On 27 September 2022, ESMA released its report on the DLT pilot regime. The report presents ESMA’s findings from its call for evidence on the question of whether the regulatory technical standards (“RTS”) developed under Regulation (EU) No 600/2014 (“MiFIR”) regarding certain pre- and post-trade and data reporting requirements need to be adapted for securities issued, traded and recorded using distributed ledger technology (“DLT”).
In summary, according to the report:
- ESMA does not believe that the RTS on data transparency and data reporting requirements need to be amended for the purposes of the DLT pilot regime;
- As requested by market participants, ESMA will issue guidance regarding the application of certain technical elements of the RTS on transparency and data reporting requirements, including clarifying certain definitions, specifying what information is to be included in certain reporting fields and how identification, reporting obligations and clock synchronization requirements would apply in relation to private individuals;
- ESMA specified several recommendations for national competent authorities regarding compensatory measures pertaining to supervisory data collected from DLT market infrastructures.
Background to the DLT Pilot Regime
In September 2020, the EU Commission announced its digital finance strategy, which outlines how the digital transformation of finance in the EU could be furthered. The strategy concentrates on four main areas: i) removing fragmentation in the digital single market, ii) adapting the EU regulatory framework to facilitate digital innovation, iii) promoting data-driven finance and iv) addressing the challenges and risks of digital transformation.
One area of legal uncertainty is how existing EU financial regulations apply to crypto-assets. Crypto-assets are digital representations of value or rights which may be transferred and stored electronically using distributed ledger technology or similar technology. Whereas some types of crypto-assets fall under the definition of financial instruments set out in Directive 2014/65/EU (e.g., transferrable securities such as stocks and bonds), others do not. For those that do, certain EU financial services legislation, including Directive 2014/65/EU (“MiFID II”), MiFIR, Regulation (EU) No 596/2014 (Market Abuse Regulation, “MAR”), Regulation (EU) 2017/1129 (Prospectus Regulation), Regulation (EU) No 909/2014 (Central Securities Depositories Regulation, “CSDR”) and Directive 98/26/EC (Settlement Finality Directive, “SFD”), may apply to issuers of such assets and to businesses which provide services related to such assets.
Certain requirements foreseen under these norms could restrict or prohibit the use of DLT in the trading and settlement of transactions of crypto-assets. While on the one hand competent authorities wish to further the development of the use of DLT, they are also unfamiliar with the risks new technology may pose and are cautious about relaxing existing protections. In order to address and balance these issues, the DLT Pilot Regime Regulation was enacted. A short summary of some of the main points of this new regulation is given below.
The DLT Pilot Regime Regulation
DLT market infrastructure
Regulation (EU) 2022/858 of the European Parliament and of the Council on a pilot regime for market infrastructures based on distributed ledger technology (the “DLT Pilot Regime Regulation”) came into force on 22 June 2022 and will apply from 23 March 2023. It provides a definition of a DLT financial instrument (a financial instrument as defined in MiFID II that is issued, recorded, transferred and stored using distributed ledger technology) and establishes a new form of market infrastructure, the DLT market infrastructure. A DLT market infrastructure can be a:
- DLT multilateral trading facility (“DLT MF”): a multilateral trading facility (“MTF”) that only admits to trading DLT financial instruments;
- DLT settlement system (“DLT SS”): a settlement system that settles transactions in DLT financial instruments against payment or against delivery and that allows the initial recording of DLT financial instruments or allows the provision of safekeeping services in relation to DLT financial instruments;
- DLT trading and settlement system (“DLT TSS”): a DLT MTF or DLT SS that combines services performed by a DLT MTF and a DLT SS.
Certain limitations have been set on financial instruments which can be traded or recorded on a DLT market infrastructure, including:
- for shares: the market capitalization of the issuer must be less than EUR 500 million;
- for certain bonds and other forms of securitized debt: the issue size must be less than EUR 1 billion;
- for certain units in collective investment undertakings: the market value of the investments under management must be less than EUR 500 million.
In addition, the aggregate market value of all DLT financial instruments admitted to trading or recorded on a DLT infrastructure shall not exceed EUR 6 billion at the time of admission to trading/initial recording. Should the aggregate market value of all DLT financial instruments traded/recorded on an DLT market infrastructure exceed EUR 9 billion, the operator of the DLT market infrastructure shall activate its transition strategy, which may include conversion to a traditional market infrastructure. National competent authorities may set lower thresholds.
Special regulatory exemptions
In general, the EU regulatory framework relating to financial instruments and to traditional market infrastructures also apply to DLT financial instruments and DLT market infrastructures. Operators can apply for certain exceptions, however, if the exception is proportionate to and justified by the use of DLT. Examples include:
- DLT MTFs: the operator of a DLT MTF may admit certain natural and legal persons (retail investors) to deal on own account as members or participants. In addition, operators, members and participants may be exempted from certain MiFIR reporting requirements;
- DLT SSs: the CSD may admit certain natural and legal persons as participants, represent securities in a form other than book entry and settle transactions in e-money tokens (delivery versus payment still required).
When granting an exception, the competent authority may impose certain conditions and request compensatory measures in order to meet the objectives of the regulations to which an exception has been requested or in order to ensure investor protection, market integrity or financial stability.
The following persons may apply for/be granted a specific permission to operate a DLT market infrastructure:
- DLT MF: A legal person who is authorized as an investment firm or authorized to operate a regulated market under MiFID II;
- DLT SS: A legal person who is authorized as a CSD under the CSDR;
- DLT TSS: A legal person who is authorized as an investment firm or authorized to operate a regulated market under MiFID II or as a CSD under the CSDR. An investment firm or market operator operating a DLT TSS will also be subject to certain provisions of the CSDR and a CSD will be subject to certain provisions of MiFID II.
Applications to the national competent authority must include information about, inter alia, the company’s business plan, the functioning of the DLT used, a description of the applicant’s overall IT and cyber arrangements, investor protection measures, a transition strategy (e.g., how an operator would exit the business or transition to a traditional market infrastructure) and justifications for any exemption requested. ESMA is in the process of preparing guidelines for application templates; the consultation period closed on 9 September 2022.
Specific permissions shall specify the exceptions granted and any associated compensatory measures. They are valid throughout the EU for a period of up to six years from the date of issuance, although may be withdrawn in certain situations (e.g., flaw in the functioning of the DLT, material change in the technology used, exemption conditions not complied with, etc.). There are also a number of information, transparency and other requirements the operator of the DLT market infrastructure must comply with during this period.
Over the past few years, there has been much interest is exploring how DLT can be used to promote efficiencies in the financial markets. The DLT Pilot Regime Regulation was enacted in order to give national competent authorities the ability to grant operators of DLT market infrastructures certain exemptions from EU regulations which otherwise might inhibit or prohibit the development of the use of DLT where financial instruments are involved. The goal is to give operators of DLT market infrastructures more legal certainty when developing and implementing new DLT business models. It remains to be seen how many operators will make use of this opportunity once the Regulation applies in March 2023.