In September 2020, the Swiss Parliament adopted the Federal Act on the Adaptation of Federal Law to Developments in Distributed Ledger Technology (DLT bill). This blanket act adapts various federal laws. The amendments to the Code of Obligations, the Federal Intermediated Securities Act and the Federal Act on International Private Law have already entered into force as of 1 February 2021. These provisions enable the introduction of ledger-based securities that are represented on a blockchain.
The remaining provisions of the DLT bill, namely the amendments to the Financial Services Act (FinSA), the National Bank Act (NBA), the Banking Act (BA), the Financial Institutions Act (FinIA), the Anti-Money Laundering Act (AMLA), the Financial Market Infrastructure Act (FMIA), and the Debt Enforcement and Bankruptcy Act (DEBA) have now entered into force on 1 August 2021, together with their accompanying blanket ordinance (the ‘Ordinance’).
The amendments to the DEBA address both the segregation of digital assets in case of bankruptcy, and access to data and personal information.
With respect to the segregation of digital assets, the amendment aims to insert a new provision giving, under certain circumstances, a right to restitution of the digital assets held by the custodian. According to these rules, in case of the bankruptcy of a custodian, crypto assets can be segregated from the other assets on condition that the crypto assets are held in constant availability for the clients and can be attributed, either individually in case of individual accounts or pro rata, in case of pooled accounts, to the clients. Correspondingly, in the BA, such crypto assets are now specifically designated as custodial assets. These crypto assets are segregated from other assets in case of a bank’s bankruptcy. This allows banks and other supervised financial institutions to hold crypto assets off-balance sheet more easily and without triggering any negative implications for their capital requirements.
Crypto assets held in individual accounts (i.e. in individual wallets for each client) as well as crypto assets held in omnibus accounts (i.e. in a wallet for multiple clients) are qualified as custodial assets and, consequently, do not qualify as public deposits. The safekeeping of crypto assets in accordance with the above does not require a banking licence except for the custody of crypto assets that serve as means of payment (i.e. crypto assets that qualify as payment tokens) in omnibus accounts. Such a set-up requires a so-called ‘fintech licence’ or a banking licence.
These new rules provide clarity to a hitherto ambiguous situation regarding the segregation of crypto assets. They are expected to foster services for crypto custody, especially among financial market participants. It is also to be expected that new custody set-ups and solutions will emerge, providing the clients with enhanced security and better convenience.
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A new form of uncertificated securities has been introduced to the Swiss Code of Obligations, the so-called ‘registered uncertificated securities’ (DLT securities). Such DLT securities have to be registered in a DLT protocol and can only be executed and transferred within this protocol. This new kind of security has, in particular, the benefit that it no longer requires a written and signed cession for a legally binding transfer of the security. There is also no central securities depository necessary to facilitate transfers.
The new DLT securities are expected to facilitate the ability of companies to issue instruments representing equity or debt, significantly reducing the cost and effort of raising capital. They are also expected to improve liquidity by making the transfer and secondary trading of DLT Securities easier and more directly and broadly accessible.
To accommodate the multilateral trading for DLT securities, a specific licence is introduced in the FMIA: the so-called DLT trading facility. DLT trading facilities are regulated following the existing rules for other trading facilities. Other than the ‘traditional’ trading facilities, such as for instance the stock exchange or the multilateral trading facility, the DLT trading facility is allowed to grant access not only to qualified participants (e.g. banks or securities firms) but also to private individuals directly. Furthermore, the DLT trading facility is allowed to provide – in addition to the core trading services – custody, clearing and settlement services for DLT securities, without the need for an additional licence. This is a major innovation since conventional trading facilities are dependent on a central securities depository to fulfil these functions. According to the amendments, however, a DLT trading facility is not allowed to clear a selected type of DLT security centrally in order to avoid risk concentration. This activity remains reserved for central counterparties.
The requirements for obtaining an authorisation as a DLT trading facility are similar to those for obtaining an authorisation as a stock exchange or a multilateral trading facility. They include that the DLT trading facility must be operated by a Swiss entity, apart from the ability to outsource certain services. Thus an entirely decentralised platform is generally not eligible to obtain a DLT trading facility authorisation in Switzerland.
The respective ordinance, the FMIO, provides further details of the requirements regarding DLT trading facilities. According to the FMIO, among other things the DLT trading facility must foresee a way of correcting or cancelling (executed) trades, which requires some innovative solutions as the functioning of blockchains usually relies on a certain finality of transactions. Furthermore, certain financial instruments are not eligible for trading on a DLT trading facility, in particular certain derivative instruments and other instruments that are deemed to significantly impede the enforcement of anti-money laundering rules. Finally, the FMIO introduces certain simplifications for smaller DLT trading facilities, following a risk-based approach, in coherence with the requirements for the other trading facilities.
Firstly, the scope of the AMLA has been updated to cover the DLT trading facility, which will be considered a financial intermediary subject to the AML rules. Secondly, the scope of the law’s applicability in regard to the provision of virtual currency payment services has been extended. Pursuant to the respective ordinance, the AMILO, qualification as a financial intermediary no longer solely depends on whether a provider has some power of disposition over the funds flowing through its services, but alternatively also on whether the provider has a permanent business relationship with its client and the availability of its service is necessary for the use of the technical solution. Thus financial intermediaries that enable the transfer of virtual currencies to a third party are subject to the AMLA, provided that a permanent business relationship is maintained with the contracting party. This includes, for instance, trading platforms that do not hold the customer’s private key but enable the transfer of virtual currencies by means of smart contracts confirming, releasing or blocking the orders or otherwise having control over the smart contract (so-called decentralised trading platforms).
According to the accompanying explanatory report from the Federal Department of Finance, this new notion has been introduced due to FINMA’s concerns that it is often not feasible to assess the detailed technicalities of a construct to determine the effective control and power of disposal of the involved parties.
This amendment of the AMLA’s scope significantly extends the range of virtual currency activities potentially subject to the AML rules. It could mean that certain constellations – that have so far relied on being outside the scope of the AMLA by avoiding obtaining any power of disposal over the funds – will now have to fully comply with the AML law, if they have a permanent business relationship with their clients and if the availability of the service they are offering is necessary for the use of the technical solution. Managing this transition and ensuring compliance may prove to be challenging for the respective providers.
The DLT framework offers new business opportunities for financial institutions and intermediaries in the context of digital assets. In particular, the regulatory framework overarching the custody of digital assets, the issuance of DLT securities as well as their trading on the newly created DLT trading facility enables new services to be offered without necessarily requiring any additional licence.
The new rules allow custody services to be provided much more easily. Generally, crypto assets may be held off-balance sheet, which reduces capital requirements. Furthermore, the implementation of respective technical set-ups, in particular as a segregation on blockchain level is no longer a necessity, can be achieved with less cost and in a shorter time. Financial institutions and intermediaries may therefore expand their services with a custody offering for crypto assets, leveraging their existing offering or even breaking ground in new client segments. Hence, the potential for providing holistic service offerings creates new value-creation opportunities for financial institutions and intermediaries.
Certain intermediaries now also have the opportunity to gain direct access to DLT trading facilities or to support their clients with specific services, as DLT trading facilities are also allowed to admit private and retail clients directly. Direct access reduces additional intermediaries and makes it cheaper for clients to trade on respective markets. Financial institutions and intermediaries can leverage this with complementary offerings, especially with custody services.
Additionally, DLT securities benefit from potentially increased liquidity in secondary markets, making these markets more efficient and prices for DLT securities fairer. This in turn makes both trading as well as listing DLT securities interesting for clients. Financial institutions and intermediaries can leverage this, not only by providing access to those markets but also by building services on top of it, such as services regarding primary issuance, market making or liquidity provision.
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The DLT trading facility not only allows the general trading of DLT securities, i.e. blockchain-based instruments, in a regulated and legally safe environment, but also provides the necessary framework to leverage some of the blockchain’s distinct features. Due to their historic legacy, driven by regulatory, economical and risk as well as technical factors, conventional trading facilities rely on different intermediating layers and a segregation of functions.
A trade via a conventional trading platform might look something like this:
Blockchain technology, however, provides the ability to execute trades subject to specific conditions and makes it possible to ensure that both parts of a trade are fulfilled. The underlying transaction takes place only if the predefined conditions are met and only if both parties are able to fulfil the trade. Otherwise, the transaction will not be executed at all. This ‘atomic’ trade function is implemented by ‘smart contracts’, i.e. programmes on the blockchain. For trades that are executed solely on the blockchain, this function allows counterparty or intermediary risks to be virtually eliminated (at least for spot trades). It also means, at least on the level of the blockchain, that there is no (or no significant) time lag between the execution of the trade and its settlement and clearing. Basically, this is already included in the trade itself and both payment and transfer of the respective token occur simultaneously and are only performed if they can be fulfilled.
By introducing the DLT trading facility, the legislator has acknowledged the distinct features of distributed ledger technologies and allows DLT trading facilities to perform certain of these so-called post-trading services within a single entity – whereas conventional trading still requires segregated entities due to the inherent risks, technology and architecture on which the legacy financial market infrastructure has been built. This is only made possible thanks to the ability of DLT trading facilities to carry out, in addition to trading services, a central depository for DLT securities services as well as clearing and settlement services for DLT securities.
A trade on a DLT trading facility could look something like this:
One of the ground-breaking innovations brought by the DLT trading facility, as mentioned above, is to be able to admit private individuals to participate to the trading. Conventional licences for trading facilities are usually only allowed to admit qualified participants, in particular supervised institutions such as banks and securities firms. For DLT trading facilities, this not only provides the opportunity to grant access to a broader range of customers and increase liquidity and market efficiency, but also allows clients to gain access to new markets and asset classes more easily and potentially at lower cost.
The ‘new kid on the block’ introduces great opportunities to leverage the features of distributed ledger technology, thereby allowing potential efficiency gains for both trading operations as well as market access and market efficiency. Nonetheless, it is important to keep in mind that the regulatory requirements closely follow the standards of the conventional licences – including, in particular, when it comes to the post-trading services. Respective business models therefore need to be able to come up with viable value propositions and should not underestimate the complexity of running a DLT trading facility under this new licence regime.
The Swiss DLT framework is now fully rolled out. It enhances legal clarity and addresses former shortfalls, in particular in the area of custody and segregation of assets. By this means, the DLT bill opens up new possibilities and business models, fostering innovation of both new players as well as existing financial institutions and intermediaries. The newly introduced DLT trading facility holds the potential to fully leverage the features of distributed ledger technology and contribute to a profound change in the current financial market infrastructure.
SDX has just been granted two licences to operate, under one company, a traditional stock exchange as well as a central securities depository. Although it takes the route of traditional financial market infrastructure licences, SDX is ramping up to build its infrastructure on distributed ledger technology, which will allow the issuance, trade, execution and settlement of listed assets tokens under one roof. The integration of institutional-grade, DLT-based financial market infrastructure is under way.
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