The EU’s pilot regime for market infrastructures based on distributed ledger technology has now been finalised. The regime will provide significant flexibility for eligible firms to experiment with DLT-based trading facilities and settlement systems for financial instruments, including the option of operating a combined trading and settlement facility. There are, limitations to consider, however, including uncertainty as to whether infrastructure developed under the regime will be permitted to live on long-term. Meanwhile, the UK is working on developing its own financial market infrastructure sandbox.
What is the DLT Pilot Regime?
The EU’s pilot regime for market infrastructures based on distributed ledger technology has now been finalised through a Regulation published in the EU’s Official Journal. The regime is effectively a regulatory sandbox. It allows eligible firms to apply to operate a DLT-based trading facility and/or settlement system for financial instruments, within a flexible regulatory environment. Broadly, the idea is to facilitate the development of secondary market infrastructure for digital securities (including both “tokenised” securities and digitally native securities), and to help inform EU regulators as to what (if any) permanent changes to the regulatory framework would be beneficial.
Applications can be submitted from 23 March 2023. Permissions will be granted for a period of up to six years (and will only be valid during the life of the pilot regime). By March 2026, the European Securities and Markets Authority (ESMA) will report on the success of the regime and recommend next steps (including whether to make any elements of the pilot regime permanent, by amending the general regulatory framework).
The final Regulation has evolved from the Commission’s initial proposal. The key features of the final version are summarised below.
- Authorised investment firms and market operators may apply to operate a DLT multilateral trading facility (DLT MTF)
- Authorised central securities depositories may apply to operate a DLT securities settlement system (DLT SS)
- Both groups may apply to operate a combined DLT trading and settlement system (DLT TSS)
- New entrants may apply for temporary authorisations as investment firms / market operators or CSDs, alongside an application under the pilot regime
- Applications are to be made to relevant national authorities
- National authorities are required to consult with (and in some cases have regard to a non-binding opinion from) ESMA, as part of their decision-making process
- Applications must indicate which regulatory exemptions the applicant is requesting
Exemptions from general regulation
- Broadly, operators will be subject to regulations applicable to the equivalent traditional market infrastructures, subject to the requested exemptions
- DLT TSSs (which have no traditional equivalent) are subject to rules applicable to both DLT MTFs and DLT SSs, with a few exceptions, primarily to avoid overlap
- Exemptions may be requested from certain specified requirements under the general regulatory framework, where those requirements are incompatible with the proposed DLT use case
- Each exemption granted will be subject to certain attached conditions, with which the operator must comply
- Among other things, exemptions may allow for models which provide direct access to retail investors, settlement in commercial bank money (as opposed to central bank money) and CSD-operated settlement systems which are not designated under the Settlement Finality Directive
- Firms operating under the pilot regime will also be subject to additional requirements aimed at the risks associated with the novel technology and structures
- Among other things, operators will require a clear business plan, an appropriate legal rulebook, disclosures to stakeholders on how the offering differs from a traditional offering, robust arrangements around technology and the protection of client assets and a credible exit strategy, in case the pilot is discontinued
Eligible financial instruments
- The regime limits the types of financial instrument that may be admitted to trading / recorded on a DLT market infrastructure (for example, in relation to shares, the issuer must have a market capitalisation of less than EUR500m and in relation to bonds, the issue size must be less than EUR1bn)
- In addition, the total market value of financial instruments admitted to trading / recorded on a DLT market infrastructure must fall within an aggregate limit, set at EUR6bn
- National competent authorities may lower any of these thresholds
Under the general regulatory framework, transferable securities which are traded on trading venues are required to be recorded in a CSD. This requirement has previously acted as a barrier to innovative non-CSD entities developing some of the more streamlined market infrastructure models which distributed ledger technologies would support. The pilot regime’s DLT TSS model will, for the first time, allow investment firms and market operators (as well as new entrants that apply for temporary authorisations) to provide settlement services in relation to securities which are traded on trading venues. This could potentially be a significant opportunity for new players to compete with CSDs on settlement services.
Equally, CSDs have not previously been authorised to offer trading facilities, and they too may look to explore the possibility of capturing new parts of the value chain through the DLT TSS model.
More broadly, firms now have the option of requesting exemptions to a number of requirements which have previously been identified in the market as potentially problematic for DLT-based systems. At least in theory, this should provide much more latitude for experimentation with innovative systems. The regime also gives firms the chance to help shape the future of EU financial services regulation.
Naturally, there are limitations to consider. For example:
- The threshold restrictions on eligible financial instruments will restrict the potential scale of projects (although it is helpful that the threshold levels have been increased significantly from the Commission’s initial proposal).
- Satisfying the conditions attached to exemptions as well as the additional requirements may not be straightforward in practice. In some cases, there may be considerable uncertainty as to how the requisite standards can be met.
- The uncertainty as to whether projects developed under the pilot will be permitted to live on beyond the permission period might inhibit some firms from committing significant investment up front.
For these reasons, it may be preferable for certain authorised firms to experiment with DLT-based innovation outside the pilot regime. Depending on the precise model, it may be possible to get comfortable that the arrangement is in fact compatible with the general regulatory framework, notwithstanding the use of DLT.
The UK is also aiming to have a “Financial Market Infrastructure Sandbox” in place by 2023. However, whereas draft legislation for the EU’s regime has been in circulation since 2020, most details of the UK’s sandbox remain unclear. The UK government is hoping to take advantage of its newfound law-making agility post-Brexit to streamline the process. It is expected to begin engaging with industry and regulators on the detail over the coming months.