Blog: Portugal: DLT – theoretical possibilities hampered by practical legal limitations – International Financial Law Review

With financial innovation in the agenda, it
is becoming undeniable that decentralised financial technology (DLT) – of which
blockchain is a subtype – is the centre piece that will underpin, and drive
decentralised financial innovation as a truly transformativeand
foundational technology.

However, the pace and the extent to which
the technology can flourish in all its theoretical potential and practical deployment
relies heavily on the willingness of legislative powers to give statutory legal
effect to DLT-based solutions when warranted. The legal world will recognise
things and give them meaning in accordance with its own set of rules, which
means that certain operations will not have their desired legal effect if the
technology is not recognised by law to produce the intended legal outcomes.

For example, the potential to tokenise any
asset and have the rights to such an asset be represented on a DLT has now been
discussed at length, and while this is true in theory, it may not be possible
for a person to transfer certain objects in this way.

In jurisdictions where an object, such as
a real estate asset, can only be transferred by execution of a deed or other
public document and/or that require public registration of property rights, it
is not possible to legally transfer property over such kinds of assets through tokenised
instruments without an adjustment of the existing legal framework. The law will
not recognise the transaction as valid for this purpose and, while other
remedies may be available for the persons holding those tokens, they will not
be able to claim the asset or any fraction of the asset in court.

It should in any event be possible to tokenise
the economic interests in the asset which leads to the question of how those
claims would be structured, considering that the asset does not have legal
personality and cannot be a subject of rights and obligations vis-à-vis
potential investors. This will probably lead to the conclusion that some form
of special purpose vehicle (SPV) must be created depending on the alternatives
available in the relevant jurisdiction and will invariably attract the legal
regime applicable to such figure, whether or not it is desired by the technology
driven promoters. Furthermore, it will become necessary to assess the type of
instrument being created to represent the claims over the asset and the legal
framework applicable to it.

If the objective is to structure a
financial instrument or transferable securities, then in principle a whole lot
of regulation should come their way. However, there is no certainty or clarity on
how these rules would apply to these instruments, as they were created for a
completely different paradigm of banking and financial services and their
participants which is based upon centralisation. This is but one example from
the many that could be mentioned.

In any event, as can be seen from the
example, there are a number of legal constructions that are required to be put
in place to make the innovative project work from a legal perspective, that
would not be necessary from a purely technical and theoretical approach of the
technology being implemented. Therefore, it becomes difficult to navigate DLT
applications in the banking and financial system, if there is no real effort to
provide legal certainty to market participants that are eager to put their proofs
of concept into practice.

This effort should be two-fold to include
legislative intervention to ensure that there is a clear legal pathway for the
application of exemptions from existing rules and the granting of powers to
supervising and regulating entities to be able to determine the application of
those exemptions in practice. Otherwise, the line between legality and
illegality will be blurred in most instances deterring significant investment,
technology deployment and scalability of DLT solutions.

This is troublesome if one considers the potential
revolutionary impact of DLT to optimise areas of banking and finance such as
payments, clearance and settlement systems, fundraising, securities and
financial instruments, custody, loans and credit, trade finance, know your
customer (KYC), anti-money laundering, prevention of terrorist financing and

Surprisingly enough, while most EU countries have innovation hubs, only a handful have yet implemented regulatory sandboxes in which DLT solutions could be tested; and while the European Commission has presented its proposal for a regulation for a pilot regime for market infrastructures based on DLT, there is no certainty as to when the legislative process will conclude and the final text will be adopted, and even then the proposal foresees a five year experimental period before a definitive legal framework for DLT market infrastructures can be proposed by the European Commission.

Taking into consideration the importance of legal certainty as a base for the growth, implementation, and adoption of DLT-based solutions in banking and finance on a EU-wide level, and the challenges arising from international competition in this field by other countries, it is worth pondering if the EU and EU countries are not setting a pace that is too slow to answer the needs of this technology and the market participants’ expectations.

Mariana Albuquerque

Principal Associate, Morais Leitão

© 2021 Euromoney Institutional Investor PLC. For help please see our FAQs.

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