US Equities Sustain the Use Case of DLT for UCITS 

Over the course of the past decade the US mostly had either to catch up or adapt to abrupt changes introduced to the regulatory framework on financial services in Europe. Whether it was AIFMD or more recently SFDR, the effect of some European regulations has always been ultra-territorial in nature. They imposed adjustments, sometimes costly, on US market participants willing to have exposure to European investors. This is the price to pay for a global economy. 

For the first time in a while, the opposite is going to take place very soon. Some soon to be enacted changes in the US ecosystem for financial services are seeing market participants in Europe scrambling to quantify the damages and put in place band aid solutions. 

We are talking about the paradigm shift taking place in May 2024 when the settlement cycle for US securities trades will be shortened from T+2 to T+1. This move will have a set of consequences also for mutual funds, ETFs in particular. Considering that Europe still functions on a T+2 trade settlement model, there will be consequences at both sides of the spectrum. The shift will create mismatches both for the US funds with underlying investments in European securities and for UCITS investing in US securities. Part of the industry in Europe and in the UK, including authorities, has been supportive for a while of the adoption of new technologies including DLT for UCITS, which would potentially fill this gap quite easily.

EU Policies and Technological Neutrality  

The approach of European authorities is nevertheless one of neutrality towards technology. In the context of policy making, technology or technological neutrality means that in the phase of design of the rules, European policy makers do not have the role of dictating the winning technology. Cherry picking the best, the one technology that will have the broadest adoption amongst similar others available, stays with the individuals and the markets. European rules accordingly should accommodate for sufficient room for changes in technology trends. And whilst technology agnostic, the rules for the financial services framework must align at the same time to the reality of the financial markets they intend to regulate.  

The T+2 settlement model was introduced in Europe for the first time in 2014. At that time the model was appropriately reflecting the reality of financial markets. If we look at the recent progress in technology and the fact that many more years of progress have been compounded over the last decade, it becomes apparent how the existing T+2 model no longer reflects the reality of global markets.  

The US is not the first nor the only global market changing its securities trade settlement standards. To a different extent, China and India have already moved to shorter cycle for the settlement of certain securities. Canada will follow the US and so will the UK at some point. Given the significant number of funds, mostly ETFs, having respectively exposure to US equity in Europe or the other way around, the concern in the short term is justified for market participants at both sides of the Atlantic. European authorities, starting with ESMA, have already started the process to gather information and facts from the market and other stakeholders, with a view to update the related settlement standards also in Europe.  

The Story of T+1, T+2 and T+3 

Shortening the trade settlement cycle for shares and bonds in the US will have as we said implications for both US and European funds. To understand them fully, it makes sense to look closer at the concepts of T+1, T+2 and T+3.  

Securities are bought or sold on T, which is the moment in time when the buyer pays the money to purchase the securities. Ownership of the securities is transferred though only after the so-called settlement window has expired. This is takes place on T+2 which is 2 days after T in the old settlement cycle. This cycle will now be shortened to T+1. The settlement window is generally used to process the security and prepare for the transfer in ownership. In the case of subscriptions for UCITS funds, these will settle only on T+3, meaning after 3 days from the payment of the subscription amounts. The same 3 days settlement window applies to redemption requests.  

The mismatch in settlement cycles will create a different set of issues for UCITS funds with underlying investments in US securities. In the case of subscriptions, based on T+3 settlement standard, the shortened cycle to purchase the corresponding securities will create liquidity issues. Whilst facilities could be put in place to take care of these temporary liquidity crunches for funds, we need to bear in mind that the UCITS directive so far allows for limited borrowing for UCITS funds versus the total amount of these assets, not to exceed 15%. Delaying the purchase of underlying assets by the UCITS to the moment in time when the subscriptions settle is an approach that does not come without market risks either. In case of redemptions, the shortened settlement cycle will create a situation of excess cash liquidity, which could also go against certain other rules under the UCITS directive.       

It is noteworthy to mention that the SEC did not introduced penalties in case the new settlement cycle is not respected. This is good news. However, we deem it simply unrealistic to purport that the lack of penalties will mean ability for market participants to completely ignore the new shortened settlement cycle. Systematic rules breaches will create issues in the market and attract attention from regulators. At the same time, it might be possible that some of the other actors in the process, like the custodian banks or brokers, might be able to cover for these liquidity issues. Whilst this is not entirely to be excluded – where possible and allowed by regulations and other operational and commercial constraints – it will come at a possibly steep additional cost. We live in an era of higher for longer interest rates.   

The Use Case of DLT for UCITS  

Notwithstanding the growing strength of a use case of DLT for UCITS, European authorities do not have the last word on technology. In observance of the principle of neutrality on technology, it will be on the markets to pick the winner technology to fill the gap created with the shift to T+1 in the US securities settlement ecosystem. From more than one side we have been hearing insistingly more about how distributed ledger technologies (DLT) might be applied to the broader markets in financial products and services. Discussions at European level on the use case for DLT started some time ago and have been ongoing since.  

For DLT being intimately connected to cryptocurrencies and for the blockchain being the best-known example of DLT so far, we believe it a fair conclusion that these technologies have suffered so far from the same volatile reputation affecting cryptocurrencies. The initial scepticism surrounding crypto assets and the emphasis posed on the risks inherent to these technologies also contributed significantly in our view to slow down the process for practical application to financial markets.  

As the first chapter on cryptocurrencies draws to a close, with the very first cases of fraud being tried successfully in US courts, we are inclined to believe that application of DLT for UCITS and broadly other securities trade and post trade environments is not necessarily that futuristic endeavour now. However, for DLT having the nature of disruptive innovation, implementation at global level will require significant time and coordination efforts. It will also require a fully restored reputation for cryptocurrencies across the globe.  

Where DLT will be certainly very well positioned to assist the transition to a T+0 settlement cycle, which represents the ultimate goal in terms of industry standards in global markets, catching up to T+1 will take place using innovations of the sustaining type. One of the inherent issues with the use of DLT for UCITS nowadays is still one of perception and reputation.   

The European Pilot Regime on DLT 

Where there is still testing to be made before the application of DLT for UCITS can go mainstream and become a reality, same as for the broader markets in financial services, it would not be entirely fair to say that no significant progress has been made so far in Europe. Along with green transition, digital transition nevertheless ranks very high in the list of priorities of the European Union.   

Significant efforts have been made already, culminating in the adoption of an European pilot regime for market infrastructures based on DLT.  The pilot regime is first and foremost a very important step in making the EU fully fit for the digital economy. It is based on the same technology neutrality principle in that the EU financial services regulatory framework should not pose obstacles but facilitate instead the application of new technologies. The Pilot regime on DLTs lays down the conditions governing the permissions to operate DLT based market infrastructures, defines which DLT financial instruments can be traded and provides the foundations for the cooperation between operators of DLT market infrastructures and national competent authorities, including ESMA. With the European pilot regime certain DLT market infrastructure will be temporarily exempted from some of the requirements applicable under the financial services regulation of the European Union that would otherwise prevent these operators from developing the related technologies. Despite the exemptions, the operators of these market infrastructures will be required to have in place sufficient safeguards to ensure investor protection. To the extent of including clear chain of liabilities for any losses that investors might suffer because of operational failures of these structures.  

The main objectives of the European pilot regime on DLT are four and can be broken down as follows: 

1. Legal certainty – during the development phase of these new technologies it is mandatory to have a clear view of where and how the existing framework is no longer fit to the purpose. 
2. Innovation support – removing any obstacles to the application of new technologies in the financial sector as part of the digital transition. 
3. Investor protection – new technologies should ensure that investors and their capital are protected from risks inherent to the adoption of new technologies. 
4. Financial stability – the adoption of new technologies should ensure that markets remain stable and can function in an orderly manner.  

The European pilot regime contains also very interesting hints on the ability of DLT to combine both trading and settlement as well as trading and post trading services and activities. On this point, it is noteworthy to mention that the way rules are currently designed reflects clear policy options whereby the unbundling of trading and post trading activities is intentionally introduced to contribute to competition in the market. And where the European pilot regime should not be used as a precedent to justify such a significant overhaul of the existing regime, it is nevertheless appropriate to test new market infrastructures as part of the pilot, where the activities normally performed by different actors in the settlement cycle are consolidated into one entity only.   

The European pilot regime also attempts to give a European definition for the main applicable terminology as follows: 

1. Distributed ledger technology or DLT means a technology that enables the operation and use of distributed ledgers. 
2. Distributed ledger means an information repository that keeps records of transactions and that is shared across, and synchronised between, a set of DLT network nodes using a consensus mechanism. 
3. Consensus mechanism means the rules and procedures by which an agreement is reached, among DLT network nodes, that a transaction is validated. 
4. DLT network node means a device or process that is part of a network and that holds a complete or partial replica of records of all transactions on a distributed ledger. 
5. DLT market infrastructure means a DLT multilateral trading facility, a DLT settlement system or a DLT trading and settlement system.  

Application of DLT for UCITS at local level – Luxembourg 

The effort at European level on the application of DLT for market infrastructures on financial services is coupled by local endeavours in certain selected European domiciles. The fact that selected European member states have their own rules on the use of DLT for UCITS bodes well to expedite adoption processes also at European level.  

One example that stands out is of course Luxembourg. With two so-called blockchain laws, Luxembourg is at the forefront also for what concerns the application of DLT for UCITS. More namely DLT is already accepted relative to certain dynamics of the administration of UCITS funds. According to a recent interpretation of a local circular, it is well possible already to use DLT for UCITS registrar functions and shareholders registers.