous organization so basically what I understand from all of your statements is that financial markets relevant activities so a financial Market

infrastructure activity or financial service activity should be subject to regulation because that was the idea of the laws and if you do a same activity then you should be regulated the same no matter if you're saying that as Oriel said we burned the keys so we are not responsible anymore but of course I I would like to challenge that a bit because I mean you could also argue and say I mean we burned the keid out can it be seen something like nature I mean it's just here it's just given it's not anymore controlled by humans and I think BAS on that maybe I start again with Emy does it make a difference I mean Financial Market L can only apply if obviously there is a relevant activity

and I mean in in in web 3 you see there are different layers so we have the layer ones we have layer twos we have layer 3es which are protocols on top we have even maybe layer four or five until the application or end user interface and what is your opinion on that is basically just a layer one there is a possibility that you can launch a protocol which is a financial Market infrastructure so basically the whole layer one should TR be regulated or what is your opinion that um and that's a really interesting question but before I'm going to answer it um I did not say that um D5 should be regulated I think what I was trying to say is that I think Regulators will think that they already are regulated or subject to applicable regulation and I think that's the point

I think everyone should be um a little bit careful about as we've seen as you said with Unis swap um I'm going back to your question um it's a really interesting one but it's not an entirely new question so that's a question that at least in the UK and also in the EU has come up before in different context in different um in different in different sort of um historical circumstances we've always had the question of um what is a newspaper doing for example if if as a financial services company you post an ad in a newspaper even a broad sheet a printed newspaper is this newspaper carrying on regulated activity is it um arranging is is the concept in the UK is

it arranging deals in financial um in financial um instruments is it is it is it making arrangements with a view to these um transactions and there is very established case law there is established guidance which is technology neutral and I think that's the beauty of um the UK regulatory regime but I'm sure it's the same in Switzerland um but from my perspective that's the beauty of it so this is a concept that that comes up again and again and again the other question was for example what about the internet is an internet provider um are they making arrangements um in respect of financial transactions if they host a website from UBS for example where you can um post your financial um so your

orders for share trades um and there we have um an exclusion in the um in the um in the relevant regulation about M conduits so actors providing mere conduits and mere means of communication they are excluded from the regulation and there is a host of applicable case law that can be equally I think applied and would be equally applied um to the question of of layer one so I think layer one is very likely to fall outside um of these activity triggered regimes um but only if if all they're doing is mere communication so as you said as soon as there's mere communication plus additional um additional Services being

provided plus profit being gained from um um specifically from the transactions then even under existing guidance and existing existing case law this the mere conduit um exclusion would no longer apply Oriel what is your on that well I when you mentioned nature I I think it's we really really have to distinguish what is and and to emy's point you know um Al purpose built for to to to host Financial transactions if you create a layer one that protocol that is really intended to be a central

Securities depository and a clearing organization it the only thing you can build on that layer one protocol is that I think it's very hard to argue that um this is not an activity that should be regulated and that those who have put in the the money and have a real stake in this at least originally should should be completely off the hook at least that's how Regulators would think about it now of course if you have a layer one protocol like ethereum where you can build all sorts of different things I think there the Nexus with with financial markets is is is further away and and and there's a good argument uh I mean in my view convincing that

that this this is something akin to a newspaper or to a Bloomberg chat which is on which you can build something you can use a Bloomberg chat to trade every every day but you can also use it to talk about the the the news and and and who is going to be the the the next president of whatever country MH yeah I I think that is absolutely correct there if if you have a very specific purpose built um first first layer then you would also the first layer would fall under the Ambit of Regulation there is at present one case in Switzerland where the people who have built this first layer they

unfortunately on their website all they were really advertising was being able to use this first layer for specific Financial transactions and uh the the inquiry of the regulator has now just started so um I think that is that is correct if you if it's purpose built and it's a question of how you yourself then advertise the first layer you have built and very often again as in this case it is um very centralized in particular actually at the beginning of a new blockchain the centralization is much much bigger you know it takes takes time until it really becomes decentralized so

the the risk at the beginning of a project to be caught by Regulators is in that case bigger but I mean let's take for example Unis swap again I mean they're also arguing in their response that the protocol was not built for Securities and it's even not clear which tokens qualify as s Securities or not because I mean I would say most of the tokens in the web 3 Industry they are not built as Securities like um Equity or bonds or something like that and does it make a difference so if someone is building a a protocol which allows to trade digital assets which is basically on ethereum it's just a standard

technical standard where it can represent whatever it is would that still mean that it's then be seen as a financial Market infrastructure don't know who who want to take it um so it's a tricky one but um I think generally we know that the SEC are quite um aggressive in this space and also just to um add to Unis swap because um before this discussion um I I quickly talked about the SEC approach with my colleagues in New York and um they flaged to me that there was a previous case in 2018 um um where uh ether Delta I think the exchange was called was enforced against so an enforcement

notice was served and the founder of ether Delta apparently found the sec's either aggressiveness or um um the sec's views so convincing um that he actually settled the case so there already is a a settled case with regard to a a defi FMI um in the US I think generally it really always comes down to the activities and um I think the one point I would just say again from a a a UK perspective it really doesn't depend on which layer we're looking at um it doesn't depend on how on what we call it at the end of the day what the regulator will look at um so usually these Regulators are um financial markets lawyers they're not very imaginative

they just look at it through their lens and and and ask what are the activities and if there are activities that are regulated activities in respect of regulated assets they will I think generally find someone to enforce against as the SEC did and for example we had discussions also um in the in in that context about Dows where um often it said well they're not um so you can't enforce against them from a UK perspective THS are very clearly um General Partnerships or unincorporate associations and they can very much be enforced against so um it's it's the activities again that but but I I mean at the end so if there is no intention to create the financial Market

infrastructure now let's let's use telegram I mean telegram today is the messenger for all kind of people whether it's terrorists whether it's drug trafficking or whatever and it was not built for that and I mean even with with a decentralized protocol I mean you can have tokens which are meme coins you can have tokens nfts or you can have whatever you want that has no relation to financial market and I don't know Ariel what do you mean from a Swiss perspective would that make a difference or would that be an argument against finma that you can say I mean that was not Our intention I think this is an argument if I were a council to Unis swap I would be all over the place with that that argument but uh if we if we if we take a

step back and try to look at it more objectively um I think if if it just so happens that occasionally there will be a security that gets traded to your system because it slip through the cracks Etc yeah that should not be considered operating a trading venue for Securities but if your system has been known to operate uh um in in this manner for a long time and there are you know liquidity pools where the only thing that are things that are traded are securities and there is still someone that maintains a some form of grip and maybe I'm jumping

to another topic we discuss but if there's someone that maintains some form of grip or in significant influence over over this project then then it the question becomes why have you not used that influence to make sure that those transactions insecurities did not happen and in in the case of Unis swap I'm not familiar with all the details but I could imagine that this is not going to be so easy to to to show I mean the whole the whole question comes from two sides doesn't it on the one hand the codified laws in our case which are open for interpretation and then on the other side the enforcement

of the laws which is a circum convention enforcement which requires broad interpretation and the the tools which The Regulators have and the Swiss Regulators use are first of all you don't have to have a legal entity they can Bunch groups of people and say you are acting in um in corporation so we're taking you as a group acting together like that you can basically pick on different people in different jurisdictions but if there's somebody in Switzerland they can also pick on that person and the other thing is they have so-called fictions and I those are the most scary parts of of the enforcement

where they say well you have created a but we think actually it's a fiction and in the fiction we are drawing all the activities into Switzerland for example it's something which they use if you have banking activities in BVI but you're running the bank out of Switzerland they would say when fiction this is a Swiss bank and that obviously can be done also for Global decentralized uh organizations if they feel that there are people in Switzerland who have a pull they can draw basically everything all activities into Switzerland and make you responsible for it and that is that is where um where the risk starts and that

is also why for me it's so important that there is Clarity also from the regulator as to how they see it and Unis swap I think would be a a difficult case possibly to argue if you have first layer protocols like ethereum which do have thousands of projects and projects Go in all different directions and not everything is financial Market I would argue with the purpose I would say it was the purpose of ethereum was not to to have any kind of financial Market author um infrastructure in place that was not the the the basic concept which was built So speaking about Clarity and maybe we can also put up slides the slides um up that

that you can better follow so there is um there was a guidance in December or recommendations by iosco so the international organization of um Securities authorities um that basically gave recommendations on how Regulators should deal with these centralized infrastructures so which it's very an extensive paper and also very interesting to read I mean of course it's the regulator's view so it's more in the direction of of course if there is a financial Market activity if there is financial services must be regulated no matter on how you do it um and then also finma came up with these anchor points which look like as they are coming out of the considerations in the

iosco which are a little bit more concrete um of course it would be interesting and and can you go one slide further another slide um of course would be interesting to see first from Emy from from a UK and and European perspective what do you think about the finma anchor points do you have something similar in the EU or the UK so um looking at the finma anchor points they're very similar to um the established case law and guidance that I talked about for the arranging activities because there um it's and again coming back to this mere conduit um exclusion and it's it's very similar because again you would look at um so

you would look at um which services are being provided specifically you would also look at um who profits from the relevant activity and all of those would then be arguments Arguments for the regulator against you um um being able to rely on this exclusion on the mere conduit exclusion so I think I'm generally um sto points but also um very much the iOS recommendations are very much in line with the UK regulatory practice also what I really liked about the iosco paper I think it was I think it was written by a regulatory lawyer not a policy person um so what I really liked about that is they also said There Will nearly

always be a person you will nearly always find the person regardless of how decentralized it is if there is an activity you as a regulator will find a person and that I think is how a UK regulator would and and also a EU regulator would probably approach that but but then it's a bit of a Pity that they don't say this a bit more clearly you put all of these criteria and say well there might be a responsible person here and there okay but maybe what would be good if the if is if the regulator said look we are highly skeptical about this we are please convince us that there is a project that doesn't uh meet

all of these criteria and that is truly decentralized to the point we cannot regulate it but so far we have not seen it and maybe they should go a step further to to help us sort of understand where their their their views and and and be clearer about it and say look if we think the project has an activity that is regulated we will seek in in in in in tandem with our uh fellow supervisory authorities abroad we will seek to identify who can be deemed to run it or to facilitate it or to Aid an abet or whatever construct they want to use and and bring it down I think because I think here we are a bit playing a game where we're not saying

clearly this is this is not all right but but between the lines this is what I this is what I read that finma thinks that there there are no projects decentralized in enough to be to be deemed unregulated I I I I really like what you're saying because I think that exactly the point and now Katrina to you I think you or Emy mentioned before that if you generate revenues out of something so let me challenge that and just say I mean if you license a software to a markup maker you also generate revenues MH yeah I mean I think this Anchor Point is basically trying to put a different word to what they have used in circumvention which is this

group idea that there are people behind it the interesting thing on on on in traditional in the traditional way of business if that group would go away the activity would go away in the decentralized space I think the big question would be what happens if does the Anchor Point have to be uhon meaning if you don't have the Anchor Point it doesn't work anymore um because only then it is really an anchor point or do you take everybody who is earning money from it who could be a service provider who can also fall away but the the the software runs on is that also an anchor point so

and on that it's not specific enough you know and I think it's they're trying to they're trying to put a word to it which actually doesn't lead to any Clarity it just it's just another word for their General circumvention if there's somebody there who is doing something we don't like we will take him yeah it's very unclear whether you have to fulfill one two and also the intensity so I'm the opinion it doesn't matter how many you fulfill but it's about the intensity but it finma never said anything about that and they just said I mean these are the anchor points we are looking at that and we believe that if it's a relevant activity then it should be regulated the question is can we enforce it or not

it's very unclear I don't know Emy do you have in the ukd or the European un do have a different approach on how it they deal with this yeah I think the reason why it's so unclear is that you just can't be clear and I think that's the problem and I think I'm The Regulators very very much do not want to be clear because they do not want someone to stand stand up in court and say well in this guidance you said this should be fine and now you're saying it's not fine so I think that's why there is I don't know the intention obviously behind what the Swiss regulator did but um if I were the Swiss regulator I would not be I would not want to be too clear I would just want I would just say existing Concepts apply and will apply appropriately and it's

that appropriately which can take so many guises in so many circumstances um that I think is a little bit tricky from the UK perspective again it's really all about the mere conduit it's all about um if you are just like the internet you're not regulated if you go beyond what we have established case law which will be applied um appropriately then um then you will be enforced against but but I think those uh those anchor points or those elements uh are not really a substitute for the broader thinking so in rethinking of financial markets laws in light of of new technology developments and and

whether the the we still need to view a trading platform as something that is operated by a group of people who are in a in a room and receiving orders and and approving transactions or or being able to influence them I think there is really a need to look at what technology can do to to drisk some of these activities and whether the regulatory framework that we have which is extremely heavy and based on the idea that you have you know one two maximum three stock exchanges in a country the size of Switzerland uh whether this is still appropriate in a world where you can have some certainty that your

infrastructure Works based on properly designed code I think the other thing I tend to struggle with in in the regulatory approach in the recent years is that at least in Switzerland there was a big discussion on whether regulation should be social social protection of the individual investor or whether it should be the it should ensure the functioning of the financial markets and my feeling is all these regulations of peer-to-peer networks in particular because defi allows so many parallel networks we're not talking about the functioning of the financial markets anymore we're talking about

social protection of the investor and that should not be the role of the regulator I think there you have to should leave it for peer-to-peer infrastructures to be able to continue to be able to develop and leave it to the investors whether they want to use Unis swap or not use Unis swap you know so I think that is where where there's a fundamental underlying shift on what the role which The Regulators are taking upon themselves which I think is not governed by by the actual ideas of the law yeah and I think it's also interesting what you said you focus back on the activity and if you look at these

requirements or anchor points I don't think so they have a real link to how the law defines an activity relevant to the financial Market um as we're running out of time I think one important topic I would like to discuss is how should Regulators deal with decentralized infrastructure I know Amy in the UK you have the sandbox regime maybe you can quick explain it is that already basically you're running into the mouth of the regulator and going or or losing the the the fight or is that something you think makes sense um I personally think it actually does make sense um I think in the UK as I said the approaches look at the activities is it regulated or not if it's not regulated

you're fine if it's regulated and you you are so you potentially have a problem and that is um what also the regulator recognized so for those and only for those um activities that would otherwise be regulated there's now a um a digital Securities sandbox which allows um or which allows I would say aspiring Financial Market infrastructures to start their operation so for example you can apply to the sandbox and become a CSD you can apply and become a a a trading venue in the form of an MTF or an OTF and then in this and you can do that in Reliance on SDF call it um developing Technologies

which means that certain requirements where the FCA and the bank of England recognize that certain requirements um under the law under um the um csdr regulation or um meere um do not work for um new Innovative um Financial Market infrastructures those are um disapplied and then um a um and then will be applied um in phases and the other point about the sandbox that I think is really interesting is it's not just for the um for for Market participants to sort of play in the sand it's also for the regulator to play in the sand because one aim of the sandbox is for the regulator to learn which of

the rules do apply neatly which of the existing rules do apply neatly and can be applied by Innovative Financial market infrastructures and which ones don't and and they already have um identified a couple that don't for example under csdr you need a a a a book Ledger system which obviously does not work for um for blockchain um csds and and the idea is that then at the end of this process the participants will exit the sent box as fully fledged mtfs otfs or digital csds which we call dsds interestingly um and also the regulator will um emerge from the sandbox with potentially a new regime

for these these um Technology based Financial market infrastructures so I think this is a really exciting this is a really exciting initiative there are a couple of clients that we are um advising already it's it's open from Autumn 2024 and um and a number of Market participants are already preparing the applications very interesting now a final statement from Katrina and Ariel do you think what should we do in Switzerland does that make sense absolutely I think it would make sense I think the important thing would be to then not put too many restrictions on these s sandbox entities like we have done in the banking regime where the

sandbo Box exists but basically has been cut down to activities which don't really allow for for revenues so doesn't really make sense so I think there we would have to be generous enough to actually also allow failure you know if you if you do a Sandbox regime and want to prevent failure you would also not have people using it because no risk no returns you know and I think that's where that's where um Switzerland would have to have a generous enough regime that it actually gets used but they could learn a lot from it I think the idea that it's not only a users sandbox

but also regulator sandbox is is very valid no and I fully agree with that I'm usually uh hesitant with sandboxes because it's quite costly Endeavor to put in place and as you said businesses May struggle to generate revenues but here I think it's necessary and I if to the extent possible I even think that Switzerland should subsidize a lot of the work around this because I think we The Regulators and and many people in the industry and also me personally I'm not sure we understand uh exactly what is what what we are witnessing right now and what direction it would go very good last statement so thanks everyone for listening and thanks

all the panelists for being here thank you very much and um yeah have a good rest of the conference thank [Applause] you so ladies and gentlemen we are going to move directly to the last round table again I haven't seen the table up front so um the table the round table will take place without the table but it will be an interesting one nonetheless