DLT pilot regime: Securities trading on the blockchain

Another important building block on the way to realising the EU Digital Finance Strategy has been laid with the European DLT pilot regime. Within so-called “regulatory sandboxes”, market infrastructures based on DLT can operate with a special authorisation.

On 2 June 2022, the final version of the Regulation on a pilot regime for market infrastructures based on distributed ledger technology ((EU) 2022/858 – known as the DLT pilot regime or the DLT Regulation) was published after a legislative process lasting two years.

The European Securities and Markets Authority (ESMA) published its report on the DLT pilot regime on 27 September 2022 (ESMA70-460-111). The report contains guidelines on certain technical elements and recommendations on revised supervisory data to ensure consistent application by DLT market infrastructures from the date of application of the DLT pilot regime.

The DLT pilot regime is embedded in the EU Commission’s Digital Finance Package of September 2020, which aims to create a competitive market within the EU’s financial sector that provides consumers with secure access to innovative financial products. Other measures in the package include the Markets in Crypto-Assets Regulation (MiCAR), the final draft of which has only recently been adopted (see our blog post on this).

On 23 March 2023, the DLT pilot regime will enter into force and will apply for an initial period of three years. Based on an evaluation of the DLT market infrastructures, as well as a report by ESMA and the Commission, a decision will be made on an extension of up to three further years and, if necessary, adjustments/changes/extensions to it.

Creation of a secondary market for crypto assets – Scope of crypto assets

Distributed ledger technology (for example, blockchain) has been on the rise in the financial industry for several years. The technology has the potential to fundamentally change the financial industry and can create new and more efficient processes in securities settlement and payment transactions.

With the German Electronic Securities Act (Gesetz über elektronische Wertpapiere – eWpG), crypto securities have experienced (civil) regulation in Germany for the first time. For crypto securities, an electronic register is maintained as a system of record in the form of a decentralised (such as DLT-based) database.

The DLT pilot regime is intended to exploit the potential of DLT as a financial market infrastructure at the European level. The focus is on creating a reliable and secure secondary market for crypto assets that are financial instruments within the meaning of the European Markets in Financial Instruments Regulation (MiFID II) – for example, securities. The scope of the DLT pilot regime covers these crypto assets.

Cryptocurrencies such as Bitcoin or Ether are not subject to the DLT Regulation.

Further restrictions regarding the scope result from the value of the financial instruments. For example, the issuer of shares must have a market capitalisation or an anticipated market capitalisation of less than €500 million. The issue volume of bonds or other forms of securitised debt must be less than €1 billion.

Units in an undertaking for collective investment in transferable securities (UCITS) fund fall within the scope only if the market value of the assets under management is less than €500 million. The total market value of the financial instruments booked in one DLT market infrastructure must not exceed the sum of €9 billion. Otherwise, the DLT market infrastructure must initiate a so-called transitional strategy governing its resolution.

The legislation envisages numerous advantages in the development of a secondary market for crypto assets covered by the DLT pilot regime, such as higher efficiency, greater transparency and increased competition in trading and settlement activities (recitals, para. 4); at the same time, it is also designed to close gaps in the existing regulation. The DLT pilot regime should be seen against this background.

Addressing difficulties of previous legal framework for DLT securities trading

Some regulations on securities trading in the EU from MiFID II and the Central Securities Depositories Regulation (CSDR) are still hindering the use of DLT in securities trading. The background to this is the book-entry of a central securities depository (CSD), which is necessary for traditional securities trading. In Germany, Clearstream Banking AG (CBF) is the only domestic CSD through which securities are booked for transfers.

The DLT pilot regime for DLT-based market infrastructures is intended to promote the development of the technology. To this end, temporary exemptions from some specific requirements that operators of these marketplaces would normally have to fulfil will apply. The DLT pilot regime is explicitly open to both established players and new market participants. Companies that are not already regulated as CSDs or investment firms can apply for a corresponding permit and at the same time for a special authorisation under the DLT pilot regime. The competent authority then does not examine whether the requirements for CSDs or investment firms are met, but whether the DLT market infrastructures are operated in accordance with the DLT pilot regime (in a “regulatory sandbox”).

Excursus: What are “regulatory sandboxes”?

“Regulatory sandboxes” are test fields limited in time and space in which innovative technologies and business models can be tested under real conditions. Often, innovative technologies and business models fall outside the applicable legal framework. This is because the innovations were not yet developed at the time the standards were enacted and therefore could not be taken into account. Under EU legislation the principle of technology neutrality applies. However, this does not exclude the possibility of including real-life conditions. Regulatory sandboxes use the regulatory leeway. They use experimental clauses and other flexibility instruments to be able to deviate from the existing legal framework. The focus is not only on promoting technical innovation, but also on looking at the adaptation of future legislation through the experience gained within the regulatory sandboxes.[1]

DLT market infrastructures

Financial market infrastructures are central elements of the financial system and connect different markets and participants. The DLT market infrastructure concept includes

• DLT multilateral trading facilities (DLT-MTF),

• DLT settlement systems (DLT-SS) and

• DLT trading and settlement systems (DLT-TSS).

1) A DLT-MTF is a multilateral trading facility operated by an investment firm or market operator authorised under MiFID II and granted specific authorisation under the DLT pilot regime. It is in principle subject to the regulatory requirements for a multilateral trading facility in MiFID II), but with exceptions. There is no obligation to report transactions (Art. 26 of Regulation (EU) No. 600/2014). However, the DLT-MTF keeps records of all trades executed through its systems. The records must contain all information referred to in Art. 26(3) of Regulation (EU) No 600/2014 that is relevant to the system used by the DLT-MTF and the member or participant executing the transaction. It shall also ensure that the competent authorities entitled to receive the data directly from the multilateral trading facility have direct and immediate access to that information. In order to have access to these records, the competent authority shall be admitted to the DLT-MTF as a participating regulatory observer.

2) A DLT-SS is a settlement system operated by an authorised CSD that has received specific authorisation under the DLT pilot regime. The DLT-SS is subject to the CSD Regulation (Regulation (EU) 909/2014), but again with exceptions. Thus, a CSD operating a DLT-SS has the possibility to apply for a time-limited exemption from the cash settlement rules of the CSD Regulation. Thus, it can develop innovative solutions under the pilot scheme by facilitating access to commercial bank money or the use of “e-money tokens”.

3) A DLT-TSS can take two forms. It is either a DLT-MTF combining the services provided by a DLT-MTF and a DLT-SS and operated by an investment firm or market operator that has received specific authorisation to operate a DLT-TSS under the DLT pilot regime. Or it may also be a DLT-SS combining the services provided by a DLT-MTF and a DLT-SS and operated by a CSD that has received specific authorisation to operate a DLT-TSS under the DLT pilot regime. It is subject to the requirements for MTFs and CSDs, but with exceptions. In particular, investment firms or other market operators may make extensive use of exemptions with regard to the CSD Regulation (for example, on settlement internalisation, CSD authorisation requirements and procedures, and organisational requirements in Art. 26 and Art. 27 of the CSD Regulation).

Additional requirements for DLT market infrastructures

The DLT pilot regime also imposes additional organisational requirements on the DLT market infrastructures (in addition to facilitations) with regard to the novelty of the technology (Art. 7 DLT Regulation). This is intended to ensure a close exchange between the competent authorities, ESMA and the DLT market infrastructures. The supervisory authorities shall prohibit the further exercise of the activity if the requirements are no longer met. The additional requirements include:

• Preparation of a clear and detailed business plan describing the services and activities to be provided, including a description of critical staff, technical aspects and use of the DLT, as well as prescribed information to members, participants, issuers and clients;

• Publication of up-to-date, clear and detailed written documentation setting out the rules under which the DLT market infrastructures are to be operated and under which operators are to act, including the associated legal terms setting out the rights, obligations, responsibilities and liabilities of the operator of the DLT market infrastructures and of the members, participants, issuers and clients using their respective DLT market infrastructures;

• Operators of DLT market infrastructures to establish or document, as appropriate, rules on the functioning of the distributed ledger technology they use, including rules on accessing the distributed ledger, on the participation of the validating nodes, on addressing potential conflicts of interests, and on risk management including any mitigation measures to ensure investor protection, market integrity and financial stability;

• Operators of DLT market infrastructures to provide their members, participants, issuers and clients with clear and unambiguous information on their website regarding how the operators carry out their functions, services and activities and how their performance of those functions, services and activities deviates from those performed by a multilateral trading facility or securities settlement system that is not based on distributed ledger technology. That information shall include the type of distributed ledger technology used;

• DLT market infrastructure operators to ensure that the overall IT and cyber structures related to the use of their distributed ledger technology are appropriate to the nature, scale and complexity of their business. Those arrangements shall ensure the continuity and ongoing transparency, availability, reliability and security of their services and activities, including the reliability of smart contracts used in the DLT market infrastructure. Those arrangements shall also ensure the integrity, security and confidentiality of the data stored by those operators and ensure that that data is available and accessible;

• Where an operator of a DLT market infrastructure ensures the safekeeping of members’, participants’, issuers’ or clients’ funds, collateral or DLT financial instruments and ensures the means of access to such assets, including in the form of cryptographic keys, that operator shall have adequate arrangements in place to prevent the use of those assets on the operator’s own account without the prior express written consent of the member, participant, issuer, or client concerned, which may be made through electronic means;

• Operators of a DLT market infrastructure shall maintain safe, accurate, reliable and retrievable records of the funds, collateral and DLT financial instruments held by their DLT market infrastructure for their members, participants, issuers or clients as well as of the means of access to those funds, collateral and DLT financial instruments;

• Operators of a DLT market infrastructure shall segregate the funds, collateral and DLT financial instruments of the members, participants, issuers or clients using the DLT market infrastructure and the means of access to such assets from those of the operator as well as from those of other members, participants, issuers and clients;

• IT and cyber arrangements ensure that the funds, collateral and DLT financial instruments held by a DLT market infrastructure on behalf of its members, participants, issuers or clients, as well as the means of access to them, are protected against the risks of unauthorised access, hacking, degradation, loss, cyber-attack, theft, fraud, negligence and other serious operational malfunctions;

• Operators of a DLT market infrastructure to establish and make publicly available a clear and detailed strategy for reducing the activity of a particular DLT market infrastructure or for transitioning out of, or ceasing to operate, a particular DLT market infrastructure, including the transition or reversion of their distributed ledger technology operations to traditional market infrastructures.

An opportunity (also) for non-regulated companies

The DLT pilot regime addresses already regulated companies such as CSDs, investment firms or market operators. They can operate DLT market infrastructures under certain facilitations (but also with the additional requirements of the regulation).

Investment firms do not have to be MTF operators; other licences (such as a mere investment brokerage licence) are also sufficient to apply for a licence under the DLT pilot regime. It also enables previously unregulated companies in the DLT industry an (easier) path to becoming a regulated market infrastructure operator. A company can apply for a corresponding MiFID II licence as an investment firm from the respective competent supervisory authority using the DLT pilot regime. For such companies, both the permission for a DLT-MTF and a DLT-TSS can be considered.

The DLT-SS (without additional DLT-MTF) is only open to CSDs.

ESMA’s recently published Annual Work Programme 2023 contained the announcement that “Guidelines on the templates for permission under the DLT pilot regime” would be published.

[1] cf. German Federal Ministry for Economic Affairs and Energy: Freiräume für Innovationen – Das Handbuch für Reallabore, section 3, as of July 2019.