Since exploding into the mainstream world, blockchain (also known as Distributed Ledger Technology – DLT) was promised to revolutionise and create a world of opportunities for financial markets. While it has the potential to make the finance sector more resilient, efficient and reliable, due to current regulations and the lack of market infrastructure, trading securities using DLT is still very restricted and there remains a number of challenges to address before unlocking the full potential of this technology.
To explore the usage of DLT, the European Commission (EC) proposed the EU Pilot Regime (PR – part of the EU Digital Finance Package) to help develop market infrastructures based on DLT and facilitate testing the benefits of this new technology. The PR regulation is expected to be officially published in the coming weeks and will apply nine months later (by early 2023). But, what exactly is the PR and how will it help shape future financial markets?
A one-of-its-kind regime
The PR will allow regulated institutions to develop and test DLT-based infrastructure for issuing, trading and settlement of certain financial instruments known as security tokens. Security tokens are digital assets, similar in nature to traditional securities, issued using blockchain technology. These are not be confused with other digital assets that do not qualify as financial instruments under EU legislations, such as so-called cryptocurrencies like Bitcoin. These security tokens, for example tokenised bonds and shares, remain subject to existing applicable legislations but will benefit from some targeted exemptions from MiFID II, CSDR and Settlement Finality Directives, under the PR. This will help facilitate trading and settlement of these securities and allow market participants to gain experience of using DLT. This ‘one of its kind’ regulatory framework could play a critical role in DLT uptake in the EU. It’s an opportunity to gather evidence of the benefits of DLT for security tokens, identify regulatory obstacles and plan for future models to eventually shape tomorrow’s financial markets.
This new regulation allows the creation of a transitional regime for market infrastructures based on DLT to foster innovation and take advantage of the opportunities offered by security tokens, while ensuring investor protection and market integrity.
SImon Laforet
Senior officer in public and regulatory affairs, Global Markets
How will the Pilot Regime work in practice?
The PR will be set up for three years, starting early 2023, with the option to be extended by three more years, and will be monitored during its entire life cycle by national authorities and the European Securities and Markets Authority (ESMA). Market infrastructures (MI) who are eligible to take part in the PR will have the option to register as either a DLT Multilateral Trading Facilities (MTF), a DLT Trading and Settlement Systems (TSS) or a DLT Settlement Systems (SS) depending on their target business model. The PR will cover the issuance, trading and settlement of security tokens such as shares, bonds and UCITS with some specific issuer or issuance thresholds per asset classes on top of an overall threshold of €9 billion per DLT MI, above which, an exit strategy must be triggered as one of the safeguards.
Unlocking the benefits of security token trading
Security tokens trading could provide a cost-effective, transparent and secure way of trading securities. Currently the scale of security tokens trading remains limited primarily by the requirement to register and settle transactions in transferable securities that are ‘Traded on Trading Venues’ (ToTV) via a Central Securities Depositary (CSD). As most EU CSDs do not offer the ability to settle DLT securities, current activity is restricted to Over the Counter (OTC) trading where a CSD is not required. In this context, the PR will help overcome these barriers by bridging the regulatory gaps, and allow DLT-based market infrastructure to trade and settle security tokens directly on the DLT.
The execution of security tokens could happen indifferently on or off-DLT depending on the business model and the trading protocol while naturally, the settlement and lifecycle will always happen on DLT, no longer within days but closer to real-time. For example, one could favour simultaneous execution and settlement directly on DLT while, on the other hand, one could favour off-DLT execution (for instance OTC) with subsequent settlement on-DLT post-execution.
“The market will ultimately drive the optimal uses of DLT that are yet to unfold but the benefits of security token trading will be unleashed primarily with the availability of tokenised cash for delivery versus payment (DVP) atomic settlement, to ensure delivery and payment happen at exactly the same moment to eliminate settlement risk” commented Simon Laforet, senior officer in public and regulatory affairs, Global Markets at BNP Paribas.
Overall DLT could streamline conventional issuance, trading and settlement models and improve the fragmented nature of the security lifecycle, the multitude of reconciliation tasks and intermediaries currently required. Additionally, the introduction of smart contracts (digital contracts stored on a blockchain that are automatically executed when predetermined terms and conditions are met), could further enhance the settlement process and remove its inherent costs, risks and inefficiencies.
The key issue identified and that DLT is trying to solve is the fragmented nature of the security lifecycle and the multitude of reconciliation tasks and intermediaries required to facilitate the end to end process.
Amelie Fremy
Global Credit COO – Business Manager
Looking forward
The PR could lower existing barriers to new security tokens markets with the hope that DLT implementation might, in the future, surpass the capabilities of conventional issuance, trading and settlement models. However, the transition between the current world and a new potentially fully DLT-based world will require a period of interoperability between the two and most likely the emergence of transitional hybrid market architectures. This PR, and any future regulatory framework derived from it, should ensure and facilitate interoperability with traditional financial markets knowing on-DLT and off-DLT processes will inevitably co-exist for years to come.