When DLT Technology enters the Bank of Italy.

When Satoshi Nakamoto published a white paper titled “Bitcoin: a peer-to-peer electronic cash system”, nobody knew what a blockchain was. It was October 31st, 2008, when the world was in the midst of one of the most severe financial crises in history, and the iconic symbol of that period was the failure of Lehman Brothers.

The paper described a new transactional model, characterized by complete decentralization of accounting with the ability to eliminate the presence of an intermediary during transactions. It was, therefore, a disruptive technology at a historical moment that would create a rift to make room for a new path for the Bank and Finance in general.

Fifteen years after that publication, just last month, Italy saw the conversion into law of the decree-law of March 17, 2023, n. 25, containing urgent provisions on the issuance and circulation of certain financial instruments in digital form (DLT Pilot Implementation) and the simplification of FinTech experimentation (https://documenti.camera.it/Leg19/Dossier/Pdf/D23025.Pdf)

But what does the Decree implementing Regulation (EU) 2022/858 say?

The EU Regulation allows for the creation of a pilot regime for market infrastructures based on distributed ledger technology (DLT) that allows certain DLT market infrastructures to be temporarily exempt from certain specific requirements of Union legislation on financial services that could otherwise prevent operators from developing solutions for the negotiation and settlement of operations in crypto assets that fall within the definition of financial instruments, without weakening any of the existing requirements or guarantees applied to traditional market infrastructures. It, therefore, introduces into our legal system the discipline of the issuance and circulation of financial instruments in digital form, through a pilot regime for market infrastructures based on distributed ledger technology (DLT Pilot Regime).

This discipline was introduced in response to the growing interest in the issuance of financial instruments through distributed ledger technology (DLT) in recent years.

For those who are not in the industry, it is probably necessary to explain what blockchain is and its use in the financial sector and, therefore, delve into how DLT technologies work.

The blockchain is a shared and immutable digital ledger that is resistant to alteration and allows for the tracking of transactions that occur within a business network. It is comparable to a communication protocol, that is, a set of rules and procedures that allow two or more entities to communicate and connect.

In essence, anything of value that is a tangible asset (such as money, houses, cars, land) or an intangible asset (such as trademarks, patents, copyrights, intellectual property, corporate sustainability) can be traced and exchanged thanks to the blockchain. Literally, we can translate the term “blockchain” as “chain of blocks”, due to the fact that transactions are grouped into blocks, ordered chronologically, so as to form a chain, which forms the complete register of all database operations. The blockchain can be inserted within the broader family of Distributed Ledger technologies, systems that allow all nodes of a network to manage a ledger synchronized between all participants, without the need for a central node to manage and control it. Similar to any database, the ledger is valuable when it can be consulted to check, verify, and manage transactions that have been made, but it differs from the traditional paper register due to the typical differences of the digital and network: decentralization, transparency, immutability, security, responsibility, convenience, and digitality.

With blockchain, fintech has taken on a leading role. Distributed ledger technology (DLT) represents a significant technological advancement, allowing for the exchange of digital tools on a bilateral basis, even between unknown parties without a trusted relationship, without the need for centralized entities, and continuously. With blockchain, Smart Contracts have become indispensable.

The concept of Smart Contracts was officially introduced in the 1990s by Nick Szabo, a cryptography expert, who was among the first to reflect on and design forms of contractual automation and experiment with their implementation, well before Satoshi Nakamoto’s position paper. The idea was to find a response to companies’ demand for greater efficiency, accelerating processes through automatic contracts. Today, thanks to the support of blockchain, much more sophisticated intelligent contract management platforms can be built, which will impact different business, governmental, and social contexts.

To fully exploit all these advantages, Regulation (EU) 2022/858 introduces an element of discontinuity compared to the current situation for the financial market: the possibility that services related to the life cycle of a financial asset may be jointly provided by a single market infrastructure, the so-called “DLT trading and settlement system” (“DLT TSS”). This DLT infrastructure can be used alongside those that offer only trading services (“DLT MTF” – DLT multilateral trading facility) or only settlement services (“DLT SS” – DLT securities settlement system).

Furthermore, the DLT Pilot Regime allows the possibility that a DLT multilateral trading system, if authorized by the competent authority, may also admit natural persons, in addition to legal persons, to trade on their own behalf, provided they meet a series of requirements provided by the Regulation. This exemption exceeds the requirement set by the MiFID II Directive, which only allows investment firms, credit institutions, and other entities to participate in traditional multilateral trading systems.

It is easy to see how the aim is to fully exploit the advantages offered by a system that is not limited to simply trading financial instruments but also includes the initial registration of instruments. In this way, the register becomes a unique and centralized place where all phases of the financial transaction’s production chain can be managed and monitored, with the participation of end investors.

The DLT Pilot Regime represents an important step towards market development, but alone cannot guarantee balanced growth because interoperability is lacking. However, technological evolution could offer plausible solutions to this problem, for example, by standardizing the structure of tokens to make them usable indiscriminately on all DLT infrastructures. Considering the importance of this task, the Bank of Italy has collaborated with two Italian universities to conduct research on the characteristics of DLT platforms’ smart contracts and their legal, technical, and economic implications.

The objective is to define a taxonomy of different types of DLT and Smart Contracts and then formulate proposals for good practices that can be used by standard-setting bodies and regulatory authorities. This will help market operators, including technology providers and algorithm developers, stay up-to-date on the best practices to adopt.

The Italian financial regulator, Consob, has also welcomed the legislative intervention aimed at aligning national regulations with other European regulations to support the transition of traditional finance towards FinTech. This intervention is seen as an important and necessary step forward for the Italian financial market, as the regulator believes that it has adequate tools at its disposal to ensure proper modulation of the effects of the new discipline. This will ensure the ability to manage risks for the protection of savings within a framework of legal certainty, while maintaining the objective of directing savings towards the real economy, including the digital economy.