Financial intermediation is essential to economic activity and the operation of financial markets. Examples of intermediation in the flow of money are numerous: commercial banks act as intermediaries between issuers (central banks) and users of money; payments are settled through clearing and settlement mechanisms, etc.
Intermediation brings significant benefits. The financial intermediary is a mutually accepted and trusted third party (TTP) and often under the supervision of a competent authority. It provides the technical infrastructure and the governance arrangements, like operation rules, dispute resolution mechanisms and central record keeping, in complicated, multi-party systems. Participants benefit, therefore, from greater security, efficiency, economies of scale and, what is most important, trust. Drawbacks, on the other hand, relate to increased costs, possible dependance on the TTPs and vulnerability to external attacks, as the TTP is a single point of failure for the whole system.
In view of the above, can we consider a financial system without or with less intermediaries? This is the overarching challenge of blockchain technology.
This presentation is an introduction to the main operational aspects of blockchain, the legal challenges that it poses and the EU approach towards the risks and the opportunities that it holds.
Blockchain is a technological revolution often compared to that of the internet. It is a disruptive technology, i. e. a technology that has the potential to radically change the existing business models and ways of market operation.1 What is revolutionary and disruptive about blockchain is its core feature, disintermediation. Blockchain is the backbone of decentralised systems allowing for peer-to-peer communication without the need for a TTP. This is the main characteristic of all Distributed Ledger Technologies (DLTs). Blockchain is a subset- the most important – of DLTs distinguished from this wider category by the use of enhanced cryptography.2
Blockchain is a digital platform or database used for safely recording and storing data. It is the electronic equivalent of traditional ledgers, where transactions are recorded in a chronological order. This digital ledger is distributed to a network of computers (»nodes»), that may be located anywhere around the globe, and operates in a decentralised manner. Each node holds a copy of the chain, which consists of files of information (»blocks»). Blocks are added to the chain following a consensus mechanism. Each block is connected to the previous one with a hash and time stamp and in such a way that it cannot be deleted or altered. The structure of blockchain presents benefits, the most important of which are the following:
– Security: The consensus mechanisms and enhanced encryption reinforce the system against external attacks. Furthermore, to be successful, such attacks should be directed to all or most of the nodes, which, although not impossible, is difficult in practice;
– Cost-efficiency, due to the elimination of middlemen as well as the increased speed and automation;
– Immutability: All entries on blockchain are tamper-resistant; any attempts to delete or alter the information stored is immediately visible to all nodes;
– Transparency: All nodes have access to all information recorded on the chain;
– Anonymity: The identity of participants may be hidden through pseudonymisation;
– Trust, obtained through the consensus mechanism used for the addition of blocks on the chain.
It should be clear that the design of blockchain systems may vary and that different types of governance may be applied to them. Blockchain, therefore, does not always mean a total absence of intermediaries nor the free access of new participants. On the contrary and depending on the needs of participants, disintermediation can be full or partial and the typology of blockchain systems may vary accordingly. There are three main types of blockchain:
(a) In its initial and standard form, blockchain is «public» or «open», in that it allows free participation without the need for any permission (»permissionless» blockchain).3 It operates without any trusted third party on a peer-to-peer basis. Bitcoin is an example of a public blockchain.
(b) In other systems, access to the chain is allowed only to certain persons or categories of persons after permission by a central party/administrator. These are «private» blockchains, often used by companies or groups of companies internally, for example for internal auditing or regulatory compliance purposes.
(c) Finally, «consortium» or «hybrid» blockchains combine characteristics of the above types. These systems usually operate with more than one administrator, so that all the parties to a transaction are represented. Hybrid blockchains are used, for example, in supply chain operations.
Blockchain became widely known after 2009 as the underlying technology for Bitcoin. Since then, it has been used for more applications and has led to the emergence of new products and markets, namely:
– Cryptocurrencies: Following Bitcoin, many cryptocurrencies have appeared. It is estimated that there are more than 20.000 cryptocurrencies in the world today.4
– Smart contracts are self-performing computer programs, stored on a blockchain and coded to automatically execute when the prescribed criteria are met.
– NFTs (non-fungible tokens) are digital representations of property rights on real or digital world assets stored and/or traded on a blockchain.
– Metaverse is a virtual reality world consisting of virtual spaces in which people can socialize, interact or transact, for example trading digital assets with the use of smart contracts.
– DAOs (Decentralized Autonomous Organisations) are blockchain-based organisational structures among members pursuing the same goals;
– CBDCs (Central Bank Digital Currencies) are digital money issued by central banks and pegged to the value of the corresponding country’s currency.
The use of blockchain technology is continually increasing and expanding to many industries; blockchain supports a plethora of activities in sectors like trade, supply chain, shipping, transportation, public government, health services, education, art, agriculture, energy, entertainment, protection of intellectual property rights,5 etc.
Blockchain affects or has the potential to affect nearly all aspects and sectors of human interaction and economic activity. The financial services sector is not an exception to this rule; starting from cryptocurrencies but also going beyond them, a significant impact is already visible. Several commercial banks around the globe have adopted blockchain solutions while banking consortia have been formed to explore the ways in which they can benefit from this new technology. Applications of blockchain can be used in the financial sector, among others, to: support internal procedures (voting, internal control systems etc.); monitor regulatory compliance; facilitate KYC and client onboarding; provide the «durable medium» required for customers’ information; protect banking secrecy; quantify and assure compliance with the ESG criteria; prevent green-washing; provide a clearing and settlement mechanism for (mainly international) payments; provide a settlement mechanism for securities transactions; facilitate the interconnection of financial entities; offer new services in relation to blockchain enabled products, which can also be accepted as collateral; support financial inclusion.
Financial entities should carefully design the incorporation of blockchain in their operations. This would entail considerations about the governance arrangements (private or consortium blockchain should be preferable), interoperability with legacy systems, possibility to comply with the regulatory requirements etc.
Despite its advantages, blockchain technology also presents some drawbacks and risks, for example:
– The anonymity feature of permissionless blockchain may be abused for illegal activities (money laundering etc.);
– Concentration of computational power may lead to an internal attack by participants possessing more than half of the computing power (the «51% risk»);6
– The consensus processes require high energy consumption;
– Complexity, limited interoperability and legal uncertainty may hinder full exploitation.
These and other risks or concerns, for example tax implications, call for the intervention of regulators, who are faced with multiple challenges in this regard. Intervention should not impede innovation and regulations should be technologically neutral but capable, at the same time, of keeping pace with developments in technology.
Furthermore, blockchain applications give rise to legal questions, for which we don’t always have (not yet at least) a safe answer. These include jurisdictional issues arising from the international and extraterritorial character of blockchain as well as issues relating to network governance or dispute resolution and enforcement mechanisms.
Compliance with existing legislation also poses challenges. In the field of personal data protection, for example, blockchain immutability impedes compliance with the GDPR right to be forgotten while the legitimacy of transborder data transmission may be questioned.
Major questions may also arise due to a lack of clarity as to the responsibilities of participants/ categories of participants, the allocation of risk and attribution of liability.
Although our legal system has the tools to respond to many of the challenges posed, some novel legal issues also emerge. Indicatively:
– Do cryptocurrencies constitute «money»? What if the owner of a digital wallet loses access to the wallet?
– What is the legal nature of smart contracts? Do they qualify as «documents» or «contracts» in the legal sense of these terms? How (if at all) can they implement legal concepts like force majeure? Are they susceptible to amendment in case of a change in the parties’ will? What if they malfunction?
– What is the legal nature of NFTs and how does tokenization relate to our traditional property law? Are initial coin offerings (ICOs) equivalent to initial public offerings (IPOs)?7
– Do DAOs constitute a (new) form of companies? Do they have legal personality? Are their members liable for breach of law by the DAO? Does the decision-making process result to resolutions equivalent to those of a corporate general assembly?
– In the metaverse, people may, through their virtual identity (avatar), «acquire» property, provide services, adopt new habits etc. Are such transactions binding and enforceable? Do or will new norms constitute customary law?
International cooperation is necessary for the comprehensive coverage of the above issues. Some existing conventions and regulations, like the Rome I and II Regulations,8 are useful but not sufficient tools in this direction. Despite a certain degree of cooperation, regarding for example interoperability, we are still far from a homogenous international legal framework for blockchain. The absence of regulation, the limited scope of national laws (if such laws are at all adopted) and fragmentation in existing legislation result to a significant lack of legal clarity and certainty. In this environment, the EU has taken significant steps for harnessing the innovation of blockchain and regulating mainly the crypto-asset related activities.
In 2018, the European Parliament emphasised the potential of blockchain technology and called for policies that would boost its use in Europe and promote the competitive position of the EU in this field.9 One year later, the European Blockchain Strategy10 articulated «Europe’s ambition ... to set the gold standard for blockchain technologies». The EU Blockchain Observatory and Forum11 was launched to accelerate blockchain innovation in the EU, while the European Blockchain Partnership12 built the European Blockchain Services Infrastructure (EBSI),13 the first blockchain infrastructure for the European public administrations.
In 2020, the EU Commission adopted the EU Digital Finance Package, with the aspiration to promote innovation, enhance consumer protection, ensure a level playing field for all financial actors, protect financial stability and, as a result, reinforce the global competitive position of the Union in blockchain development. The Package included, among others, the following components relating to the use of blockchain technology in the financial sector:
Τhe Strategy aims to support the digital transformation of the EU financial sector, among others, by a regulatory framework enabling the uptake of blockchain technology in the financial sector.
Regulation 2022/858 introduced a flexible regulatory framework (the pilot regime) to facilitate the development and testing of DLT applications by DLT market infrastructures. The operation of DLT market infrastructures requires prior specific permission by the national competent authorities. Applicants must already be authorised as investment firms or central securities depositories. DLT market infrastructures may be: (a) trading facilities for DLT financial instruments, (b) DLT settlement systems, i. e. systems settling transactions in DLT financial instruments or (c) a combination of the two. They must comply with the obligations set forth by the Regulation (disclosure of information, risk management, business continuity etc.) and cooperate with the competent authorities.
The financial instruments accepted under the pilot regime are a subset of the financial instruments defined as such under MiFID II, namely:
– shares, if the market capitalization of the issuer is less than €500 million;
– bonds and other forms of securitized debt or money market instruments, of value less than €1 billion;
– units in collective investment undertakings, if the market value of the assets under management is less than €500 million.
In addition, the total value of all DLT financial instruments admitted for trading or recorded to a DLT Market Infrastructure should not exceed the amount of €6 billion.
The regime will be subject to evaluation and review by the European Securities and Markets Authority (ESMA) by March 2026.
Adopted in June 2023, MiCA is the first comprehensive regulatory regime for crypto-assets globally and is, therefore, expected to influence other jurisdictions in the adoption of corresponding legislation.
Crypto-assets are broadly defined in MiCA as the “digital representation of value or rights stored and exchanged via blockchain”. However not all types of crypto-assets fall within the scope of the Act; only the following three types are subject to MiCA:
– utility tokens, which are only accepted by the issuer and provide digital access to goods or services available by the issuer;
– asset referenced tokens (ARTs), i. e. tokens maintaining a stable value by reference to other value or right or both, for example the value of an official currency or a commodity; and
– electronic money tokens (EMTs), maintaining a stable value by reference to an official currency.
The Regulation includes provisions, i.a., about:
– the transparency and disclosure requirements for the issuance and admission to trading of crypto-assets;
– the authorisation and supervision as well as the operation, organisation and governance of ART and EMT issuers and crypto-asset service providers; and
– consumer protection and prevention of market abuse.
MiCA will apply from 30.12.2024, except for the provisions on ARTs and EMTs, that will apply from 30.6.2024. European authorities are expected to issue guidelines for the interpretation and application of certain provisions of the Act. In this context, ESMA has launched, i.a., a consultation on the conditions and criteria for the qualification of crypto-assets as financial instruments under the Act,17 the final report on which will be published by the end of 2024.
On 28.6.2023, the EU Commission came forward with a legislative proposal for the establishment of the digital euro,18 as a response to the increasing use by EU citizens of private digital means of payment and to the challenges that this trend, together with eventual third-country CBDCs and privately issued stablecoins, may pose for the role of central bank money and the role of the euro in payments. The proposal is consistent with the 2020 EU Strategies for Digital Finance and Retail Payments. Privacy, financial stability, accessibility and financial inclusion are major considerations, while the proposal also aims to foster competition and innovation.
Under the proposal, the digital euro is established as a digital form of the single currency, complementing cash as an alternative means of payments for retail transactions. It is issued by the European Central Bank (ECB) and the National Central Banks, representing a direct liability of these institutions towards users, and distributed by credit institutions and other payment service providers.
The digital euro is granted the status of legal tender; this entails that it is, with very few exceptions, mandatorily accepted at full face value, with the power to discharge from payment obligations and that it is convertible with euro banknotes and coins at par. It is not meant to be used as a store of value and ECB will issue instruments to control such use.
The digital euro will be available for payments both online and offline preserving, in the latter case, (most of) the anonymity and privacy features of cash.
Blockchain is only one of the technologies, both centralised and decentralised, under consideration for the deployment of the digital euro; a final decision on this has not yet been taken.
Although the preparation phase is underway, the decision on whether to issue digital euro will be considered by the ECB after the completion of the legislative process for the adoption of the proposal.
The proposed Regulation on the establishment of the digital euro is accompanied by two additional legislative proposals:
– a proposed Regulation for the provision of digital euro services by payment services providers incorporated in Member States whose currency is not the euro,19 aiming to ensure the distribution of digital euro in a similar manner throughout the EU; and
– a proposed Regulation on the legal tender of euro banknotes and coins,20 aiming to safeguard the role of euro cash as a widely accepted means of payment which remains easily accessible for people and businesses across the euro area.
Blockchain presents many opportunities but also challenges for the financial sector. It is already disrupting certain aspects of the financial markets and may even be affecting the notion of money, as we know it. In this fast-changing landscape, awareness and openness may prove critical for financial entities. n
