Months of turbulence across the banking sector have led many senior finance decision-makers at banks to review their capital structure processes and ensure they can effectively navigate future liquidity risks and regulations. Collateral management has become a particularly important consideration for banks, with many now exploring new ways to bolster their risk management measures.
Embracing the correct technologies will be central to the banking world’s overall digitalisation efforts. The European Union’s (EU) distributed ledger technology (DLT) pilot regime, launched in March 2023 as part of the European Commission’s digital finance strategy, offers one of the biggest opportunities for financial institutions in the region to harness technology as a means of innovating in a risk-controlled environment.
Under the pilot, participants will be able to apply for temporary exemptions from certain requirements of existing European financial legislation in order to use DLT for the issuance, trading and settlement of tokenised financial instruments. This offers a huge opportunity to truly enhance efficiency across trading facilities and settlement systems.
With the pilot now live, how can banks use it to future-proof their infrastructures in a controlled and risk-free manner?
Navigating new regulations
Open participation and collaboration have been consistent themes as regulated market participants work towards a common goal, and the regime is a well-received addition to this critical cooperation.
The pilot allows market participants to connect their private placement and internal assets to a regulated secondary market. Buy-and-sell-side participants have identified opportunities with workflow optimisation, strategic positioning, and cost-benefit analysis.
Banks can tap into the pilot regime for the launch of the Eurosystem Collateral Management System (ECMS), whose go-live was recently rescheduled by the Governing Council of the European Central Bank from 20 November 2023 to 8 April 2024 to help mitigate the impact of the rescheduled T2 launch. The ECMS aims to set out a unified system for managing assets used as collateral in Eurosystem credit operations and will replace the existing individual systems of the Euro area national central banks.
On top of this, the RTGS renewal programme and subsequent changes to mandatory clearing obligations create an opportunity to future-proof financial markets by offering wider interoperability, improved user functionality and strengthened end-to-end risk management of the UK’s High-Value Payment System. Innovation must be undertaken with caution, which is why the regime acts as a useful safety net when implementing these updates.
To stay ahead of the competition and on top of the impending collateral management changes, banks need to look at the overall digitisation of asset management, settlement processes and the acceleration of payments.
DLT and the pilot regime can act as critical cogs in optimising a complete digitisation process across banking ecosystems. Encrypted distributed ledgers provide real-time verification of transactions, removing time and cost-consuming reconciliation. This ensures processes that typically take a few days can be completed in a matter of minutes.
Moving from legacy to next-generation technology
Capital markets are about networks and standards, and therefore to be successful, these networks need to interoperate with existing processes and systems in a standardised form.
This requires a heavy lift in ensuring a successful balance between the implementation of new models and integration into current systems. These networks also need to be complementary to one another and without total disruption to day-to-day processes.
Existing stakeholders in capital markets rely on the market’s trust and resiliency, needing to consistently meet standardised levels of security and trust. This is a key feature that banks cannot forget amidst innovation, moving from legacy to next-generation systems.
To maintain these levels of security and trust, permissioned distributed ledgers can help capital markets meet these demands. With permissioned structures, all data is verifiable using secure cryptography and digitally-verifiable signatures for the upmost security and resiliency. These ledgers are also tokenless to offer higher performance for timelier transactions.
Staying ahead of the curve: open industry collaboration is key
The EU is not the only jurisdiction to begin experimenting with DLT at scale in financial services. The UK Government, for example, has established its FMI Sandbox, which is expected to be up and running in 2023 and will enable firms to experiment with DLT in areas that underpin financial markets, such as securities settlement.
Against a backdrop of global competition, we expect an increasing number of banks and financial institutions to turn to pilot programmes and regulatory sandboxes to stay ahead of the curve. This will likely be accelerated by the recent banking crisis, which has heightened the impetus amongst banks to find new ways of increasing operational efficiency.
For FMIs to make the most of the EU’s DLT pilot regime, they must take banks and other financial institutions along for the journey. For banks, this is both an opportunity and a necessity. The pilot not only enables them to adapt and influence regulations, but also stay at the forefront of innovation as global competition rises.