DLT Pilot Regime, a European sandbox for market infrastructures

Overview

Since the arrival of Bitcoin 15 years ago, the growth of crypto assets has been unstoppable. With a significant impact on the financial sector, we have seen the emergence of multiple companies offering services for the issuance, custody, trading, and settlement of operations involving so-called “security tokens.” All these services have been based on the increasing development of decentralized ledger technologies, or DLT. However, there is still a certain level of fear within the sector due to being a very new and lightly regulated industry. To mitigate some of these concerns, the DLT Pilot Regime has been introduced in Europe.

The DLT Pilot Regime doesn’t replace other regulations on crypto assets such as MiCA or DORA; instead, it complements them. In essence, it aims to address the current lack of regulation concerning these assets, hindering the proper development of the sector. This way, companies can benefit from a more comprehensive legal framework to conduct their activities.

What is the DLT Pilot Regime?

The DLT Pilot Regime is a testing environment, commonly known as a “sandbox,” designed to foster the development of financial services based on decentralized ledger technologies (DLT). Companies participating in this pilot regime are exempt from complying with certain requirements set for the traditional financial industry, with a particular focus on financial market infrastructures.

The primary goal is to reduce the legal requirements for providing certain services, thereby encouraging innovation and experimentation in this field. At the same time, it aims to maintain market stability and investor protection. After the initial three-year duration, the plan is to produce a report by the European Securities and Markets Authority (ESMA) to the European Commission. This report will be used to decide on the potential extension of the regime (up to three more years), its modification, cancellation, or even its conversion into a permanent regime with appropriate modifications.

Which Entities Can Benefit?

As this is a space directed at securities markets, the benefiting companies are always infrastructures of such markets. However, not all infrastructures can join the pilot regime. In fact, the DLT Pilot Regime defines a new concept, which is “DLT-based Market Infrastructures.” Specifically, the entities considered are:

  1. DLT-based Multilateral Trading Facilities (MTFs): These are MTFs that only admit the trading of security tokens. They must be managed either by an Investment Firm (IF) or by an authorized market governing body under MiFID II.
  2. DLT-based Settlement System (SS): These entities settle transactions involving security tokens against payment or delivery, allowing both the initial registration and the provision of custody services. These systems must be managed by Central Securities Depositories (CSDs) authorized as such under the corresponding European Regulation.
  3. DLT-based Trading and Settlement Systems (TSSs): These systems combine services offered by both types of infrastructures. They must be managed either by an IF (or a market governing body) or by an authorized CSD.

Infrastructures falling into any of the above categories can apply for membership in the pilot regime. Under this regime, the competent authority may grant certain exemptions, which will be discussed later. In any case, these exemptions will always be subject to the approval of the competent authority after undergoing an authorization process.

Which Financial Instruments Are Affected?

As it is a pilot regime that must be delimited, evaluated, and, if necessary, modified, only three types of financial instruments that may be issued/traded/settled by these market infrastructures have been defined. This way, the integrity and stability of the financial markets are preserved during the pilot regime. The instruments are as follows:

  1. Shares of issuers with a market capitalization of less than 500 million euros.
  2. Bonds and obligations, other forms of securitized debt with an issuance volume of less than 1,000 million euros. This calculation excludes bonds from companies with a market capitalization of less than 200 million euros at the time of issuance.
  3. Shares of harmonized UCITS (Undertakings for Collective Investment in Transferable Securities) whose managed assets have a market value of less than 500 million euros.

The pilot regime, therefore, allows for the creation of a complete secondary market for these crypto assets. This market can benefit from the guarantee and support of European authorities, as well as a high level of innovation. Additionally, by doing so, it strikes a balance between fostering innovation and ensuring financial stability.

Exemption Regime

In the exemption section of the DLT Pilot Regime, exemptions differ depending on the type of infrastructure in question. It’s worth noting that access to this pilot regime is not limited to already authorized entities but should admit new participants. However, these participants can only manage DLT-based infrastructures under the pilot regime, and their authorization will expire once it concludes, unless they apply for full authorization. Let’s explore the exemptions for each of the DLT-based market infrastructures:

Exemptions for MTF (Multilateral Trading Facility)

An MTF based on DLT, managed by an Investment Firm (ESI) or by a Market Operator with the corresponding authorization, can request an exemption from:

  1. The obligation of intermediation, and therefore the admission of natural and legal persons to trade on their own account as members or participants.
  2. Transaction reporting requirements under MiFIR (Markets in Financial Instruments Regulation).
  3. The application of Article 3.2 of the CSDR (Central Securities Depository Regulation). Thus, securities can be registered in the MTF itself and not necessarily in a Central Securities Depository (CSD).

Exemptions for DLT-based Settlement Systems (SS)

DLT-based Settlement Systems can request the following exemptions:

  • DLT-based Settlement Systems can request the following exemptions from the rules applicable to CSD (Central Securities Depository) that mention the terms “dematerialized form,” “securities account,” or “transfer orders.” This can be requested under the following conditions:
    • The use of a securities account or entries in an account is incompatible with the use of DLT.
    • Guaranteeing the use of a decentralized ledger, the integrity of issuance, and the ability to segregate financial instruments belonging to different participants.
    • Not allowing uncovered positions in securities.
  • The obligation to establish procedures to prevent and address settlement failures.
  • The requirement for authorization to outsource basic services when incompatible with the use of DLT.
  • The obligation of intermediation and, therefore, the admission of natural and legal persons as participants.
  • Requirements for participant access to the SS and communication procedures between CSDs and participants and other market infrastructures, as well as certain transparency requirements under certain conditions.
  • Rules on settlement finality, provided that real-time settlement is guaranteed.
  • Rules on cash settlement, provided that the CSD performs settlement according to the delivery-versus-payment mechanism.
  • The obligation for a CSD, when managing a DLT-based SS, to provide access to another CSD or market infrastructure when the use of DLT is incompatible with legacy systems or when granting access with such systems is disproportionate.

Relation to Other Regulations

Like any other pan-European regulation, its integration with other regulations is crucial. In the case of the DLT Pilot Regime, it is more of an exemption regime than a regulation itself. However, its integration into the current legal framework is equally important.

On the one hand, it involves finding a fit between this regime and existing regulations, especially MiFID and MiFIR. On the other hand, as it directly impacts several market infrastructures, these infrastructures must be prepared to apply for authorizations and exemptions where necessary.

Additionally, whenever personal data is involved, the General Data Protection Regulation (GDPR) comes into play. Furthermore, we must not forget that there are approved regulations that will be applicable in the future, especially MiCA, whose relationship with the DLT Pilot Regime is crucial. Therefore, once the trial period is over, the decision made will have a significant impact on the EU legal framework regarding market infrastructures and financial instruments.

Conclusion

The DLT Pilot Regime allows for the exemption of certain obligations for market infrastructures based on DLT. These exemptions aim to maintain innovation and investment in these technologies while ensuring a minimum of requirements to guarantee the integrity and stability of the overall EU capital markets.

A series of participants and instruments subject to this regime have been defined to limit its scope. With this regime, and after the corresponding evaluation period, it will be possible to determine the extent to which the regulation of crypto assets is sufficient in the EU. For the entities affected, it is clear that this regime represents an opportunity to continue innovating under the legal framework provided by current regulations.

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