On June 2, 2022, Regulation (EU) 2022/858 of the European Parliament and of the Council of May 30, 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 that introduces a European regulatory sandbox. It aims to facilitate experiments in the financial services sector through exemptions from 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 use Distributed ledger technology (DLT) in trading and post-trading of crypto-assets that qualify as financial instruments (tokenized securities or security tokens) where existing legislation could exclude or limit their use.
It also aims to facilitate the development of a secondary market for crypto assets that qualify as financial instruments. In addition, the DLT pilot regime would enable real-world use cases and help build the necessary experience and evidence on which a permanent EU regulatory regime could be based.
The DLT pilot program, which will come into force in March 2023, is in line with the European Commission’s strategy on digital finance for the EU financial sector, which aims to ensure that the EU embraces the digital revolution and joins it with innovative European companies at the forefront to reap the benefits of digital finance for European consumers and businesses.
context and background
In early 2019, the European Banking Authority (EBA) and European Securities and Markets Authority (ESMA) determined that while most crypto assets fall outside the scope of EU financial services legislation, several crypto assets could fall under existing financial services regulations. such as MiFID II and Directive 2009/110 on electronic money institutions3 (EMD II). However, in these cases, the EBA and ESMA also found that applying this regulatory framework effectively to crypto assets was not always easy.
In September 2020, the European Commission adopted the Digital Finance Package, a comprehensive set of measures aimed at further enabling and supporting the potential of digital finance in terms of innovation and competition, while mitigating the risks. The package included the proposal for the DLT pilot regime, along with the proposal for a regulation on crypto asset markets (the MiCA proposal) and the digital operational resilience proposal (the DORA proposal).
One of the Commission’s priorities in this regard was to ensure that the EU regulatory framework for financial services remains innovation-friendly and does not pose barriers to the development and application of new technologies such as DLT, which are expected to open up opportunities for efficiency gains in trade and industry Post-Trade Processes.
DLT pilot regime: transition to secondary markets for tokenized financial instruments
The European Commission viewed DLT as potentially transformative for financial markets, but noted that the use of this technology in the financial services sector, particularly by market infrastructures, is limited due to regulatory barriers to its use and a lack of legal certainty. It has therefore implemented this European regulatory sandbox to allow targeted exemptions from certain provisions of MiFID II and CSDR as these regulations were not designed for the development of DLT and crypto assets in the financial markets. And some of their provisions may, in practice, limit 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)) wishing to apply for permission to build a DLT market infrastructure, a new status that includes three new types of entities:
- Multilateral DLT trading facilities (DLT MTFs)
- DLT billing systems
- DLT trading and settlement systems
DLT financial instruments and tokenization
This new regulation concerns the admission to trading and recording of DLT financial instruments on a DLT market infrastructure, i.e. financial instruments issued, registered, transmitted and stored using distributed ledger technology such as blockchain.
As such, the DLT pilot regime changes the definition of “financial instruments” under MiFID II to allow financial instruments (such as stocks, bonds and mutual fund shares) to also be issued using distributed ledger technology. In other words, it is about the legal inclusion of security tokens in the scope of MiFID II.
permit
Market participants wishing to operate a multilateral DLT trading facility, a DLT settlement facility or a DLT trading and settlement facility must submit an application to the Competent Authority to obtain specific approval from the Competent Authority. This request will contain information such as the applicant’s business plan, a description of how the distributed ledger technology operated will work and, if applicable, a description of the arrangements made for the custody of the clients’ DLT financial instruments.
Permissions granted under the DLT pilot regime would allow market participants to operate a DLT market infrastructure and offer their services in all Member States.
Exemption Rule
The DLT pilot regime offers the opportunity for DLT market infrastructures to benefit from certain temporary exemptions from the regulatory requirements that normally apply to traditional market infrastructures.
However, the granting of these exemptions is subject to compliance with specific requirements for each type of exemption, additional general requirements to address new forms of risk that may arise from the use of DLT, and any other compensatory measures imposed by the regulator.
Market infrastructures must also demonstrate to the regulator that the exemptions requested are proportionate and justified by the use of DLT and that they are limited to that use and, where appropriate, do not extend to other MTFs operated by the same investment firm or to another securities settlement system, operated by the same CSD.
Above all, the application for authorization specifies the exceptions from which the applicant wishes to benefit. The applicant must justify any exemption requested, indicating whether it intends to take compensatory measures and how it intends to meet the conditions attached to those exemptions.
- DLT for multilateral trading systems
The DLT pilot regime allows DLT-MTF operators to apply to their regulator for an exemption from the mediation requirement for access to regulated markets under MiFID II, to grant direct access to retail investors and allow them to trade on their own account, provided they the requirements meet certain conditions.
In addition, operators of MTF-DLTs can also benefit from an exemption from MiFIR transaction reporting obligations, 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 apply for certain exemptions imposed by the CSDR, subject to certain conditions being met.
As in the case of DLT MTFs, it provides an exemption from intermediation by allowing CSDs operating a DLT settlement system to admit natural or legal persons as participants that meet certain conditions, giving retail clients direct access to settlement and delivery systems is granted .
In addition, the DLT pilot regime also provides for other exceptions to the requirements set out in the CSDR; for example, requirements related to securities accounts that provide for ledger of financial instruments in dematerialized form to allow registration of DLT financial instruments in a distributed ledger, if the use of ledger with the use of DLT, subject to the adoption of compensatory measures.
Next Steps
The DLT pilot regime will apply from March 2023 for a maximum of six years.
The European Commission expects companies in the EU to realize the full potential of this new framework and, on the other hand, for regulators and legislators to identify barriers to regulation, while regulators and companies gain valuable insights into the use of DLT.
By 2026, ESMA will produce a detailed report on the functioning of the DLT pilot regime, on the basis of which the European Commission will decide on its future, such as whether to extend it, expand it to other asset classes, end the regime or adopt European legislation on it Generalization of the use of DLT.
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