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24 April 20235 minute read

Tokenization of financial instruments and the new legal framework in EU: the DLT Pilot Regime and ESMA guidelines

The European Union’s Regulation (EU) 2022/858 (the so-called DLT Pilot Regime) finally came into force on March 23, 2023, allowing market infrastructures to apply for authorization to trade tokenized financial instruments on distributed ledger technology (DLT) platforms in accordance with the provisions of the DLT Pilot Regime. In addition, earlier this month, the European Securities and Markets Authority (ESMA) issued its latest guidelines regarding the applications for the authorization to manage a market infrastructure based on DLT.

The DLT Pilot Regime is based on the EU’s interest in exploring, developing and promoting the adoption of transformative technologies in the financial sector, including the adoption of the DLT.

To enable the development of financial cryptoassets and DLTs while ensuring investor protection, market integrity, and financial stability, the DLT Pilot Regime allows certain market infrastructures to be temporarily exempted from specific financial legislation requirements.  This would facilitate the creation of solutions for both trading and settling transactions, with reference only to a limited number of financial instruments (such as shares or bonds). For these purposes, the functions typically performed by multilateral trading facilities and securities settlement systems are merged in the pilot regime's specialized market infrastructure based on distributed ledger technology, called DLT TSS.

The DLT Pilot Regime defines “tokenization of financial instruments” as a process that involves the conversion of traditional financial asset classes into digital tokens that can be stored, transferred and traded on distributed ledgers. This process is foreseen to revolutionize the financial sector by improving efficiency in the trading and post-trading processes. 

The adoption of tokenization has the potential to reduce costs and increase the speed of transactions. Moreover, the decentralized nature of distributed ledgers allows for more secure and transparent transactions and, since tokens can be designed to represent fractional ownership in the underlying asset, market accessibility would be increased. As a result, tokenization is expected to enhance market liquidity, reduce counterparty risk, and promote innovation in the financial sector. 

In addition, tokenization can take many forms, including the creation of digital representations of financial instruments on distributed ledgers or the issuance of traditional asset classes in tokenized form. 

The potential benefits of tokenization are not limited to the trading process; the use of smart contracts, which can be programmed to execute automatically upon the occurrence of specific events, can reduce the need for intermediaries in post-trading activities (ie, clearing and settlement).

Among the critical aspects of the provisions of the DLT Pilot Regime is the process it sets out to for authorization only by national authorities> It should particularly be noted that the application process for authorization to be admitted to the European experimental regime may require a non-binding opinion provided by ESMA. Overall, different access regimes and parameters may be established by each national authority, potentially resulting in uneven access to the regime across the member states.

Among the most significant developments: the requirements set out in the DLT Pilot Regime allow the admission of natural persons as members in the execution of transactions within DLT market infrastructures. In this regard, ESMA raised some questions during the Q&A process: for example, under Article 26(5) of MIFIR, trading venues must report to the competent authority all the information on transactions in traded financial instruments that were executed by a firm and not by a natural person. For this reason, ESMA suggested that national authorities should ask for compensative measures, such as adapting the template provided by the actual Regulatory Technical Standards (RTS 22) on the reporting of transactions to competent authorities and populating the relevant Legal Entity Identifier (LEI) section with the national ID of the relevant natural person executing the transaction. 

The most recent ESMA guidelines do not present any updates from those published in December last year. However, it is worth mentioning that the economic operators have highlighted some uncertainties in terms of (i) the clarity of the definition between DLT permissioned and permissionless; (ii) the definition of the institution of the so-called “transition strategy” provided for in Article 7(7) of the DLT Pilot Regime; and (iii) the clarity of the requirements provided for the access to market infrastructures by natural persons.

With respect to the above points, according to ESMA, a permissioned DLT grants more control in terms of admission to the network and performance of any action on the DLT, whereas, in a DLT permissionless environment, participants are free from reading data and interacting on the DLT. 

Secondly, according to ESMA, in order to be admitted as a natural person who may execute transactions within the DLT market infrastructure, the DLT Regime requires that natural person to prove good reputation and sufficient knowledge of the DLT. Such admission to transact as a natural person may therefore depend both on the possible presence of negative concerns, such as pending charges or warnings from regulatory authorities, and on the assessments carried out by the national authorities on the natural person’s technical skills (eg, previous experience in the field of tokenization or in DLT projects).