artikel | 16 aug 2023

Blockchain Regulation in the Spotlight: Key Takeaways from the EU DLT Pilot Regime

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Is your organization interested in testing blockchain-based business models for digital finance platforms or considering issuing shares on the blockchain? Did you know that operators in the EU financial market now have the opportunity to utilize blockchain solutions for tokenized financial instruments, such as shares, bonds, and depositary receipts, while being temporarily exempted from certain requirements of EU financial services legislation? If the exciting realm of blockchain-powered finance has sparked your curiosity, you’ll definitely want to check out the article below!

This article highlights the key takeaways from EU’s new blockchain regulation — the “DLT Pilot Regime” establishing EU:s new “regulatory sandbox”. Readers will gain insights into the scope and purpose of the regulation, the requirements for applying for permission to operate a so called DLT market infrastructure and the EU financial services legislations (such as MiFID II and CSDR) that the applicants have the opportunity to be exempted from if participating in the regulatory sandbox.


The Regulatory Sandbox: Tailored for the Exploration of Tokenized Financial Instruments and DLT

The regulation (EU) 2022/858 on a pilot regime for market infrastructures based on distributed ledger technology (“DLT”), (the “DLT Pilot Regime”) entered into force on 23 March 2023. The DLT Pilot Regime is part of the EU Digital Finance Package.

The EU Digital Finance Package was adopted by the EU Commission in 2020 for the purpose of further enable and support the potential of digital finance in the EU while mitigating associated potential risks. The package included a digital finance strategy and legislative proposals on crypto-assets and digital resilience. Apart from the draft DLT Pilot Regime, the Commission introduced the draft Markets in Crypto-Assets Regulation (known as the “MiCA Regulation”) and the Digital Operational Resilience Act (“DORA”). The Commission also adopted a retail payments strategy to strengthen and develop different payment solutions and innovations.

The DLT Pilot Regime introduces a union wide legislation which provides the opportunity of operating DLT market infrastructures subject to temporary exemption from some specific requirements of EU financial services legislation. The overall goal of letting players on the market operate “freely” is for the purpose of testing and letting the EU legislators gain valuable experience regarding crypto-assets that qualify as financial instruments (i.e., tokenized financial instruments, or “DLT financial instruments”) and their underlying technologies. The aim is to develop the trading and settlement for DLT financial instruments and insights to be gained are supposed to be helpful in the identification of possible practical proposals for appropriate regulatory frameworks. The focus is on regulatory proposals for the issuance, safekeeping and asset servicing, trading, and settlement of DLT financial instruments.

The European Securities and Markets Authority (“ESMA”) is responsible for providing a report to the EU Commission on 26 March 2026, stemming from this “Pilot Regime-project” evaluating a number of different aspects. The ESMA report shall serve as a basis for the final evaluation report to be presented by the EU Commission to the European Parliament and the Council. This final report shall include a cost-benefit analysis on whether the pilot regime should be extended, if it should include also other kind of financial instruments, be amended, be made permanent or terminated. ESMA will also provide interim reports annually in order to, e.g., provide the market participants with information on the functioning of the markets, address incorrect behavior of operators of DLT market infrastructures, provide clarifications on the application of the regulation and update previous indications based on the evolution of DLT.

The Applicants, Systems and Assets in Scope: Who can Apply for Permission to Operate a DLT Market Infrastructure?

Entities subject to EU financial services legislation, fulfilling certain requirements, and who wish to operate a DLT market infrastructure may apply for authorization under the DLT Pilot Regime. The entities under scope are such as investment firms or market operators authorized under EU’s second Markets in Financial Instruments Directive (“MiFID II”) and the Markets in Financial Instruments Regulation (“MiFIR”) and/or central securities depositories authorized under the Central Securities Depository Regulation (“CSDR”). Such entities must submit its application to the designated competent authority which finally decides on permission to operate and which requested exemptions shall apply.

Three kinds of DLT market infrastructures are introduced by the DLT Pilot Regime (somewhat simplified in the below description):

  • DLT multilateral trading facilities (“DLT MTFs”): multilateral systems operated by an investment firm or market operator approved under MiFID II — which only admits to trading DLT financial instruments.
  • DLT settlement systems (“DLT SS”): a system that settles transactions in DLT financial instruments against payment or against delivery and that allows the initial recording of or the provision of safekeeping services in relation to DLT financial instruments.
  • DLT trading and settlement systems (“DLT TSS”): a DLT MTF or DLT SS that combines services performed by a DLT MTF and a DLT SS.

Additional to an entity qualifying as operator of a DLT market infrastructure, other parameters decide if an entity is qualified to apply for authorization — e.g., the type and size of the DLT financial instruments to be admitted to trading or recording on the DLT market infrastructure.

Further, the specific kind of DLT financial instruments which are enumerated in the regulation are:

  1. Shares, the issuer of which has a market capitalization, or a tentative market capitalization, of less than EUR 500 million;
  2. Bonds, other forms of securitized debt, including depositary receipts in respect of such securities, or money market instruments, with an issue size of less than EUR 1 billion, excluding those that embed a derivative or incorporate a structure which makes it difficult for the client to understand the risk involved; and
  3. Units in collective investment undertakings covered by Article 25(4), point (a)(iv) of MiFID II, the market value of the assets under management of which is less than EUR 500 million.

The market value of the named DLT financial instruments is of interest considering the threshold values that apply, and notably, the specific rules for the calculation of such market value provided by the regulation.

Several additional requirements apply to entities which seeks to be authorized. For instance, such requirement includes the obligation to establish, maintain and provide documentation and description of the business, the establishment on rules on the functioning of the DLT, as well as appropriate IT/ and cybersecurity arrangements.

Exemptions from Financial Services Legislations

The permission to operate a DLT market infrastructure under the DLT Pilot Regime can be granted up to six years’ time by the competent authority.

Operators of DLT MTFs or DLT TSSs can, aside from being authorized to operate the infrastructure itself, also request to be exempted from certain requirements of MiFID II and MiFIR, e.g., permitting the extension of the scope of persons admitted dealing on own accounts as members or participants as otherwise is determined by MiFID II, and/or exemption from the obligation on investment firms to report transactions under MiFIR.

Central security depositories operating a DLT SS or DLT TSS may, aside from being authorized to operate, be exempted from several obligations under the CSDR. Such as, the obligation to represent transferable securities in book entry form, requirements on settlement finality and on cash settlement, measures to prevent and/or address settlement fails and the obligation to apply for authorization regarding the outsourcing of core services.

Liability on Operators; Cooperation with Authorities

The permission to operate a DLT market infrastructure or the grant of exemptions from financial services legislation will be combined with strict requirements and regular evaluations and follow-ups. It should also be duly noted that operators of a DLT market infrastructure may be held liable in the event of a loss of funds, a loss of collateral or a loss of a DLT financial instrument up to the market value of the asset lost.

Notably, the DLT Pilot Regime requires entities granted permission to operate a DLT market infrastructure to cooperate with national competent authorities as well as with ESMA. For instance, the permissioned entity can expect to provide requested information, implement measures and submit reports on a regular basis.

In summary, the DLT Pilot Regime, along with the Digital Finance Package represents a bold step from the EU legislators towards the future — where DLT systems and DLT financial instruments hopefully finds their place in a regulatory system balancing the protection of market participants and the market itself as well as enhancing digitalization and innovation in EU’s financial market. Setterwalls will therefor monitor the development and application of the DLT Pilot Regime to prepare clients for the legal developments in the blockchain and crypto market.

Setterwalls can assist in the application process to the authorities and provide you with tailored legal expertise that safeguards your interests and maximizes your opportunities. Contact our team for more information.

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