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Unlocking the potential of DLT market infrastructure in the EU

Updated: Jun 17



Financial intermediaries' responsibilities and duties, as well as the infrastructure of the banking industry, are significantly impacted by distributed ledger technology (DLT). In the coming years, its potential will become clearer as it has already started to reorganise capital market value chains since 2020 and the adoption of the EU digital finance package.


Introduction


The DLT pilot regime is primarily set for financial instruments, which are financial instruments within the meaning of MiFID II, issued, registered, transferred, and stored using distributed ledger technology, and applies since March 23, 2023.


Indeed, the Distributed Ledger Technology Pilot Regime among other regulations provides clarity on the legal framework for trading and settlement of transactions in crypto assets that qualify as financial instruments under MiFID II.


Distributed ledgers are a new way to record transactions, within a information repository that keeps track of all transactions and allows for innovative financial services while ensuring transparency and reliability, making it harder for unauthorised changes to occur.


These tokenised securities using DLT are granted a regulatory sandbox that allows them for the temporary exemption of certain European laws, such as MiFID II.


In addition, the DLT Pilot Regime facilitates the set-up of new types of market infrastructures, such as DLT multilateral trading facilities (DLT MTF), DLT settlement systems (DLT SS), as well as combined DLT trading and settlement systems (DLT TSS). In addition to established investment firms, market operators or Central securities depositaries (CSDs), new entrants may also apply for the DLT Pilot Regime.


The regulation applies to DLT market infrastructures that operate in the EU and are subject to EU financial markets regulation.


In this article, we will explore the key components of DLT market infrastructure under Pilot regime and examine the reasons behind the slow uptake of DLT market infrastructure operators in the EU.



DLT Pilot Regime


The (DLT) Pilot Regime is set to structure the way financial instruments are issued, stored, and transferred. This innovative initiative aims to improve efficiency in trading and post-trading processes, while ensuring a high level of investor protection, market integrity, financial stability, and transparency.


Objectives and Scope

Under the DLT Pilot Regime, eligible market participants can apply for authorisation to operate DLT-based market infrastructures:


  • DLT Multilateral Trading Facilities (DLT MTFs) for trading DLT financial instruments

  • DLT Securities Settlement Systems (DLT SSs) for settling transactions using DLT

  • DLT Trading and Settlement Systems (DLT TSSs) that combine trading and settlement functionalities


Authorised participants can obtain temporary exemptions from specific EU financial regulations, allowing them to use DLT without violating existing laws. The experimentation phase will continue up to six years.


To be eligible, DLT financial products must achieve certain criteria such as market capitalisation or issuance size. The rule applies only to instruments that qualify as financial instruments under MiFID II.


The DLT Pilot Regime is part of the EU's larger Digital Finance Package, which seeks to promote digital innovation while also preserving financial stability and consumer safety. However, the regime has experienced a limited acceptance in its first year, with no participants authorised as of mid-2024.


The DLT Pilot Regime is an important step towards enabling the use of blockchain technology in European financial markets. While early acceptance has been slow, the regime has the potential to accelerate the development of the EU's digital finance ecosystem if properly implemented.


Categories of DLT Infrastructure


As the financial industry continues to evolve, the need for robust and secure infrastructure has become increasingly important to ensure the information related to the transfer of crypto assets are submitted in a secure manner and in advance of, or simultaneously or concurrently that allows multiple parties to record and verify transactions in a secure and transparent manner.


DLT MTFs: Multilateral Trading Facilities

An investment business or market operator approved by Directive 2014/65/EU may operate a DLT MTF, which is a multilateral trading facility.


A particular authorisation under the Pilot Regime is required for an entity to run a DLT MTF. DLT MTFs are governed by MiFIR Regulation, which imposes all rules on multilateral trading facilities and their operators. A platform known as a multilateral trading facility allows several buyers and sellers to exchange financial items in one marketplace, such as derivatives, equities, and bonds. Trading over-the-counter (OTC) securities—those not listed on a typical stock exchange—occurs often on MTFs.


DLT TSSs: Trading and Settlement Systems

A DLT TSS is a system that combines the services performed by a DLT MTF and a DLT SS. To operate a DLT TSS, an entity must be authorised as an investment firm or market operator under MiFID II as well.


Alternatively, a DLT TSS can be operated by a CSD that has received a specific permission to operate a DLT TSS under the Pilot Regime. DLT TSSs are subject to the requirements that apply to DLT MTFs or DLT SSs. It is designed to facilitate the buying and selling of financial instruments, such as stocks, bonds, and derivatives, while also providing a secure and efficient way to settle trades.


DLT SSs: Settlement Systems

A DLT SS is a settlement system operated by a CSD authorised under Regulation (EU) No 909/2014 that has received a specific permission to operate a DLT SS under the Pilot Regime. DLT SSs are subject to all relevant requirements under Regulation (EU) No 909/2014, and any other applicable Union financial services legislation. Settlement refers to the process of exchanging or transferring ownership of financial instruments, such as stocks, bonds, or derivatives, from one party to another.


The DLT infrastructure categories’ presentation remind us that criteria for DLT infrastructure are primarily designed to ensure the security, integrity, and efficiency of financial transactions in which DLT market infrastructures are platforms that use blockchain technology to facilitate trading, clearing, and settlement of financial instruments.






DLT solution process

Distributed Ledger Technology (DLT) generates an immutable chain of titles by recording each transaction or event in a decentralised network of nodes. This creates a tamper-proof record that simplifies reconciliation between previously disparate databases.


Key features of how DLT achieves immutability:


  • Decentralisation: Data is stored across a distributed network of nodes, making it virtually impossible for any single entity to alter the records without consensus.

  • Cryptography: Transactions are secured using digital signatures and cryptographic algorithms, preventing tampering. Each block is linked to the previous one, creating an unalterable chain.

  • Consensus: All nodes must agree on the validity of a transaction before it is added to the blockchain through a consensus mechanism. This prevents any single node from manipulating the ledger.

  • Transparency: Every change to the ledger is recorded and traceable, enhancing accountability. Parties can verify the history of an asset or transaction.


By creating an immutable chain of titles, DLT reduces the complexity and costs associated with reconciling multiple databases. It eliminates the need for intermediaries and manual reconciliation processes. This increases efficiency, security, and trust in the system.


The immutability of DLT records is particularly beneficial in industries like finance, supply chain, and healthcare, where data integrity is critical. It enables applications such as tracking goods through the supply chain and creating an auditable trail for financial transactions.


However, the immutability of DLT also presents challenges, such as the difficulty of reversing erroneous or fraudulent transactions. Policymakers are working to address these issues and enable the adoption of DLT in capital markets.

 

DLT process infographic
DLT process


Financial Instruments in scope

The DLT Pilot Regime focuses on financial instruments, specifically:


  • Shares with a market capitalisation or estimated market capitalisation of less than EUR 500 million.

  • Bonds, including various types of securitised debt, having an issuance amount of less than EUR 1 billion. This criterion does not apply to corporate bonds issued by issuers with a market capitalisation of less than EUR 200 million at the time of issuance.

  • UCITS (Undertakings for Collective Investment in Transferable Securities) manage assets worth less than EUR 500 million.


As a result, DLT financial instruments may only be admitted to trading or recorded on a DLT market infrastructure if they meet the aforementioned criteria at the time of admission or recording on a distributed ledger.


The DLT Pilot Regime intends to encourage the establishment of a solid DLT market infrastructure in the EU.


Exemptions regime


The Pilot Regime exempts some DLT market infrastructures from specific EU financial services regulations, allowing them to develop solutions for trading and settling cryptocurrency assets as financial instruments transactions.


This regime grants market infrastructures a six-year exemption from current legislation such as MiFID II, CSDR, Prospectus Directive, Short Selling Directive, Market Abuse Directive, Transparency Directive, and Settlement Finality Directive. It allows for experimentation in issuing, trading, settling, and safeguarding fund tokens on blockchain networks.


This exemption should not undermine existing protections for established market infrastructures. To protect investors, DLT market infrastructures and operators must have explicit liability chains in case of operational failures.

However, due to limited experience with trading crypto-assets as financial instruments and related post-trading services, it may be premature to significantly modify Union financial services legislation to fully deploy these assets and their underlying technology.


Simultaneously, the development of financial market infrastructure for crypto-assets that qualify as financial instruments is currently hampered by requirements embedded in Union financial services legislation that are unsuitable for crypto-assets that qualify as financial instruments or the use of blockchain technology.


Crypto trading platforms offer direct access to regular investors, unlike traditional trading venues that rely on financial intermediaries.


As the European Supervisory Authority (ESA) takes on the responsibility of maintaining the stability and integrity of the financial system, it is critical that it closely monitors the development of Distributed Ledger Technology (DLT) exclusively through financial institutions.


  

Luxembourg: A preferred jurisdiction for DLT market infrastructures


Luxembourg has positioned itself as a leading European hub for financial technologies, particularly in the realm of distributed ledger technology (DLT).


The country's latest legislative initiative, the Blockchain III Law, further solidifies its commitment to fostering innovation while ensuring legal certainty for DLT-based market infrastructures. The Blockchain III Law, which came into force on March 23, 2023, implements the EU's DLT Pilot Regime. This regulatory framework allows firms to apply for authorisation to operate DLT-based trading and settlement systems for financial instruments within a flexible environment.


The Blockchain III Law brings the following major features:

  • Extending the definition of "financial instruments" to include those issued and represented using DLT

  • Clarifying that financial instruments booked in securities accounts held on DLT qualify as financial instruments under Luxembourg's Financial Collateral Law

  • Enhancing legal certainty for collateral arrangements over DLT-based financial instruments


Luxembourg's proactive approach to DLT regulation has already attracted major players in the digital finance space. The European Investment Bank has conducted two fully digital bond issuance on a blockchain governed by Luxembourg law.


By providing a clear and supportive legal framework, Luxembourg aims to maintain its position as a preferred jurisdiction for DLT market infrastructures.


The Blockchain III Law builds upon previous legislative initiatives, such as the Blockchain I Law (2019) and Blockchain II Law (2021), which introduced the possibility to hold, register, and transfer securities using DLT.


As the EU DLT Pilot Regime continues to evolve, Luxembourg's commitment to technological neutrality and its willingness to adapt its legal framework to accommodate new technologies positions the country as an attractive destination for DLT-based financial services.


Erwin SOTIRI, Avocat à la Cour
Loïck KABONGO, Avocat



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