Technological innovation and financial regulation – a maturing relationship - Remarks by Gerry Cross, Director for Financial Regulation, Policy and Risk

Introduction      

Good Morning. I am delighted to be back speaking at Blockchain Ireland week again. Thank you to Blockchain Ireland for the invite.

My theme this morning is the relationship between innovation and regulation and its ongoing development. I will consider this relationship through a number of lenses. Firstly, the importance of innovation to the success of the financial system and how regulation recognises this. Secondly, the need for innovation as it develops and takes hold to understand and respond to regulatory concerns. And thirdly, I will consider some practical examples of where this is happening. I will focus on the new Markets in Crypto Assets Regulation (MiCAR) and its imminent implementation but also look at some other aspects.

Change, innovation and technology are a key part of the financial services landscape.

A central theme of the Central Bank’s Strategy is being Future-Focused. We recognise the many potential benefits and opportunities that technology brings to financial services and consumers in Ireland and in Europe. It is important that these benefits can be realised, whilst also ensuring that the risks are well understood and managed. Regulation plays a crucial role in the safe, and therefore enduring, adoption of innovation into the system.

Innovation has brought in new entrants, new products and new ways of serving customers and the economy. As a result, technological innovation continues to be a focus for the Central Bank. Our financial system has changed significantly and continues to change – in material part driven by innovation. This is one of the reasons why we are seeking to enhance our innovation facilities, so that we can continue to engage, learn and develop a deeper understanding of the ecosystem, the opportunities, the benefits and the risks. Our goal is not to remain stagnant but to evolve and iterate so that we continue to regulate and supervise effectively to deliver our mandate of a well-functioning financial system in a rapidly changing environment.

Innovation and the financial system

Since 2018, our Innovation Hub has been open to all firms innovating in financial services, enabling them to engage with the Central Bank on an informal basis. The Innovation Hub is our direct link to the innovation ecosystem to help us get a better understanding of the scale of innovation taking place in financial services, the technologies being created and deployed, and the new types of business models being developed. The Innovation Hub also helps those firms engaging with us get a better understanding of the financial regulatory framework and its demands. These engagements come from a wide range of firms in the innovation ecosystem, from firms – large and small - that are already within the regulator perimeter to firms innovating outside the regulatory perimeter (for example, RegTech firms).

We will be publishing in the coming days our annual report into the activities of the Innovation Hub during 2023. Once again, firms in the blockchain and crypto space remained the highest sector to engage with the Innovation Hub.

Enhancement of our Innovation Facilities.

During my speech at this event last year, I outlined our intention to enhance our innovation facilities. I am delighted to say that this is now a reality.

As many of you are aware, we issued a public consultation in November 2023. This consultation set out our plans to enhance our Innovation Hub and to establish an Innovation Sandbox Programme.

We are greatly appreciative of Blockchain Ireland and everyone who engaged in the consultation process and participated in our outreach activities during the consultation period. Overall, we engaged with over 250 individuals as part of the consultation outreach programme and received 27 responses to the consultation from stakeholders.

The consultation closed on 8 February 2024 and the feedback received was very positive, reflecting strong support for the proposed enhancements in both the Innovation Hub and the establishment of the Innovation Sandbox Programme.

We are also publishing in the coming days our Feedback Statement outlining our considerations on the responses that we received and setting out our finalised approach and next steps.

We have already made a number of enhancements to our Innovation Hub including the launch of our new Innovation Hub webpage^[1], introduced a new engagement form to ensure more structured and fruitful engagement, and updated our engagement approach to provide additional clarity to innovators engaging with the Hub, including time lines. Over the remainder of 2024, we will continue to add additional innovation-related content online, to enhance the Innovation Hub.

2024 will also be the first year of our new Innovation Sandbox Programme. This new facility will provide regulatory advice and support for participants while adopting a thematic approach in relation to innovating technology. Its aim is to enhance and support innovative technology outcomes aligned with the public interest, to facilitate the mutual understanding and development of new ventures, innovative business models, and new ways of serving customers and potentially expedite the deployment of substantially new technologies, new products, or new services across the ecosystem.

In this new sandbox we will bring together a focus on identified themes, structured programmes, regulatory expertise, and technological innovators in an effort to catalyse and support enhanced outcomes in the common good.

Innovation and regulatory expectations

Having talked a little about the importance of innovation to the financial system and to successful financial regulation, let me turn now to a related question. That is the question of the things that innovators should think about when it comes to engaging with the regulatory system.

I will focus on three aspects: (1) the use case; (2) consumer focused culture; and (3) upfrontedness.

The use case

When regulators are asked to engage with a product or a firm, the very first thing that we will want to understand is its purpose, its use, or, in the case of a firm, its business model. Pretty much all of our approach will come from this starting point. Of course, we understand that there will always be trial and error, that innovation very often involves trying things that in the end don’t work out. But it is important for us to understand what it is that you are trying to achieve and what the product or service you are developing tries to do for its users.

This is particularly important when it comes to the blockchain and its deployment. There are many areas where the blockchain has significant potential to bring about positive change, even transformation, in how we do things. Whether this be tokenisation, for example, in the area of investment funds, or improvements in post-trade infrastructure and interoperability, there are important positive stories to tell.

Unfortunately, for the moment these stories are largely still at the potential stage. Meanwhile the story that resonates the loudest is that of crypto products, and in particular the widespread, intensive marketing of unbacked crypo products to retail customers. Not only is this a problematic story for regulators in view of the enormous volatility and uncertainty surrounding these products, but this has been compounded by events of significant misfeasance deriving from inherent conflicts, weak governance and opacity. This is a very negative story and it is impacting directly how we regulators see important parts of the crypto market.

But of course, there is a different more positive story that could potentially be told. This includes the significant potential of Web3 developments in the evolution of the internet and how it is experienced by and impacts society and individuals. If Web3 technology does have the potential to help address some of the significant challenges faced by the current version of the social media-centred mode of the web or so-called “platform societies”, and if crypto products have an important role to play in this, then that is a story that needs to be more fully told and, no doubt, debated. Similarly if there are forms of unbacked crypto that are different from others, then this is also something that needs to be better articulated.

In short, don’t overlook the fundamental importance of purpose and use, and of wider narratives, when it comes to engagement with regulation.

Customer-centred focus

Secondly, if there is a hallmark of the financial regulatory approach it is the importance of a customer-centred focus – both in the firm and in the products and services they provide.

If you want to get a good sense of this take a look at the consultation that we currently have underway at the Central Bank of Ireland. CP 158 is a consultation on a review of our consumer protection code. At the heart of the consultation is the powerful idea of financial firms’ obligation to secure their customers interests. This basically says that at the core of financial regulation is the idea that financial firms are required to act at all times in such a way that the interests of their customers, and potential customers, are served and secured.

The idea is that financial services depend so much on trust and confidence – without which the overall system functions sub-optimally and all participants are worse off in the medium- to long-term. And that there is a generally a material disparity between the information and resources of financial firms and their customers. This means that in order for the financial system to function successfully customers have to have confidence that firms are operating genuinely in their interest – and not just engaging in rhetoric to that effect.

In our consultation we explain in detail, with many examples, what it does and does not mean to act in such a way as to secure customers’ interests. So when you, as innovators with an eye on financial services, are wondering what is the secret to a successful relationship with regulators, this is an idea to keep very much to the front of your mind and at the heart of your activities.

Upfrontedness

Thirdly and finally in this section let me mention the idea of upfrontedness. I am not sure if it is actually a word or not, but it is certainly a concept and a powerful one.

A key thing that regulators look for from regulated firms – at times explicitly, but probably more often implicitly and without even knowing it – is upfrontedness. Its presence is the foundation for a high quality regulatory relationship and experience; its absence…? Well, the opposite of that.

By upfrontedness, I simply mean that the engagement with the regulator, as well as more generally, is one of openness and transparency, of straightforwardness of engagement, as well as ownership of mistakes.

This is something that applies to all financial firms, and not just to innovative ones. It is something that fundamentally is about culture and that is very much related to the new Individual Accountability Framework, which is being introduced in Ireland at the moment. In short, if innovative firms are to achieve the best outcomes as they engage with the regulatory framework, and as they deepen that relationship, they, you should bear in mind that a key aspect of building trust and credibility with regulators is that sense of upfrontedness in dealings which is conducive to a sense of trust and confidence. And of course, there is a two way aspect to this as well: firms that build a sense of upfrontedness and trust can rightly expect to find that sense embedded in the way that regulators engage with them.

Let me turn now to some more specific features of the regulation as in relates to technological innovation at the present moment.

Implementing MiCAR

MiCAR will become applicable to issuers of asset-referenced tokens (ARTs) and issuers of electronic money tokens (EMTs) at the end of June, and for crypto asset service providers (CASPs) and issuers of utility tokens, at the end of December this year. MiCAR recognises the need for transitional arrangements for firms providing CASP services, and following a public consultation, the Department of Finance will implement a 12-month transitional period for those crypto asset service providers already operating in accordance with applicable law to continue to do so until end December 2025. This transition period will mitigate risks of a cliff-edge occurring as MiCAR takes effect.

A priority for us has been working with our EU Peers and the European Supervisory Authorities (ESAs) to ensure the necessary coordination and consistency across Europe as we implement MiCAR in the 27 jurisdictions of the Union. This work is focused on completion of the level 2 and level 3 text, the more detailed regulations and guidance.  The ESAs continue to seek stakeholders’ input into the design of this level 2 and level 3 text through their consultation process, and I would encourage you to engage with this consultation process in order to convey your observations and insights.

Crucially, this European work is focused on driving a convergent approach to the implementation of MiCAR in authorities authorisation and supervision processes. We see this as highly important work. MiCAR, being a first attempt at regulation in this area, leaves a great deal of room for interpretation and divergent approaches between jurisdictions. If these materialise too significantly then far from being the significant success that it should be, MiCAR will have failed in one of its key aims.  It has been significant that both ESMA and EBA have established supervisory coordination networks to facilitate convergence between regulators. At the Central Bank of Ireland, we are active participants and strong supporters of this work. It is not only hugely important for the successful achievement of MiCAR’s objectives, it is represents a great example of the type of integrated approach that contributes significantly to the building of a Capital Markets Union in Europe. It would be good to see such a determined, integrated approach to consistent implementation adopted more widely across EU financial regulation.

Locally, we know that firms are getting ready now for the formal authorisation process of MiCAR. In this context, the Central Bank intends to open our MiCAR authorisation gateway in early quarter three. We encourage firms that will seek to provide services or products under MiCAR to engage with the Central Bank at their earliest convenience.

We appreciate that industry is looking to understand our approach to MiCAR and we are keen to bring clarity here. To that end, we will be hosting an industry event in July where we will set out our authorisation and supervisory expectations in detail. However today provides an excellent opportunity for me to outline some high level expectations for firms, and our thoughts as to how industry should prepare for the MiCAR authorisation process.

Authorisations

The Central Banks mission requires us to ensure that the financial system operates in the best interests of consumers and the wider economy.

Consumer and investor protection risks are inherently high in some crypto-assets and services and this underpins our approach to assessing MiCAR authorisation applications from such applicants. We want to learn from experiences to date, while also ensuring that well-run, customer-focused businesses are given the opportunity to develop and be successful.

The 2022 crypto related crash of TerraLuna, and the failing of Celsius, 3AC and FTX through 2022 were informative in that they highlighted what and how key risks in parts of the sector could manifest. That period was also marked by high volatility in valuations, a feature that is never far away in the context of certain types of crypto products.

Other risks have also manifested including a lack of consumer protection, the power of aggressive advertising, sectoral contagion, lack of transparency, and instances that demonstrated a disregard for good governance and conduct. It comes as no surprise that the ESAs and we at the Central Bank of Ireland have warned consumers that many crypto-assets are highly risky, speculative and are not suited for most retail consumers as an investment or as a means of payment or exchange.^[2]

But it is also very important to take an appropriately discriminating view and one that does not generalise unduly from the failings of some firms to the potential of others. So how do we inform our view of the risks presented by these crypto products and services? Our assessments are guided though a number of perspectives including the use case and utility, suitability for target markets, and the risks associated with a crypto product or service.

Whether, and how, the crypto that is issued or offered is backed by underlying assets, is an important aspect. Governance and safeguarding are key. Regarding services, the target customer and investor base, and whether it is retail focused or aimed at institutional clients, is key in shaping our view of risk. We play close attention to the sustainability of the business model of the crypto issuer or crypto-asset service provider.

As we have said a number of times, we take a sceptical view on business models where profitability is driven from the heavy marketing, offering and distribution of unbacked crypto to retail customers for speculative purposes. Where we see higher inherent conduct and investor protection risks in the products offered to customers and investors, we will have higher expectations of firm’s ability to manage these risks.

Our intent is that there is clarity, transparency and predictability for applicant firms looking to be authorised, while maintaining the high standards the public expects for regulated providers of financial service.  Our authorisation assessments will be thorough and robust as well as being efficient, timely and outcome oriented. Through that assessment, we expect all firms to demonstrate, should they be authorised, that they can continue to meet our supervisory expectations on an ongoing basis.

We aim to carry out our authorisation processes with appropriate timeliness, conscious of the importance of this aspect particularly in the context of technological innovation where time to market is an important aspect of success. We also aim to achieve high levels of transparency and predictability so that firms seeking authorisation know what to expect and when.

Of course authorisation is a two way process. A successful process depends crucially on the preparation and approach of the applicant. With this in mind, it is worth recalling the key aspects of a successful application.

Firstly, transparency: firms should act in a fully transparent and open manner with respect to their proposed application and the MiCAR activity they intend to undertake including whether they are speaking with other EU regulators.

Secondly, preparation: firms should prepare well and be appropriately resourced to engage with the Central Bank in a comprehensive and timely manner throughout the assessment process. Preparation also means that firms understand the local regulatory environment.

Thirdly, supervisibility: authorised firms should operate with strong local autonomy and be accountable for all aspects of the local entity. Where we identify obstacles to firm’s meeting this expectation, they will not be authorised.

Finally, consumer focus: firms should ensure that securing customer interests is at the core of their business. This is particularly the case for retail facing business models.

The scope of different regulatory regimes is just that – it is different. Where we have existing regulatory relationships with firms, supervisory knowledge and our existing risk assessment will be taken into account for firms moving from an EMI licence or VASP registration to a MiCAR authorisation, but it will be a stand-alone process, and should certainly not be assumed to be automatic.

Over recent years, we have been working to continually improve our authorisation process. Through engagement with industry, other public bodies and applicants, we have sought to better explain our expectations, resulting in increased clarity and predictability. Better risk assessment, better communication and better supervisory outcomes have been the output of that work. We have produced new publications, enhanced our internal processes and responded to the changes in the authorisation landscape, including the increase in the number of complex applications. Authorisation in Ireland means something, and so you can expect that continuous improvement and indeed innovation are part of our processes too. The feedback is positive, and applicants value the robust but clear process.

Supervisory Expectations

We will be speaking about our  MiCAR Supervisory Expectations at our industry event in July and they will be published thereafter Today, I would like to focus on some of the key expectations, which relate to the Protection of Client Assets, Good Governance, Anti-Money Laundering / Countering Terrorist financing, and identification and management of Conflicts of Interest.

Starting with Client Assets. The guiding principle underpinning the Central Bank’s expectation is that the local firm must have full control of all client assets, with prompt access to the reserve assets to meet redemption demands. 

Moving on to good governance. This is underpinned by the principle that firms must be able to demonstrate an appropriate level of “substance” in Ireland and be led by a local crypto competent executive and board with a strong grasp of the local regulatory environment. Firms must maintain high quality governance and risk management arrangements.

AML risks is a particular area of concern. In short, our expectation is quite simple.  At all times, firms must know who its customers are, how they are funding their crypto activities and ensure these funds are not emanating from criminal activities. 

The final key expectation is the identification and management of conflicts of interest. The principle underpinning this expectation is that no risks are posed to customer interests through conflicts of interests. Firms must ensure a robust system is in place, which can proactively identify and subsequently remedy any conflicts in a timely manner.

In our supervisory expectations document we will provide some further supporting details on how these expectations can be met.

VASPs

At the start of the month, we published an update^[3] on our website setting out the impact of MICAR on VASPs. We recognised that it was important that we provide some clarity to the market.

Registered VASPs operating under the VASP regime prior to 30 December 2024, under MiCAR, will be permitted, post 30 December 2024, to avail of a transitional period enabling them to continue to operate for up to 12 months or until their CASP authorisation is granted or refused, whichever is sooner. All registered VASPs that intend to continue to operate following the 12-month transitional period, will require a CASP authorisation from the Central Bank prior to 30 December 2025.

For firms that are not registered VASPs but are considering seeking CASP authorisation, our experience from assessing VASP applications, highlights that a period of at least ten months is required to conclude the assessment of a VASP application. Therefore, such firms should focus their efforts on preparing for a CASP application rather than seeking a VASP registration at this time.  For those VASPs that have already applied for a registration but have not reached the end point of the process, the Bank will continue to assess these applications and will engage bilaterally with these firms on the progress of their applications.

Crypto funds

Let me say a few words about investment funds investing in crypto. There has been much attention paid to the approval of spot Bitcoin exchange traded products (ETPs) in the US. When considering this topic it is very much worth reading the statement of the US Securities and Exchange Commission (SEC) Chair, Gary Gensler, accompanying the SEC decision. This statement, including what it says as to the context and the scope of the decision as well as challenges associated with crypto, is instructive.

The Central Bank addressed the issue of funds investing in crypto in a set of Q&A’s published in 2023 We indicated there that Qualifying Investor Alternative Investment Funds – that is funds available to professional investors - would be permitted to invest in digital assets subject to clear disclosure requirements and exposure limits. Limits are 20% if the QIAIF is open ended and 50% if limited liquidity or closed. So far, this approach has only been implemented for indirect crypto exposures. We are open also to direct exposure funds, subject to their being able to demonstrate that the custody/safekeeping requirements are met.  We also confirmed that we were unlikely to approve such exposures in a Retail Alternative Investment Fund, which is aligned with our position to not permit such exposures through UCITS.

Our approach in relation to digital assets in investment funds will be kept under review, and continues to be informed by European regulatory discussions. Most recently, we have been engaging with ESMA on its technical advice to the Commission on a review of the Eligible Assets Directive, which will consider digital assets in the context of UCITS. On the 7 May 2024, ESMA launched its ‘Call for Evidence - On the review of the UCITS Eligible Assets Directive’ paper and are inviting comments from a wide array of market participants.

Tokenisation

At last year’s speech, I touched on the evolving area of tokenisation. Tokenisation in the context of financial markets can be broadly understood to refer to the process of directly issuing or generating a representation of an asset in the form of a digital token using DLT.

At the Central Bank, we are supportive of exploring how tokenisation and the technology can bring benefits to both firms and investors. I touched on many of these potential benefits during last year’s speech, including enhancing liquidity, improving valuations, broadening access, and improving transparency and realising cost and timing efficiencies around record keeping and reporting. 

At an international level, we are engaging with international policy makers to assess the current state of financial asset tokenisation in the capital markets space and the associated risks and challenges, and to look at whether there are areas that would benefit from policy guidance.

In recent months, we have been actively engaging with the funds industry to explore pathways and potential for tokenisation for investment funds. We look forward to continuing to engage with industry on tokenisation, as the sector and the technology evolves, and as we enhance our shared learning.

DLT Pilot regime

On the topic of tokenisation, I would like to touch on the EU’s DLT Pilot regime. This time-limited regulatory regime has been in place since 23 March 2023 and provides the legal framework for trading and settlement of transactions in crypto that qualify as financial instruments under MiFID II, while facilitating the set-up of new types of market infrastructures, including the following types of entity: a DLT multilateral trading facility, a DLT settlement system and a hybrid of the two known as a DLT trading and settlement system^[4].

In April, ESMA published a letter^[5] to the European Commission, providing an update on the uptake of the DLT Pilot Regime. The challenges identified by ESMA include challenges with cash settlement, challenges with custody through self-hosted wallets, challenges with the interoperability between DLT market infrastructure and traditional market infrastructure, investor protection challenges including the scope of DLT financial instruments and challenges with competitiveness versus other third country regimes.

No doubt, these challenges will be addressed and overcome in time, as the market and the associated regulatory landscape evolves and matures. The Central Bank will continue to engage with our European colleagues with regard to the DLT Pilot Regime so that it can deliver the potential benefits and opportunities of the technology, whist also enabling regulators to gain a greater understanding of the associated risks and challenges presented by these technological developments.

Conclusion

Let me conclude by saying that we are committed to continuing to strengthen our engagement with the innovating ecosystem and we see the enhancements we are making to our innovation facilitates and  engagement, as a way for us to better deliver on our mission to serve the public interest. Stakeholders emphasised through the Consultation process the importance of continued engagement, inclusivity, and transparency to drive innovation across the financial services ecosystem, to deliver for its participants, the Central Bank and the public good.

We all play an important role in the financial system ecosystem. We recognise our unique and important role when it comes to innovation and new technologies and their underlying use cases and this is why we have enhanced our innovation facilities and our engagement with innovators. Industry also plays an important role in ensuring that use case of new technologies and business models are developed with consumers at the forefront, so that the ultimate benefits can be realised by consumers, and the wider economy.

Thank you very much for your attention.