Embracing the Future of Finance: EU DLT Pilot Regime and Its Impact on the Financial Services Sector
George Agathangelou 15:33 - 23 March 2023
The European Union's Distributed Ledger Technology (DLT) Pilot Regime is an innovative regulatory framework that aims to foster innovation and competition in digital finance while mitigating associated risks.
This article delves into the DLT Pilot Regime, its objectives, and its significance in the European financial services sector. For more information on how the DLT Pilot Regime can benefit your business, contact Grant Thornton Cyprus, a leading provider of professional services.
Overview of the DLT Pilot Regime
The DLT Pilot Regime is a regulatory sandbox established by the European Union to facilitate the development and application of distributed ledger technology in the financial services sector. The regime is part of a comprehensive package of measures called the Digital Finance Package, introduced by the European Commission in 2020 to support the potential of digital finance in terms of innovation and competition while addressing potential risks. The regulation was published in the Official Journal of the European Union on 2 June 2022 and most of its provisions will apply from 23 March 2023.
DLT and its Potential in the Financial Sector
Distributed ledger technology, commonly known as blockchain, is a decentralized digital database that allows multiple parties to securely record, share, and maintain transactions and data. DLT has the potential to revolutionize the financial services sector by enhancing transparency, reducing costs, and increasing the efficiency of operations.
In the financial sector, DLT can be used in various applications, including trade finance, cross-border payments, and digital asset management. Despite its potential, the adoption of DLT in the financial services sector has been slow, partly due to the lack of a clear regulatory framework.
The Need for a Regulatory Sandbox
When the EU's financial services legislation was initially drafted, it did not consider DLT and digital assets. As a result, the existing provisions may hinder the use and adoption of DLT in the financial sector. The DLT Pilot Regime addresses this issue by providing a regulatory sandbox that allows companies to test and develop DLT-based solutions within a controlled environment, without violating existing laws and regulations.
The regulatory sandbox concept is designed to enable experimentation and learning by market participants and regulators alike. It allows companies to develop innovative solutions and identify potential risks, while regulators can observe, learn from the experiments, and adjust the regulatory framework accordingly.
Objectives of the DLT Pilot Regime
The main objectives of the EU DLT Pilot Regime are to:
- Promote the development and adoption of distributed ledger technology in the European financial services sector.
- Encourage innovation and competition in digital finance while addressing potential risks.
- Provide a controlled environment for testing DLT-based solutions.
- Enable regulators to observe, learn from, and adapt the regulatory framework to accommodate DLT-based solutions.
- Ensure a consistent and harmonized approach to DLT regulation across EU member states.
Significance of the DLT Pilot Regime
The EU DLT Pilot Regime has significant implications for the European financial services sector. It is part of the Digital Finance Package introduced by the European Commission in 2020, aiming to enable and support the potential of digital finance in terms of innovation and competition, while mitigating potential risks associated with it.
The DLT Pilot Regime allows both regulators and financial market participants to test and experiment with distributed ledger technology (DLT) and provides beneficial exemptions from traditional financial services laws. This regulatory framework aims to foster innovation in financial services while ensuring that potential risks are managed effectively. By enabling companies to test and develop DLT solutions within a regulated environment, the European financial services sector can benefit from increased efficiency, transparency, and security in various processes, including post-trade operations.
The concept of DLT Market Infrastructure
The concept of DLT market infrastructure refers to the systems and platforms that enable the trading and settlement of financial instruments using distributed ledger technology (DLT).
The DLT market infrastructure includes three main components:
A. DLT Multilateral Trading Facilities (DLT MTF): These are platforms for trading financial instruments that use DLT, operated by an investment firm or a market operator authorized under Directive 2014/65/EU. Credit institutions authorized under Directive 2013/36/EU can only operate a DLT MTF if they are also authorized as an investment firm or market operator under Directive 2014/65/EU.
B. DLT Settlement Systems (DLT SS): These systems facilitate the settlement of financial transactions using DLT. Settlement is the process where the ownership of assets is transferred from one party to another after a trade. By employing DLT, the settlement process can be accelerated, reducing the time and costs associated with traditional settlement methods. DLT SSs can also improve security and reduce counterparty risk due to the decentralized and tamper-resistant nature of the technology.
C. DLT Trading and Settlement Systems (DLT TSS): These systems combine both trading and settlement functionalities using DLT. By integrating trading and settlement into a single system, DLT TSSs aim to streamline the entire process, reducing operational complexities and costs. This integration can lead to increased efficiency, as well as faster and more secure transaction processing.
DLT market infrastructures aim to cooperate with other market participants to test innovative solutions based on DLT in different segments of the value chain for financial services. This cooperation allows for the exploration and development of new ways to improve efficiency, security, and transparency in the financial sector.
DLT MTFs and their operators are subject to the same regulatory requirements as traditional multilateral trading facilities and their operators under Regulation (EU) No 600/2014 (MiFIR) and Directive 2014/65/EU (MiFID II), as well as other applicable Union financial services legislation. However, competent authorities may grant exemptions from specific requirements under this Regulation. This allows DLT MTFs to operate within a regulated environment while also providing some flexibility to innovate and experiment with DLT-based solutions.
Access to the DLT Pilot Regime should be open to both existing financial institutions and new entrants. Entities not authorized under Regulation (EU) No 909/2014 - also known as the Central Securities Depositories Regulation (CSDR)[GA1] - or Directive 2014/65/EU - commonly known as MiFID II (Markets in Financial Instruments Directive 2)[GA2] - can apply for authorization under those regulations while simultaneously seeking specific permission under the DLT Pilot Regime. Competent authorities should not assess whether such entities fulfil the requirements for exemptions requested under the Pilot Regime. These entities can operate DLT market infrastructures according to the Pilot Regime, and their authorization will be revoked once their specific permission expires, unless they submit a complete request for authorization under the CSDR or MiFID II.
Operators of DLT market infrastructures should be liable for losses of funds, collateral, or DLT financial instruments, with liability limited to the market value of the lost asset at the time the loss occurred. They should not be liable for events beyond their control or not attributable to their operations. To maintain a sound regulatory environment and protect investors, market integrity, and financial stability, the types of financial instruments allowed on DLT market infrastructures should be limited to shares, bonds, and units in collective investment undertakings[GA3] with execution-only exemption under Directive 2014/65/EU. The regulation should set value thresholds, which could be lowered in certain situations, and limit the aggregate market value of DLT financial instruments admitted to trading or recorded on a DLT market infrastructure to avoid risks to financial stability.
Upon the request of a DLT MTF operator, competent authorities may grant an exemption from the obligation of intermediation under MiFID II. Traditional multilateral trading facilities admit only investment firms, credit institutions, and other qualified persons, while many crypto-asset trading platforms provide direct access for retail investors. The intermediation obligation under MiFID II could be a potential regulatory obstacle for DLT financial instruments' multilateral trading facilities. Competent authorities may grant a temporary exemption to allow direct retail investor access and enable them to deal on their own account, provided adequate investor protection safeguards are in place, retail investors meet certain conditions, and the operator complies with any additional investor protection measures required by the competent authority. Retail investors with direct access to a DLT MTF under an intermediation exemption should not be considered investment firms solely by being members or participants in a DLT MTF.
Types of financial instruments allowed for trading on DLT market infrastructure[GA4] include:
a) Shares with a market capitalization of less than €500 million.
b) Bonds, securitized debt, depositary receipts, and money market instruments with an issue size of less than €1 billion, excluding complex instruments.
c) Units in collective investment undertakings with assets under management worth less than €500 million.
The total market value of all DLT financial instruments on a DLT market infrastructure cannot exceed €6 billion when admitting or initially recording a new instrument. If it reaches this threshold, the new instrument cannot be admitted or recorded.
If the total market value of all DLT financial instruments reaches €9 billion, the operator of the DLT market infrastructure must activate its transition strategy and notify the competent authority.
The DLT market infrastructure operator must calculate the monthly average market value of DLT financial instruments and use it to assess the impact of admitting or recording new instruments and decide whether to activate its transition strategy.
The operator must submit monthly reports to the competent authority to show that the total market value of DLT financial instruments does not exceed the thresholds. Competent authorities may set lower thresholds than those mentioned above.
Having recognised early on the disruption this technology will cause to the way traditional industries go about their business, Grant Thornton Cyprus set up a specialized business unit offering a series of services to companies that are interested in exploring a whole new world of opportunities opening for them through the implementation of blockchain technology. Grant Thornton Blockchain Cyprus can help you navigate this pristine environment, understand, and define your digital strategy, identify how these new instruments and tools might impact your environment and organization, and even accompany you on the path of asset tokenization for financial or other purposes. We service a multiple of industries such as Property Development and Financing, Supply Chain Management, Renewable Energy, E-commerce, Entertainment, Occupational Health and Safety, Finance, among others.
George Agathangelou is Senior Manager, distributed ledger technology at Grant Thornton Blockchain (Cyprus)