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The Swiss DLT: Making the case for amendments, not overhaul

On August 1, 2021, the Federal Act on the Adaptation of Federal Law to Developments in Distributed Electronic Register Technology, more catchily known as the Swiss DLT Act, came into force.

It’s a piece of legislation that created a legal framework for using distributed ledger technology (DLT) and blockchain across various sectors, aimed at enhancing legal certainty, promoting innovation, and strengthening investor protection in the sector.

“DLT” refers to a digital system that records, verifies, and shares information across multiple participants in a decentralized and—in theory—secure manner. It involves a network of computers, or “nodes,” that work together to maintain the shared database of transactions and records. This database is referred to as a “ledger” and is distributed across the nodes.

DLT is the overarching technology from which blockchain and digital assets were born, the former being a specific type of DLT that uses a chain of blocks for data storage and security, while the latter are secured assets that utilize cryptography and exist on blockchain or DLT networks.

In terms of blockchain and digital asset space, while the Swiss DLT law doesn’t specifically address all aspects of blockchain or digital assets in the broader sense, it does provide a legal foundation for the integration of DLT-based financial instruments, which could include certain types of digital assets, into the Swiss financial system.

“Even before the law came into force there was already enough legislation around to enable businesses to start their undertakings in Switzerland, and the DLT Act made it even easier for DLT undertakings in specific areas of the law,” says Tina Balzli, head of Fintech and Blockchain at CMS Switzerland and Co-Head of the law firm’s Crypto, Digital Assets and FinTech International Focus Group.

Speaking to CoinGeek, Balzli explains how the DLT Act was designed to expand and build on existing laws and regulations rather than being a new legal regime in itself.

“Not changing everything, just identifying specific areas and points of regulation which can be altered to benefit enterprises and customers. Therefore, it’s referred to as a framework act, not as a standalone law,” she explains.

Specifically, the DLT Act adjusted ten federal laws, including the amendments to the Code of Obligations, the Federal Intermediated Securities Act, and the Federal Act on International Private Law.

One of the key changes involved the creation of two new categories, DLT Security and DLT Trading facility.

DLT securities

“DLT security” refers to a digital representation of a financial or ownership right that is issued, recorded, and transferred using DLT or blockchain. It can encompass various traditional financial instruments such as shares, bonds, or other securities.

These DLT securities are essentially digital versions of paper stocks or securities, and the DLT Act simply defines this and makes them legally recognized and regulated within the Swiss financial markets.

“The DLT act, with regard to the registered securities, does not include an additional definition of what a security is, it just says ‘okay, if it’s a security then it can be issued on the blockchain’ in such and such a manner,” says Balzli.

“It also means that if you want to issue a share, you don’t have to first issue a paper-based share, which you then transform or replicate on the blockchain. That’s not necessary, you directly issue it on the blockchain and it has more or less the same kind of effects from a legal perspective, in the sense that the holder of that registered security roughly has the same level of protection as if the person were to hold a physical paper-based security.”

It does not create a whole new asset type with new rules and protections. It simply defines a new way of issuing and trading securities; the difference is one of technology, not the level of protection.

DLT Securities offer the possibility to streamline the issuance and trading of securities, and the Swiss DLT Act provided official recognition of this new form of security, bringing it under the umbrella of the Swiss Financial Market Supervisory Authority (FINMA), the main financial markets regulator in the country.

The second major new addition to the Swiss financial market lexicon was a new type of platform that would exclusively facilitate trading in these DLT securities.

DLT trading facilities

“DLT trading facilities” are DLT or blockchain-based trading systems providing an organized and controlled environment for buying and selling DLT securities. Similar to traditional financial exchanges, DLT trading facilities are subject to regulatory oversight and requirements to ensure fair and transparent trading practices.

Regulation for this new exchange category followed the existing laws applying to other Swiss trading facilities, and it is mandatory for all entities that trade securities using DLT to register with FINMA.

In Switzerland, traditional trading facilities, such as stock exchanges, are primarily regulated under the Swiss Financial Market Infrastructure Act (FMIA), a comprehensive piece of legislation that covers various aspects of financial market infrastructure, including trading venues and central counterparties.

Key points related to traditional trading facilities under FMIA include a licensing regime for trading venues, which are required to obtain a license from FINMA. Trading venues must have effective risk management systems, rules to prevent market manipulation, and procedures for monitoring and ensuring market integrity.

The Swiss DLT Act also adapted existing anti-money laundering (AML) rules to include the category of DLT trading facility to the list of entities subject to AML regulation in the financial sector—the AML regulation itself was not changed.

“There were no major changes to AML due to the DLT Act. There have been previous changes in anti-money laundering, where it was clearly defined that virtual currencies should be treated the same as fiat money, but the DLT Act was not mainly targeted towards AML considerations,” explains Balzli.

The existing Know-Your-Customer (KYC), AML, and consumer protection rules in Switzerland for physical securities, which come from the Financial Services Act and the Financial Institutions Act, were deemed well-functioning and suitable for the new categories of DLT security and DLT trading facility.

KYC regulations require financial institutions to verify the identity of clients for both physical and DLT securities transactions; AML rules derive from the Anti-Money Laundering Act (AMLA) and the corresponding Anti-Money Laundering Ordinance (AMLO), which obligate, amongst other things, financial institutions to conduct customer due diligence, report suspicious transactions, and maintain transaction records; and consumer protections involve a number of transparency and fairness related obligations, including Swiss banks being required to perform due diligence on clients’ sources of wealth and funds, maintain transaction records, and financial institutions must disclose risks associated with securities investments.

Amendments made to the AMLA and AMLO in 2021 placed obligations on digital asset’ financial intermediaries,’ such as wallet providers and trading platforms, to verify the identity of the beneficial owner of assets; periodically reverify and update client data; and report activity to the regulator in cases where the mediator has an indication that particular assets are connected with a criminal offense.

In the DLT Act, DLT Trading Facilities were classed as financial intermediaries and made subject to these rules as well.

But securities are just one—admittedly core—area of the DLT Act. Another crucial change came in the banking area and related directly to digital assets, as opposed to DLT securities; ‘digital assets’ being a blanket term encompassing various digital currencies, tokens, and other types of value representations that use cryptography for secure transactions.

Banking changes

“The DLT Act, in terms of the banking framework and insolvency framework, set up criteria when the digital assets do not form part of a bankruptcy or the bankruptcy estate. So under which criteria do the digital assets, from a legal perspective, belong to someone else, separated from the bankruptcy estate, if, for instance, the bank goes bankrupt,” says Balzli.

In other words, as of 2021, digital assets could be segregated from other assets in case of a custodian’s default, improving security for those using blockchain technology in the country.

This new approach, introduced as part of the DLT Act, allowed banks and other financial institutions to hold digital assets off balance sheets without triggering any negative implications for their capital requirements.

“That makes it, of course, more attractive for customers to put their digital assets into custody in Switzerland, because they can benefit from the rules,” suggests Balzli. “It is separated from the balance sheet of the bank, but also other custodians, to the extent that no fully fledged banking license is required under very specific circumstances and, in particular, depending on the exact type of digital assets. The clarifications as regards bankruptcy scenarios is an important part and is something that wasn’t regulated on a statutory level prior to the entry into force of the DLT act.”

If the DLT Act has made Switzerland, as Balzli suggests, a more appealing prospect for advocates of DLT technology and players in the blockchain space, has this translated into increased activity? And have there been any stumbling blocks along the way?

How has it played out?

In terms of adoption, it didn’t take long for some major market players to jump on the DLT bandwagon after the passage of the law.

In December 2022, Baker McKenzie advised UBS AG on a cross-border digital securities issuance using DLT. The $50 million fixed-rate digital securities were issued in Switzerland and settled in Singapore and Hong Kong on December 15, 2022.

The transaction represented one of the first transnational issuances of DLT-based securities by a financial institution.

A month later, in January this year, Switzerland’s Cite Gestion became the first private bank to issue shares as ledger-based securities under Swiss law.

The bank partnered with digital assets firm Taurus to issue its tokenized shares, manage the smart contract that creates the shares, and perform asset servicing of its securities.

“At Cité Gestion, our vision is to make it possible for our clients to take full advantage of technological progress in the capital markets, and in particular of the huge potential of rationalization and efficiency gains that the distributed ledger technology offers in this field. It was important for our bank to be among the first to take advantage of the new possibilities offered by Swiss law for the digitalization of securities by tokenizing our own shares,” said Christophe Utelli, Deputy CEO of Cité Gestion.

But despite activity in the DLT security realm, Balzli suggests Switzerland is yet to see its first DLT trading facility established.

“In terms of the trading venues and trading facilities, hopefully by the end of the year or the first half of next year the first institutions will be up and running, and there might be certain aspects of that license, which might need to be slightly amended or changed. So that might be the first thing which is coming up later.”

Of course, until an exclusively DLT trading facility is up and running, it’s difficult to know if the licenses will need to be amended to account for how it plays out in practice. However, while there might not yet be any uniquely DLT trading facilities, there are examples of existing platforms adapting to the new format.

In October last year, a three-way deal was announced between Berner Kantonalbank (BEKB), digital stock issuance startup daura, and the SIX Digital Exchange (SDX).

BEKB, which is 51.5% owned by the Kanton of Bern, has become a member of the blockchain-based Central Securities Depository (CSD) operated by SDX. The combination of the three firms enables the issuance, trading, and custody of tokenized stocks or ‘security token.’

“By integrating the central securities depository (CSD), we enable bank custody of such shares for a broad public,” said Armin Brun, CEO of BEKB. “SMEs in particular will benefit from this, as they will be able to issue their shares digitally from now on and thus appeal to a broader investor base.”

Peter Schnürer, daura CEO, echoed these sentiments:

“With this partnership, we enable Swiss SMEs to connect their share register directly to the Swiss financial infrastructure… This allows shares to be booked directly into investors’ accounts with custodians and traded at the push of a button on a marketplace.”

This could become increasingly common as time passes, with existing digital assets and traditional exchanges/venues adapting to facilitate DLT security trading. While uptake might be more gradual or cautious than anticipated in certain areas, in terms of major problems, Balzli suggests the DLT Act has been very smooth sailing so far.

“I’m not aware of any notable litigations or court actions going on currently based on any aspects of the DLT act,” says Balzli. “No particular hiccups or issues with those parts of the law which were amended by the DLT act.”

This is an encouraging start for the forward-thinking DLT Act and perhaps one that has not gone unnoticed by international peers.

European approach and pilot DLT regime

In April, the EU’s sweeping Markets in Crypto-Assets Regulation (MiCA) legislation was passed by the European Parliament. When it comes into force, likely in early 2024, it will bring with it a licensing regime for crypto-asset service providers, such as exchanges and wallet providers, and rules for a range of assets, including ‘security tokens,’ that cover transparency, disclosure, authorization and supervision of transactions.

As part of its digital decade policy program, the EU also launched a DLT Pilot Regime on March 23, which aimed at boosting the development of market infrastructure for digital securities and helping EU regulators decide what changes to the regulatory framework might benefit DLT financial instruments. Specifically, the pilot regime seeks to fill the gaps in the Central Securities Depositories Regulation (CSDR) and the Markets in Financial Instruments Regulation (MiFIR), which in their current state do not account for the transparency and data reporting requirements of securities issued, traded, and recorded on DLT.

The DLT Pilot Regime is a regulatory sandbox. Interested market participants must apply for a specific license under the DLT Pilot Regime to operate as a DLT market infrastructure. This license may exempt them from certain obligations in the existing EU market infrastructure regulations while imposing obligations under the DLT Pilot Regime to manage associated risks.

“The proposal aims to allow for experimentation through derogations for the use of DLT in the trading and post-trading of crypto-assets that qualify as financial instruments, where existing legislation precludes or limits their use,” stated the EU’s proposal for the pilot. “Through the introduction of a common EU pilot regime for the experimentation of DLT market infrastructures, firms within the EU would be able to exploit the full potential of the existing framework, allowing supervisors and legislators to identify obstacles in the regulation, while regulators and firms themselves gain valuable knowledge about the application of DLT.”

The scope of the DLT Pilot Regime encompasses ‘DLT financial instruments,’ such as stocks, bonds, and fund units managed through DLT for issuance, recording, transfer, and storage. It is aimed at enabling direct trading access to a broader range of participants.

Combined with MiCA, the EU’s DLT Pilot regime provides a comprehensive framework focused on blockchain and DLT. In contrast, Balzli says of the DLT Act: “It just fits in elements where necessary, and that also means that given that it fit into the existing law, the law still continues to be relevant, practices are already good… the Swiss approach is in my view, lean, pragmatic and easier to handle.”

The suggestion is that while the EU has gone down the route of bringing in a complete regime specifically aimed at digital assets and blockchain technology, Switzerland has looked to adapt existing well-functioning rules to include new technologies—if it ain’t broke don’t fix it, amend it.

This is the approach also favored by the United Kingdom.

UK mirrors Switzerland

Taking a leaf out of the Swiss book, the United Kingdom has gone down the route of adapting and amending existing financial sector laws to include new technologies.

To this end, the Financial Services and Markets Act (FSMA) received Royal assent from King Charles on June 29. The FSMA extended the banking rules of the previous FSMA iteration to stablecoins and digital assets, covering any form of value representation, including digital or physical securities.

The FSMA update gives U.K. regulators, namely the Financial Conduct Authority and the Prudential Regulation Authority, the powers they need to implement the rules on which the U.K. Treasury began consulting in February, making it the first step towards a digital asset framework.

The February consultation laid out plans to wrap digital asset activity into existing financial regulation and included establishing an issuance and disclosure regime tailored to digital assets, strengthening the rules that apply to financial intermediaries and custodians of digital assets, and adopting a bespoke, digital asset-specific market abuse regime.

The updated U.K. rules bring DLT and blockchain, such as DLT securities and digital assets, into a financial regulatory regime with AML and KYC requirements comparable to those in the Swiss system.

Under the FSMA, the Treasury was also granted powers to establish financial market infrastructure (FMI) sandboxes and to experiment with new technologies or practices in a way that would inform changes to law and regulation.

In July 2023, the Treasury began consulting on the framework for its first FMI sandbox, the ‘Digital Securities Sandbox’ (DSS). The DSS consultation set out how institutions would be able to apply to establish and operate digital securities depositories and/or trading venues under a modified temporary legislative framework, which could potentially become permanent.

The activities proposed to be in the scope of the DSS were the operation of a trading venue notary, and settlement and maintenance services, in other words, those functions currently performed by central securities depositories. This lays the groundwork for a U.K. equivalent of the Swiss digital security trading facility.

The DSS is intended to run for five years, with the possibility of extension, and the U.K. Treasury intends for temporary modifications to be made permanent. So, eventually, the landscape for DLT and blockchain in the U.K. could look very much like the current Swiss situation.

There is, however, a third option, outside of sweeping landmark regulatory regimes or targeted incremental changes to existing laws— the U.S. approach.

If Balzli was describing the current Swiss system as “lean,” then the U.S. is barebones at best.

The US quagmire

The U.S. does not currently have specific regulations exclusively focused on DLT securities, DLT trading facilities, or digital assets, with existing securities and commodities regulations, overseen by the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) respectively, being applied to the blockchain space.

An example is the current furor around the definition of ‘security,’ as applied by the SEC to digital assets, some suggesting it’s a jurisdictional overreach from the SEC, stifling innovation, while others claim it’s a fair application of current financial regulations in the United States.

Several blockchain bills are working their way through Congress that would help to clarify the position of certain assets and firms, such as the Financial Innovation and Technology (FIT) for the 21st Century Act and the Blockchain Regulatory Certainty Act, both of which aim to provide clarity over definitions and governance of the space—including what constitutes a security and a ‘money transmitter.’

Assuming the bills pass, they might not come into force until 2025. In the intervening period, the U.S. will continue to lag behind international peers, the EU, U.K., and Switzerland, in clarity for DLT and blockchain technology in the financial sector.

Swiss haven

In contrast to the litigious minefield the U.S. currently finds itself in, Switzerland’s holistic approach to digital asset, blockchain, and DLT legislation ensures that the legal framework remains adaptable in the face of rapidly evolving innovations.

“Purely from the Swiss internal perspective, it is a good ecosystem, it’s excellent regulation,” says Balzli. “Even foreign issuers can choose to issue securities under Swiss law under certain circumstances, and I can tell you that there are already examples out there where this is being done. Foreign companies explicitly choosing Swiss law for issuing their security tokens. That already shows quite clearly there is a successful relationship.”

By addressing key areas such as digital asset custody, DLT securities, and inclusive DLT trading, the Act has opened up fresh avenues for financial institutions, intermediaries, and individuals to explore new business prospects and laid the legal foundation for the trading and issuance of rights represented through tokens.

At its core, the DLT Act appears to have also succeeded in giving some level of legal certainty to participants in the market—activity in the area from traditional finance players speaks to this—while bolstering the country’s standing as a financial hub and, potentially in the future, a digital asset hub.

While it’s still early days in the life of the Swiss DLT Act, at the very least, it could be said that it demonstrates the country’s interest in adapting its legal framework to accommodate advancements in technology and financial innovation.

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