EU adopts DLT Pilot Regime

The Regulation concerning a pilot regime for financial market infrastructure based on distributed ledger technology (EU DLT Regulation) was published in the Official Journal on 2 June 2022 and will enter into force on 22 June 2022, with an implementation date of 23 March 2023.

The EU DLT Regulation, which was introduced by the European Commission in September 2020 as part of the EU Digital Finance Package (see our briefing here), seeks to address the limited use to date by trading venues or central securities depositories of DLT. EU financial services legislation was not drafted with DLT and digital assets in mind, and contains provisions that may inhibit the use of DLT in the issuance, trading and settlement of digital assets that qualify as financial instruments. The regime therefore seeks to provide authorisation to Multilateral Trading Facilities (MTF) and Central Securities Depositaries (CSD) to operate DLT financial market infrastructure and exempt these entities from certain existing requirements under financial services legislation (where these provisions potentially inhibit or limit the use of DLT). It provides for authorisation of new entrant firms as well as upgrading existing entities' scope of activities.

DLT market infrastructure

The concept of DLT market infrastructure comprises DLT multilateral trading facilities (DLT MTF), DLT settlement systems (DLT SS) and DLT trading and settlement systems (DLT TSS).

• A DLT MTF is an MTF that is operated by an investment firm or a market operator authorised under the Markets In Financial Instruments Directive (MiFID) with specific permission under the EU DLT Regulation. A credit institution authorised under CRD IV providing investment services/performing investment activities would only be allowed to operate a DLT MTF when authorised as an investment firm or market operator under MIFID. DLT MTFs would be subject to all requirements that apply to MTFs under MIFID and Markets In Financial Instruments Regulation (MiFIR) and under any other applicable EU financial services legislation, except for requirements in respect of which an exemption has been granted in accordance with the EU DLT Regulation.
• A DLT SS is a settlement system operated by a Central Securities Depositary authorised under the Central Securities Depository Regulation (CSDR) with specific permission to operate a DLT SS under the EU DLT Regulation. A DLT SS, and the CSD which operates it, would be subject to all relevant requirements under CSDR (as well as other applicable EU financial services legislation) except for requirements in respect of which an exemption has been granted in accordance with the EU DLT Regulation.
• DLT TSS combines the activities normally performed by MTFs and securities settlement systems. A DLT TSS can either be a DLT MTF that combines the services performed by a DLT MTF and by a DLT SS, and be operated by an investment firm or market operator that has received a specific permission to operate a DLT TSS under the EU DLT Regulation. A DLT TSS can also be a DLT SS combining the services performed by a DLT MTF and by a DLT SS, and would in that case be operated by a CSD that has received a specific permission to operate a DLT TSS under the EU DLT Regulation. A DLT TSS will be subject to both the MTF requirements under MiFID/MiFIR and the CSDR, subject to the amendments/exemptions under the EU DLT Regulation.

Limitations of the EU DLT Regulation

• Only certain securities satisfying certain criteria are in scope. This includes shares (in respect of an issuer which has market capitalisation/tentative market capitalisation of less than EUR 500 million), bonds including bonds taking the form of securitised debt, money market instruments and depository receipts for bonds and securitised debt (with an issue size of less than EUR 1 billion) and units in collective investment undertakings (the market value of assets under management is less than EUR 500 million). Bonds that embed a derivative or incorporate a structure which makes it difficult for the client to understand the risks involved are excluded from the regime.
• The EU DLT Regulation also provides that the aggregate market value of all the DLT financial instruments that are admitted to trading on a DLT market infrastructure or that are recorded on a DLT market infrastructure should not exceed EUR 6 billion at the moment of admission to trading, or initial recording, of a new DLT financial instrument.
• The EU DLT Regulation provides that where the aggregate market value of all the DLT financial instruments that are admitted to trading on a DLT market infrastructure/recorded on a DLT market infrastructure has reached EUR 9 billion, the operator of the DLT market infrastructure must activate a so-called transition strategy (a strategy for reducing the activity; transitioning out of, or ceasing to operate, a particular DLT market infrastructure; and transition or reversion of DLT operations to traditional market infrastructure).

Specific Permissions

The EU DLT Regulation sets out a procedure for obtaining a specific permission to operate a DLT MTF, DLT SS or DLT TSS. The specific permissions and exemptions would be granted on a temporary basis, for a period of up to six years from the date of on which the specific permission was granted. Where the specific permission has been granted, the exemptions granted by the NCA and will be valid throughout the EU (but only for the duration of the pilot regime). ESMA is expected to publish relevant details on its website in this regard over the next few weeks.

Exemptions regarding DLT MTFs

Under the EU DLT Regulation DLT MTFs may, subject to certain conditions, admit a broader range of participants on the DLT MTF (including natural persons). By comparison, under MiFID, traditional MTFs only admit as members/participants investment firms, credit institutions and other persons with sufficient trading ability and competence to maintain adequate organisational arrangements and resources. DLT MTFs may also be exempted (together with its participants) from the transaction reporting requirements, as long as competent authorities have direct and immediate access to transaction reporting data.

Exemptions regarding DLT SS

The EU DLT Regulation exempts DLT SS from a number of obligations under the CSDR, including:

• the intermediation via credit institution/investment firm obligation contained in the CSDR. CSDs operating a DLT SS seeking this exemption would need to ensure that their participants have the required ability, competence, experience and knowledge in relation to post-trading activities and the workings of a DLT;
• requirements in the CSDR concerning the terms "dematerialised form", "securities accounts" or "transfer orders";
• requirements referring to the term "book-entry form" where this is necessary to allow for the recording of DLT financial instruments on a distributed ledger; and
• requirements under the CSDR concerning the settlement of cash payments in central bank money.

Additional requirements for DLT market infrastructures

• The EU DLT Regulation sets out additional requirements applicable to a DLT MTF, DLT SS and DLT TSS concerning liability in the case of loss of funds, of collateral or of a DLT instrument. Other requirements include: documenting rules on the functioning of the DLT used, including rules on accessing the distributed ledger, on the participation of validating nodes, on addressing potential conflicts of interests; website disclosure detailing how operations and services differ from an MTF or securities settlement system that are not based on DLT; and specific operational risk management procedures for the risks posed by the use of DLT and digital security.

Other considerations

ESMA issued a call for evidence on whether MiFIR regulatory technical standards concerning pre-and post-trade transparency and data reporting need to amended in light of the EU Pilot Regime (see our briefing here).