Tokenized securities and blockchain: Opportunities of the DLT Pilot Regime

On 2 June 2022, Regulation (EU) 2022/858 of the European Parliament and of the Council of 30 May 2022 on a pilot regime for market infrastructures based on distributed ledger technology (the DLT Pilot Regime) was officially published in the EU Official Journal.

The DLT Pilot Regime is an innovative piece of European financial services legislation introducing a European regulatory sandbox. It aims to allow experimentation in the financial services sector through derogations to Directive 2014/65/EU of 15 May 2014 on markets in financial instruments¹ (MiFID II) and Regulation 909/2014 of 23 July 2014 on central securities depositories2 (CSDR) for the use of distributed ledger technology (DLT) in the trading and post-trading of crypto-assets that qualify as financial instruments (tokenized securities or security tokens) where existing legislation might preclude or limit their use.

The goal is also to facilitate the development of a secondary market for crypto-assets qualifying as financial instruments. In addition, the DLT Pilot Regime would allow for real use cases and help build the necessary experience and evidence on which a permanent EU regulatory regime could be inspired.

Effective in March 2023, the DLT Pilot Regime is in line with the European Commission’s Strategy on digital finance for the EU financial sector that aims to ensure the EU embraces the digital revolution and drives it with innovative European firms in the lead, making the benefits of digital finance available to European consumers and businesses.

1. Context and background

In early 2019, the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA) assessed that while most crypto-assets fall outside the scope of EU financial services legislation, several crypto-assets might fall under existing financial services regulations, such as MiFID II and Directive 2009/110 on electronic money institutions³ (EMD II). However, in those cases, the EBA and ESMA also found that effectively applying this regulatory framework to crypto-assets was not always straightforward.

In September 2020 the European Commission adopted the Digital Finance Package, a comprehensive package of measures that aims to further enable and support the potential of digital finance in terms of innovation and competition while mitigating the risks. The Package contained the Proposal for the DLT Pilot Regime, along with the proposal for a regulation on markets in crypto-assets (the MiCA Proposal) and the proposal for digital operational resilience (the DORA Proposal).

One of the Commission’s priorities in this respect was to ensure the EU financial services regulatory framework remains innovation-friendly and does not pose obstacles to the development and application of new technologies, such as DLT, which is expected to open up opportunities for efficiency improvements in the trading and post-trading processes.

2. DLT Pilot Regime: Moving towards secondary markets for tokenized financial instruments

The European Commission considered DLT as potentially transformative for financial markets but noted that this technology is only used in a limited way in the financial services sector, notably by market infrastructures, due to regulatory barriers to its use and lack of legal certainty. It therefore introduced this European regulatory sandbox to allow for targeted exemptions from certain provisions of MiFID II and CSDR, since these regulations were not drafted envisaging the development of DLT and crypto-assets on financial markets. And some of their provisions may, in practice, restrict or even prevent the use of DLT in financial markets.

DLT Market Infrastructures

The DLT Pilot Regime introduces harmonized requirements for market participants (investment firms, market operators or central securities depositories (CSDs)) who wish to apply for authorization to establish a DLT Market Infrastructure, a new status encompassing three new types of entities:

• DLT Multilateral Trading Facilities (DLT MTFs)
• DLT Settlement Systems
• DLT Trading and Settlement Systems

DLT Financial Instruments and tokenization

This new regulation concerns the admission to trading and recording on a DLT market infrastructure of DLT financial instruments, ie financial instruments issued, registered, transferred and stored using distributed ledger technology, such as blockchain.

As such, the DLT Pilot Regime amends the definition of “financial instruments” under MiFID II to provide that financial instruments (such as stocks, bonds and units of investment funds) can also be issued by means of distributed ledger technology. In other words, this is the legal inclusion of security tokens in the scope of MiFID II.

Authorization

Markets participants wishing to operate a DLT Multilateral Trading System, a DLT Settlement System or a DLT Trading and Settlement System will need to apply to the competent authority to obtain a specific authorization from the competent authority. This request will contain information like the applicant's business plan, a description of the functioning of the distributed ledger technology operated, and, if applicable, a description of the arrangements put in place for the safekeeping of clients' DLT financial instruments.

Permissions granted under the DLT Pilot Regime would allow market participants to operate a DLT market infrastructure and to provide their services across all Member States.

Exemption regime

The DLT Pilot Regime offers the possibility for DLT market infrastructures to benefit from certain temporary exemptions from the regulatory requirements normally applying to traditional market infrastructures.

The granting of these exemptions is, however, subject to compliance with specific requirements for each type of exemption, additional general requirements to address new forms of risk that may be posed by the use of DLT, and any other compensatory measures imposed by the supervisory authority.

Market infrastructures will also have to demonstrate to the supervisory authority that the exemptions requested are proportionate and justified by the use of DLT, and that they are limited to this use and do not extend, where applicable, to any other MTF operated by the same investment firm or to another securities settlement system operated by the same CSD.

Above all, the application for authorization will indicate the exemptions the applicant wishes to benefit from. The applicant will have to justify each exemption requested and specify whether it intends to adopt compensatory measures and by what means it intends to comply with the conditions attached to these exemptions.

• DLT for Multilateral Trading Facilities

The DLT Pilot Regime allows DLT MTF operators to apply to their regulator for an exemption from the intermediation requirement for access to regulated markets under MiFID II to provide direct access to retail investors and to allow them to trade on their own account, subject to compliance with certain conditions.

In addition, operators of MTF DLTs may also benefit from an exemption from MiFIR transaction reporting requirements, provided that the MTF DLT meets certain conditions.

• DLT for Settlement Systems

The DLT Pilot Regime also allows CSDs operating a DLT Settlement System to request certain exemptions imposed by the CSDR, subject to compliance with certain conditions.

As in the case of DLT MTFs, it provides for an exemption from the intermediation requirement by allowing CSDs operating a DLT Settlement System to admit as participants natural or legal persons who meet certain conditions, allowing retail investors to have direct access to settlement and delivery systems.

In addition, the DLT Pilot Regime also provides for other exemptions from the requirements set forth in the CSDR; for example, requirements in relation to securities accounts that provide for book entry of financial instruments in dematerialized form, to allow for the registration of DLT financial instruments in a distributed ledger, in the event that the use of book entry is incompatible with the use of DLT, subject to the adoption of countervailing measures.

3. Next steps

The DLT Pilot Regime will apply from March 2023 for a maximum of six years.

The European Commission expects firms in the EU to exploit the full potential of this new framework, and on the other hand supervisors and legislators to identify obstacles in the regulation, while regulators and firms gain valuable knowledge about the application of DLT.

By 2026, ESMA will prepare a detailed report on the functioning of the DLT Pilot Regime, based on which the European Commission will determine its future, such as its extension, its enlargement to other asset classes, the end of the regime or the adoption of European legislation to generalize the use of DLT.