DLT for the OTC

By Tyler Kirk

On June 21, 2016, some of Europe’s largest financial institutions announced they had entered into a memorandum of understanding (“MOU”) under which they would work together to develop a blockchain-based settlement procedure for over the counter (“OTC”) transactions. According to the MOU, several European legislators are concerned that small and medium-sized enterprises (“SMEs”) do not have adequate access to capital. The MOU seeks to solve such concerns by bringing together European exchanges and investment banks under a common mandate to reduce the cost for SMEs raising capital in the OTC market. Blockchain may be the solution they are looking for.

Generally, blockchain is a decentralized digital ledger, and its creation established a new class of digital ledgers called, distributed ledger technology (“DLT”). Unlike current financial settlement systems, DLTs are more efficient because all transactions are mathematically provable and do not require a multi-day verification process. DLT protocols use encryption combined with distributed copies of the ledger to replace the need for a third-party to serve as the ledger’s custodian. In short, DLTs create an immutable record of the truth arrived at through distributed consensus.

 According to the MOU, a post-trade blockchain infrastructure would reduce transaction costs and increase security, providing SMEs with greater access to the capital markets.  Typically, a financial instrument is traded OTC because its issuer is too small to meet the listing requirements of formal exchanges. Without the cost advantages of economies of scale, SMEs may abstain from raising capital in the OTC market, unnecessarily stifling their growth. By leveraging the efficiencies of DLT, European financial institutions are hoping to reduce the costs associated with raising capital for SEMs.

Significantly, European regulators have provided financial institutions with some breathing room. The European Parliament has proposed legislation that would make it easier for SMEs to access markets outside their home countries. Further, the parliament voted earlier in 2016 to take a hands-off approach to regulating blockchain and other similar DLTs. Yet again, innovation finds itself at the crossroads of globalization and regulation.

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