Pilot Regime for use of Distributed Ledger Technology in Capital Market Infrastructures

Scope of the DLTR

The DLTR applies to what may be commonly referred to as crypto-assets, crypto-securities, or tokenised securities. The DLTR defines such as a “DLT financial instrument” being a financial instrument that is issued, recorded, transferred, and stored using DLT (8). A DLT is an information repository that keeps records of transactions and that is shared across, and synchronised between, a set of DLT network nodes using a consensus mechanism (9). The term financial instrument is derived from the definition in MiFID II (10). However, the DLTR limits the scope of the financial instruments which can be trading or recorded on a DLT MI to shares, bonds (and other securitised debt) and units in collective investment undertakings (11).

Consequently, a DLT financial instrument for the purpose of the DLTR is a share, bond or unit in a collective investment undertaking that is issued, recorded, transferred and stored using DLT. The ISIN of the DLT financial instruments should, as a general rule, be the same as the “traditional” financial instrument (12). Notwithstanding the definition of a DLT financial instrument, which seems to imply that only newly issued shares are covered by the definition (financial instruments that are “(…) issued”), the ESMA Q&A seems to imply that already existing “traditional” financial instruments can be digitally represented as a DLT financial instrument. 

Provisions on market abuse, insider trading and public offerings and admittance to trading also apply to DLT financial instruments.

New Market Participants

The DLTR introduces three new types of market infrastructures: 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 authorised under MiFID II which has also received specific permission under the DLTR on which DLT financial instruments can be traded (13);
2.  A DLT SS is a settlement system operated by a central securities depository (“CSD”) authorised under Regulation (EU) 909/2014 (“CSDR”) that settles transactions in DLT financial instrument against payment or delivery and differs from the existing settlement system by being compatible with the technological basis of DLT financial instruments (14); and
3. A DLT TSS is either a DLT MTF or a DLT SS that combines services performed by a DLT MTF and a DLT SS (15).

The specific requirements for operating a DLT MTF, a DLT SS and a DLT TSS are set out in Articles 4-6 and 8-10 of the DLTR. As stated above, to operate a DLT MTF and DLT SS, the operator must already hold a license as an MTF or CSD, respectively, and the pilot regime is consequently only available to entities already licensed under existing regulations. 

Importantly, however, the DLTR allows MTF’s and CSD’s to apply for exemptions applicable to MTF’s and CSD’s pertaining to the operation of the DLT MI to the extent it is proportionate to, and justified by, the use of distributed ledger technology. These include:

1. DLT MTFs to be exempt from the obligation to report transactions on a daily basis (16);
2.     DLT SSs to be exempt from various requirements relating to CSDs, importantly the requirement for transferable listed securities to be issued and recorded in bookentry form in the CSD (17), the requirements regarding settlement finality (18); and
3. he option for a DLT SS to settle securities transactions in cash payments through accounts opened with a central bank of issue of the relevant currency where practical and available (19) (this means that DvP settlement of securities transactions on DLT SSs may be done with tokenised cash instead of central bank money, i.e., settlement may occur with a digital currency referencing a single fiat currency instead of with central bank money).

The status of DLT MIs is optional and does not prevent financial market infrastructures, such as trading venues, CSDs and central counterparties from developing trading and post-trading services and activities for DLT financial instruments that qualify as financial instruments or are based on DLT (20)

An operator of a DLT MI must additionally fulfill the requirements listed in the DLTR Article 7 and 8, which includes high-level requirements for the operator’s business plan, description of how the DLT functions, overall IT and cyber arrangements, safe-keeping arrangements for clients’ DLT financial instruments, arrangement for ensuring investor protection, and mechanisms for handling client complaints and redress, and evidence of sufficient prudential safeguards to meet its liabilities and to compensate its clients.

Outlook

Some market participants have already issued DLT securities in the EU in “sandbox”-testing environments, such as EIB (21) and Santander (22). The technology is, however, still in its nascent state with respect to the issuance and settlement of trades in financial instruments and certain barriers to scale the technology still exist, such as the potential large power consumption required to operate DLT networks. The Pilot Regime is an important step on the way to creating more efficient securities trading and settlement systems by providing market participants with better regulatory frames for innovating. It opens the possibility for incumbent and new market participants to develop and offer solutions that will contribute to, among other, reducing the settlement time lag, such as the Project Ion does in the US (23).

Link to the DLTR can be accessed here, the ESMA Guidelines here, and the ESMA Q&A here.