New pilot scheme opens pathway for blockchain technology

A new regulation introducing a pilot scheme based on blockchain technology is set to come into force on 23 March 2023. The new European regulation¹ is an experiment to develop secondary markets for financial securities based on distributed ledger technology (DLT).

Authorised participants in the scheme will be able to provide trading services and settlement-delivery services on security tokens, which is usually impossible in traditional finance.

To facilitate the use of blockchain technology, the regulation will allow participants to request targeted exemptions from the MiFID 2 and Purpose Directives² and from the Central Securities Depositories Regulation (CSDR). The pilot scheme will apply for a minimum of three years, after which the European Commission (EC) will have to propose its termination, its renewal for another three years, or its continuation by bringing it into common law.

The European Securities and Markets Authority (ESMA) will establish appropriate regulatory guidelines.

Scope of the pilot scheme

Only three players qualify to join the pilot scheme. Firstly, DLT multilateral trading facilities (DLT MTF) within the meaning of the MiFID 2 directive whereby only blockchain-listed financial instruments, also called security tokens, are admitted to trading. Secondly, DLT settlement systems (DLT SS)  that settle transactions relating to security tokens. Thirdly, a new player (DLT TSS) that combines the services of both DLT trading (DLT MTF) and settlement systems (DLT SS).

Regarding products, the regulation provides that only certain DLT financial instruments fall within its scope. Such products include equities and units or shares of collective investments (UCITs). The issuer must have a market capitalisation or provisional market capitalisation of less than €500m, and the issue volume cannot exceed €1bn. For collective investments, the market value of assets under management must also be less than €500m.

In addition to these player and product requirements, a trading and registration cap within DLT infrastructures applies. As a result, the maximum market capitalisation of a DLT market infrastructure is set at €6bn.

Authorisation of DLT market infrastructures

To join the pilot scheme, DLT market infrastructures must request specific authorisation and comply with certain obligations plus any compensatory measures that the competent national authority deems appropriate. A request for authorisation to operate a DLT market infrastructure must include detailed information on the business plan of the applicant, the rules of the infrastructure, legal provisions, as well as information relating to the operation, services, and activities of the infrastructure.

Further information required includes a description of the operation of the DLT used and all of the applicant’s IT and cybersecurity devices, as well as proof that the applicant has put in place sufficient prudential safeguards to honour its commitments and compensate its customers. It’s also necessary to describe the arrangements in place for the custody of clients’ DLT financial instruments and arrangements adopted to guarantee the protection of investors and a description of the mechanisms for handling customer complaints and appeals.

Finally, the applicant’s transition strategy and any exemptions requested by the applicant, as well as the justification provided for each exemption requested and the possible compensatory measures proposed, are required, including how the applicant plans to comply with the conditions attached to these exemptions.

The competent authority will have 30 working days to assess the completeness of the application and 90 working days to evaluate the file to decide whether or not to accept the authorisation to create a DLT market infrastructure. In addition, authorities must inform ESMA as soon as possible of the granting, refusal, or withdrawal of authorisation.

ESMA will publish on its website the list of DLT market infrastructures. In particular, the start and end dates of specific authorisations and the list of exemptions granted.

The competent national authority may refuse to grant an application for authorisation when there are significant investor protection risks, the integrity of the markets or even financial stability is compromised. The authority may also refuse authorisation in the event of an attempt to circumvent the regulations, or if the applicant does not seem capable of complying with applicable regulations.

Approval as a DLT market infrastructure entails obtaining a European passport allowing services throughout the European Union.

Obligations and exemptions

In addition to compliance with the requirements of MiFID 2 and the CSDR regulation, this regulation imposes common obligations on all DLT infrastructures. Responsibilities include establishing clear and detailed business plans describing how the infrastructure intends to provide its services and carry out its activities, rules applicable to the DLT’s operation, and information on how the operators carry out their functions, services, and activities. Participants must also ensure that all IT and cybersecurity devices related to the use of DLT are proportionate to the nature, size, and complexity of their activities, segregate items held on behalf of third parties from assets held for their own account, and protect against asset loss and establish complaints handling mechanisms. Finally, participants must adopt a transition strategy when switching activities from an infrastructure operating on DLT to a common law infrastructure.

Regarding exemptions, market infrastructures eligible for the pilot scheme may request to be exempted from certain obligations that should normally apply to them. They are specifically referred to in the text of the pilot regime, and correspond to the provisions identified as being a brake on the admission of security tokens on trading platforms. Possible exemptions for DLT MTFs include the obligation of intermediation provided for by MiFID 2As well as the obligation to declare transactions carried out on an MTF. However, the latter shall retain relevant details of all transactions executed through its systems.

For DLT SSs, a range of exemptions can apply, including exemption from the settlement of financial instruments in central bank money, as the pilot scheme paves the way for a shift from payments through accounts opened in central bank books to settlements made in the currency issued directly on the blockchain. Settlement finality exemption applies as the infrastructure should propose compensatory measures in order to achieve the planned objectives. The infrastructure must guarantee at least the settlement of transactions in near real-time, no later than the second business day following the conclusion of the transaction.

Exemption relating to the application of certain articles of the CSDR regulation on accounting entry rules is intended to make it possible to establish that an entry on the blockchain has the same value as an entry on a securities account, or even to allow the circulation, storage and transfer of financial securities via a DLT.

Further exemptions relate to outsourcing the basic services of a central securities depository, the definition of participants in a settlement system and certain business conduct rules.

DLT TSSs may request the exemptions applicable to both DLT MTRs and DLT SSs.

Coordination at European level and bringing regulations into force

Once the market infrastructures are included in the pilot scheme, authorised participants must cooperate with their competent authorities. In particular, when a change of business model, or any major change in the information provided to the authority as part of the authorisation, occurs. In addition, any malfunction, fraud, theft, loss or cyberattack, Technical or operational difficulties and risks relating to investor protection, market integrity or financial stability must also be notified.

Every six months, the DLT market infrastructures must submit a report to the competent authority providing a quantitative assessment of the transactions carried, an assessment of the problems encountered and the corrective measures adopted.

ESMA will monitor the application of the exemptions granted and the compensatory or corrective measures requested, enabling them to submit an annual report to the EC.

Before the regulation enters into force, ESMA must amend the Regulatory Technical Standards (RTS) of the Markets in Financial Instruments (MiFIR) and CSDR regulations to adapt them to the pilot scheme and publish different guidelines. For their part, member states will have to adapt their national regulations regarding the law on securities registered on a DLT and designate the competent authority responsible for granting authorisations and exemptions.

¹Full text of the regulation in the Official Journal of the European Union: Publications Office (europa.eu).

²Directive 98/26/EC of the European Parliament and of the Council of 19 May 1998 on settlement finality in payment and securities settlement systems.