europe and tech

Digitalisation is the best opportunity so far to create a fully-integrated EU market for new listings, cost-effective secondary markets, and to further SME access to finance.

The digitalisation of the financial services value chain gathered further pace during 2020 because of the advent of the Covid-19 pandemic.

It is mainly premised on automation of the investment process through the use of low-cost high-impact algorithmic tools, such as roboadvisors, and the remote delivery of financial services via internet apps with no access fees.

Together these developments constitute a revolution in terms of retail investors’ participation in stock markets. The recent GameStop debacle shows that digitalisation has also led to unprecedented empowerment of retail investors.

During the same period, we witnessed the emergence of a decentralised finance (DeFi) and the increased use of blockchain technology for transactions involving not so much trading in cryptocurrencies but rather the mining of new assets and borrowing and lending using crypto-currencies such as Bitcoin and Ethereum as collateral.

The transformation of the marketplace is manifested through two radically opposing models of financial services infrastructure integration.

EU financial services regulation and in particular MiFID II will soon require a wholesale overhaul in order to keep pace with the digital transformation of the financial value chain

The first is represented by the increasing domination of the financial services infrastructure by very large institutions, such as the US investment manager BlackRock, that operates the infrastructure service Aladdin, and the Chinese powerhouse Ant Group.

Furthermore, the widely expected entry into the market for wholesale and retail financial services of Google, Facebook and other big technology companies, so-called 'big tech', will lead to further centralisation of financial markets infrastructure.

The second model is represented by the emergence of DeFi. Already trade finance and other business and commercial banking activities – such as payments processing – are increasingly moving to a decentralised model that is, in fact, championed by big financial institutions.

Furthermore, fintech firms, which operate on very thin margins, have a finite amount of time once they have burned through their seed capital to forge, co-operate and complete relationships marketing and selling their products on decentralised platforms.

Apart from a drastic lowering of transaction costs, digitalisation holds great promise in other areas. It may bring benefits that elude mainstream markets, such as increased small and medium-sized enterprise (SME) access to finance, and the emergence of new markets in ethical and social market products to complement the present boom in green finance.

A fully-integrated EU market

Digitalisation is the best opportunity so far to create a fully integrated EU market for new listings, cost-effective secondary markets, and to further SME access to finance, therefore supporting the vision of an EU Capital Markets Union.

But for that to happen DeFi infrastructures must come within the regulatory perimeter. DeFi platforms pose challenges for the existing regulatory framework. The centrepiece of EU financial regulation is the Markets in Financial Instruments Directive II (MiFID II), which is a complex piece of legislation that is not entirely fit for the new digital era.

It is hard to see how the different functions of such platforms can be disaggregated to be regulated as distinct investment services.

For example, mining a new token via the platform, storing in an individual digital wallet and using the wallet to trade on the platform, entrusting platform apps with asset allocation advice and carrying execution function can create a real conundrum for the regulatory framework given also the fact that all the above activities might take place real time in an automated mode.

How do you unbundle the token when it both incorporates the service and the investment at the same time? Is the platform collectively a provider of financial services?

EU regulation has to become more proactive fostering regulatory experimentation in tandem with technological one to make sure that consumers interests are safeguarded and competition is furthered. The EU Commission has recently proposed a digital finance package aimed at fostering Europe’s competitiveness and innovation in the financial sector.

The package includes legislative proposals on crypto-assets and digital operational resilience and a pilot regime for market infrastructures powered by distributed ledger technology. But the EU's Digital Services Act package that is still under consideration is only the beginning.

EU financial services regulation, and in particular MiFID II, will soon require a wholesale overhaul in order to keep pace with the digital transformation of the financial value chain both within the EU and globally.

There are important obstacles on the road towards a complete overhaul of MiFID II. There is first the issue of status quo inertia. Upsetting settled industry practices might earn regulators industry’s ire. Then, it is not always easy to reach an intra-EU political compromise.

Regulatory experimentation with DeFi and ensuing reform is, nonetheless, an essential process if policy-makers wish to harness the potential of decentralised finance. Properly regulated DeFi infrastructures can become a safe passage to the democratisation and further integration of capital markets.

Once properly regulated DeFi can transform the investment paradigm heralding a totally new era in financial services where investment markets will become the servant of society and real economy and not, as we have been accustomed in the past three decades, its master.

Emilios Avgouleas holds the chair in international banking law and finance at the University of Edinburgh and Alexandros Seretakis is an assistant professor in law at Trinity College Dublin.

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