RegCORE Client Alert | EU Digital Single Market
QuickTake
Imagine you design, deploy and deliver (in record time) one of the most comprehensive (regulatory) sandboxes and no one turns up to play. This is exactly what has happened during the first year of operation of the EU's Distributed Ledger Technology (DLT) Pilot Regime, which was introduced by an EU Regulation of the same name (the DLTR or PDMIR). Whether the lack of take-up in the Pilot Regime is down to simple growing pains or more fundamental deficits in its design and/or deployment is something that EU policymakers have been forced to digest and to provide an interim update on implementation (the 2024 Implementation Update). This update was provided instead of the full report mandated under the DLTR as no eligible participants have been authorised under the DLTR to take part in the DLT Pilot Regime. Eligible participants or "DLT market infrastructures" include (i) DLT multilateral trading facilities (DLT MTFs), (ii) DLT securities settlement systems (DLT SSs) and (iii) DLT trading and settlement systems (DLT TSSs).
The DLTR introduced the ability for DLT market infrastructures to avail of exemptions and/or derogations from those parts of the EU's existing financial services legislative and regulatory framework, which are not conceptually designed to accommodate DLT- and/or crypto-asset-based activities. Accordingly, the DLTR established a legal and regulatory framework for the trading and settlement of transactions in "tokenised securities", i.e., digital representations of MiFID II financial instruments. Notably the scope of DLTR does not extend to other forms of tokenisation, such as stablecoins, which for MiCAR purposes are differentiated between (i) asset-referenced tokens (ARTs) and (ii) electronic money tokens (EMTs).
This Client Alert assesses the findings, the practical bottlenecks that the DLTR sought to break and what further potential may be on the horizon for both supervisory policymakers and supervised DLT market infrastructures seeking to become eligible to test in what is the first true pan-EU regulatory sandbox.
The DLT Pilot Regime and key takeaways from the 2024 Implementation Update
Under the DLT Pilot Regime, national competent authorities (NCAs) are allowed to grant derogations and/or exemptions from specific applicable rules, subject to DLT market infrastructures meeting (i) certain conditions and (ii) the on-going need to comply with minimum organisational requirements. Subject to periodic review of EU-level supervisors and NCAs, the permission to operate a DLT market infrastructure is, under current rules, therefore not time-bound. That is to say, until a legislative proposal is adopted that amends the DLT Pilot Regime to that end. On a similar note, under the DLTR, the European Securities and Markets Authority (ESMA) is required to publish annual interim reports so as to (i) provide interested parties with information on the functioning of the markets in scope, (ii) address incorrect behaviour of DLT market infrastructure operators and (iii) provide clarifications on the application of the DLTR and to update previous indications based on the evolution of DLT more widely as well as how it contributes to completing the EU's efforts on establishing a deeper Capital Markets Union (CMU).
Surprisingly, in a short (4 page) letter dated 3 April 2024, Verena Ross, ESMA's Chair wrote to Mairead McGuinness, the EU Commissioner for Financial Services, Financial Stability and CMU (DG-FISMA) setting out, in an annex, the 2024 Implementation Update with its observations on the state of play of the Pilot Regime and its implementation. DG-FISMA is the gatekeeper of the legislative and regulatory rule- and policymaking for the DLT Pilot Regime. ESMA specifically calls upon DG-FISMA to clarify certain aspects of the Pilot Regime notably around (i) innovative solutions for cash settlement, (ii) use of self-hosted wallets, (iii) the scope and thresholds of admitted DLT financial instruments and (iv) the duration of the DLT Pilot Regime.
The letter clarifies that ESMA does not intend to publish the first annual interim report, as required – which was due on 24 March 2024 – one year after the DLTR became applicable but instead that ESMA could only provide key suggestions for improvement of the DLT Pilot Regime in the form of the 2024 Implementation Update. The reason for this is down to the rather unsatisfactory level of interest by and applications received from DLT market infrastructures since the DLT Pilot Regime's start.
Although the Pilot Regime's derogations/exemptions can only apply to a DLT market infrastructure conceived to be operating inside the DLT Pilot Regime, contrary to popular belief, and as now clarified by the EU Commission in an even shorter (1.5 page) letter dated 3 May 2024 responding to the 2024 Implementation Update, there is no expiration date for the DLT Pilot Regime. Moreover, in its unwavering support for the policy objective and DLT-based innovation in financial markets, EU Commissioner McGuinness highlights in her response to the 2024 Implementation Update that it is nonetheless encouraging to see four applications (across the entire EU) which are currently being assessed by the national competent authorities. Accordingly, market participants, regardless of what stage of consideration they are at in whether to participate in the DLT Pilot Regime may want to consider how ESMA and EU policymakers may seek to develop the DLT Pilot Regime forward.
In its 2024 Implementation Update, ESMA expressed that:
- No DLT market infrastructures have been authorised as of yet. ESMA notes that part of this is due to the DLT Pilot Regime's relevant novelty but also key challenges.
- Challenges were observed during ESMA's interactions with NCAs and (potential) applicants.
- As of 3 April 2024, ESMA had only received four (4) official applications. Applications were received from one DLT TSS and a DLT MTF from Germany, one DLT SS in the Czech Republic and one DLT TSS in the Netherlands. These applications are currently under assessment by the respective NCAs, who have raised questions arising from the applications for discussion at ESMA's DLT Working Group, which is comprised of representatives from NCAs, ESMA, the European Central Bank and the European Commission.
- A further eight (8) potential applications are expected to be submitted during the course of 2024. These applications were submitted from France, Germany, Lithuania, Poland and Spain.
- In the absence of central bank digital currencies (CBDCs) a significant challenge but also one of opportunity for the DLT Pilot Regime is to test the use of innovative solutions for cash settlement that does not involve traditional cash. DLT market infrastructures can used DLT settlement solutions, such as tokenised commercial bank money or EMTs (as defined in MiCAR – which becomes operational reality on 30 June 2024 for ARTs and EMTs and in full for other MiCAR tokens by 31 December 2024). ESMA notes that DLT Pilot Regime applicants find it difficult to find cash leg providers (commercial banks or EMT issuers). This is problematic as, according to the DLTR, a DLT SS/TSS operator benefiting from an Article 5(8) exemption can settle payments in EMTs only if they are issued by credit institutions and not by e-money institutions, i.e. a license type that most EMT issuers are envisaging and which most DLT Pilot Regime (potential) applicants are applying for. As explored in the following Client Alert, the scope of the e-money institutions' license requirements is equally expected to change.
- ESMA welcomes the Eurosystem's initiative to conduct trials in 2024 for central bank money settlement of wholesale financial transactions recorded on DLT platforms. Nevertheless, ESMA notes that given the short duration of the trials and focus only on wholesale as opposed to retail solutions, the trials, while innovative, would represent a long-term solution for the DLT Pilot Regime at this stage.
- The regulatory expectations for custody services in respect of DLT market infrastructures, roles/responsibilities of entities involved – in particular for self-hosted wallets (i.e., non-custodial wallets under MiCAR) are deserving of further clarifications in the Pilot Regime and in light of potential overlap for custody services/activities that are governed by MiCAR and/or MiFID II.
- Interoperability is key within and across the DLT ecosystem as well as between the DLT-based and traditional financial services ecosystem. This applies well beyond just DLT market infrastructures but ESMA notes that with the limited participants in the regulatory sandbox, those participating cannot play with others in the absence of a critical mass of participants and thus trading and settlement chains cannot complete as they would (ideally do) outside the sandbox. DLT MTFs find it difficult to find a DLT TSS or DLT SS (since none have been authorised as of yet) or to have access to traditional central securities depositories (CSDs) including given technological and operational complexities. ESMA notes the particular requirement under Article 3(2) of the EU's CSD Regulation according to which transferable securities traded on a trading venue should be recorded in book-entry form in a CSD, which in the context of DLT and the Pilot Regime needs amending.
- ESMA has an investor protection mandate within its charter, however ESMA calls for clarity on the complex interaction between MiFID II and the DLT Pilot Regime plus investor protection issues concerning the implications of direct access trading and in light of identifying sound and convergent supervisory expectations in this specific area. ESMA has submitted a Q&A on this topic (notably on what type of financial instruments should be included in the sandbox) as well as called for clarity on the treatment of pre-emptive subscription rights attached to shares admitted to trading and/or recorded on DLT market infrastructures. Any clarifications (if clear...) may have implications well beyond the DLT Pilot Regime.
ESMA rounds up its 2024 Implementation Update by comparing the DLT Pilot Regime's competitiveness vis-à-vis third country regimes outside of the EU. ESMA does not focus on arguing "my sandbox is better than yours" (in particular given the UK's own aspirations for a more ambitious Digital Securities Sandbox applying lessons observed from the Pilot Regime's limitations) but instead identifies that a major hesitation amongst potential applicants is the uncertainty about the duration (3 years with close of play in 2026) of the DLT Pilot Regime overall. ESMA calls upon the European Commission to publicly clarify as soon as possible that the DLT Pilot Regime will be extended for a further three years from 2026 onwards, as permitted under Art. 14 DLTR. ESMA expects that this would allow eligible market participants sufficient time to implement and operate their projects, making the required investments worthwhile for them. This would also be helpful given (i) the operationalisation of the timelines around MiCAR's full implementation but also its pending review report on MiCAR's scope due in December 2024 (which may set out further (minimum) principles around regulating decentralised finance (DeFi) protocols, non-fungible tokens (NFTs), crypto-asset lending and staking) along with (ii) reflecting the outcomes and adjustments following the recently finalised MiFID II review.
Finally, ESMA states that the "low thresholds" for the DLT financial instruments that are admitted to trading and/or recorded on a DLT market infrastructure are in need of adjustment. While the thresholds mandated in Art. 3 DLTR are "clearly in line with the 'experimental' nature of the DLT Pilot Regime, further flexibility in this respect would likely attract more applicants." Attracting more participants would serve to strengthen linkages amongst participants in the regulatory sandbox overall. In the interim, the technical staff at ESMA, NCAs and DG-FISMA may also want to take note of other areas of concern but also opportunity that were not addressed in the 2024 Implementation Update.
Other areas not addressed in the 2024 Implementation Update
What is also promising is that ESMA seems to have taken note, even if not explicitly mentioned in its 2024 Implementation Update of concerns expressed in other public forums and industry-organised events during the course of 2024. Some of the feedback from larger financial market infrastructures is that the Pilot Regime is not geared towards big market infrastructures and big market players and that some of those prefer to build infrastructures based on "real and sound regulations so that we ensure our investments...pay off."
Some of these other areas requiring reform include:
- Reducing barriers to entry: potential applicants to the DLT Pilot Regime are mainly technology driven players. The "assets" of these organisations are streamlined technical solutions to tokenise assets and implementation of effective, blockchain-based trading and settlement mechanism. Becoming a licensed financial institution at first, is a burden for these potential applicants that is also out of their scope of available know-how and resources. This complexity regrettably may prevent innovative projects from becoming direct participants of and benefiting from the DLT Pilot Regime in the short-term. Technology "unicorns" will either have to step up the effort of planning and building up resources with regards to regulatory requirements themselves or engage in partnerships with already-licensed financial institutions. Echoing the words of EU Commissioner McGuinness in her response to the 2024 Implementation Update, it is perhaps important that the DLT Pilot Regime establishes and maintains a space for innovative businesses in the asset tokenisation and market infrastructure. These two policy avenues would ideally merit further alignment.
- Interoperability: DLT Platforms often operate in silos, making it difficult for different platforms/infrastructures to communicate and share data.
- Standardisation: in addition to interoperability is a key factor for establishing successful trading of financial instruments in several perspectives. Beginning with the standardisation of token standards and their underlying data models is the conditio sine qua non for establishing efficient markets as well as efficient regulatory frameworks. In addition to token standards, the on- and off-chain functionalities regarding the lifecycle of tokenised financial instruments still lacks standardisation or best practices, which leads to a fragmented and complex technology landscape.
Despite perhaps what some market participants may view as a disappointing and underwhelming start, ESMA's expressions of support set out in the 2024 Implementation Update and the European Commission's response thereto are promising. It however does remain to be seen how DG-FISMA and the incoming European Commission will react – we anticipate this being well after the 9 June 2024 European Parliament elections and following the appointment of new officeholders across key posts.
Outlook
In summary, the EU's DLT Pilot Regime may be ripe for reform, so as to perform as it was intended by policymakers but also to reflect the needs of the DLT and traditional financial markets overall. What is clear is that the rules balancing safety and sustainability of who can test and participate in this pan-EU-27 regulatory sandbox may need to focus on facilitating the use-cases to be tested and to concurrently create easier means of interaction with ESMA and NCAs. Equally, the gatekeepers of the DLT Pilot Regime may need to review the current findings and criticisms, they should ideally also look to apply lessons learned from other third-country regime's sandboxes, not just the efforts of the UK, as invariably those third-countries are looking to avoid some of the pitfalls endured in the EU so far.
Targeted changes could ensure that the Pilot Regime is more efficient for DLT and MiCAR plus MiFID II use cases but also capable of expansion to support other anchors of the EU's CMU efforts more broadly. This comes on top of the easier call to send a signal to the DLT and traditional market ecosystem that the Pilot Regime's regulatory sandbox is open to play for longer (i.e., beyond 2026) with a greater scope of financial instruments that can be tested.
In addition to public sector efforts, the private sector has an important role in ensuring the DLT Pilot Regime is open to the right types of rules that encourage participation. A number of analytical work hoping to achieve that is well underway. As an example, PwC has recently conducted an in-depth professional and technical analysis of common DLTs to shed light on their functionalities with regard to the necessary transaction reporting under the DLT Pilot Regime. Expert interviews were conducted with applicants (DLT MTF, TSS, SS) under the DLT Pilot Regime to include their implementation principles in the technical analysis. In addition, the opinions of all national competent authorities were included in the studies for a better understanding of supervisory strategies as well as supervisory convergence. The analysis culminated with the publication of two reports on the topic of transaction data on Corda, Ethereum and Hyperledger Fabric and the extraction of this transaction data from the corresponding market infrastructures including delivery to the regulatory authorities. In any event, the consensus across interested parties and regulators in the EU is resoundingly clear regardless of any changes amongst policymakers: the role of crypto-assets, the opportunities afforded by the DLT Pilot Regime and indeed the use of regulatory sandboxes more broadly are simply too big to ignore and too important to allow to fall short of achieving their intended aims.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.