One of the three pillars of the Digital Finance Package of the EU Commission from 2022 is the creation of a so-called “Regulatory Sandbox” for market infrastructures that are based on distributed-ledger-technologies. The European regulator finally published the final version of its DLT Pilot regime on the 2nd of June 2022. The new regulation will be effective as of the 23rd of March 2023. The DLT Pilot regime will not have anything to do with crypto assets such as Bitcoin or Ether. At least for the time being it will rather be about the creation of a temporary, simplified regulatory environment for investment firms, market operators and central securities depositories, which intend to engage in the trading of tokenized securities on regulated markets pursuant to the MiFID II regulation. The regulation will create simplified conditions for DLT-based multilateral trading facilities (DLT MTF), DLT securities settlement systems (DLT SS) and DLT trading and settlement systems (DLT TSS). The objective of the pilot regime is to enable the trading of tokenized securities (Security Tokens) on regulated markets in the EU.

Why is the DLT Pilot Regime Required for the Organized Trading of Security Tokens?

There have been numerous issuances of security tokens in the last couple of years worldwide and also within the EU, which qualified as transferable securities pursuant to MiFID II in accordance with the applicable financial markets regulations. These tokens were regularly offered outside of regulated markets. There was no listing of tokenized securities on regulated exchanges and multilateral trading facilities. The reason is that it is required for the admission of a security to an organized market, that the security is registered as a book entry security with a central securities depository. The central securities depository is tasked with the safe custody of the (securitized) security and shall ensure the correct documentation of the transaction record of the respective security. Both aspects are essential for functioning professional trading on organized markets. According to the applicable regulations, these tasks are not performed by the market operator itself, but instead by a trusted third party, the central securities depository. In contrast, in case of tokenized securities, the tokens can be kept in custody and transferred by the owners themselves instead of a securitized document which requires to be kept in custody. The transfer of a security token may take seconds, minutes or even hours depending on the specific underlying DLT, which is not feasible for organized trading. The DLT Pilot regime will enable investment firms, respectively market operators to either take on the obligations of a central securities depository or to temporarily release them of those obligations, if they fulfill specific requirements.

How Will Investment Firms and Market Operators Benefit from the DLT Pilot Regime?

In order to benefit from the privileges of the DLT Pilot regime, market operators, investment firms and central securities depositories will have to apply for special authorizations and prove to the respective competent national authorities that they are eligible. They must show in their applications which technical precautions they undertake in order to ensure a sufficient security level for all involved parties and what transitional measurements they implement to ensure a transition to a proper regulation, after expiration of the DLT Pilot regime. The DLT Pilot regime will initially be effective for three years. Subsequently, the member states will report their experiences with the Pilot regime to the European Securities and Markets Authority (ESMA) in order to create the basis for a validity extension or for the creation of a follow-up regulation.

Attorney Lutz Auffenberg, LL.M. (London)