With the March 2023 go-live date for the EU’s DLT pilot regime fast approaching, Dr Alisa DiCaprio, chief economist at R3, discusses four actions that participating firms can take to prepare.
The European Union’s (EU) Distributed Ledger Technology (DLT) pilot regime is part of the Digital Finance Package introduced by the European Commission in 2020. The pilot, which was officially agreed upon by the European Council in December 2021, is a decisive step forward in the promotion of DLT use in capital markets. Specifically, this action aims to promote the use of blockchain for the issuance and trading of tokenised stocks, bonds, and funds – including money market funds.
With the pilot set to launch on 23rd March, here are four key steps that participating banks and FMIs should take to improve their readiness for the program.
1) Identify which financial assets to use as an initial offering
There are a limited number of financial instruments that are admitted to the Pilot Regime. Each of these has specific exemptions and mitigation requirements.
The Pilot Regime exempts participating multilateral trading facilities (MTFs) and Central Securities Depositories (CSDs) from existing governing rules, including the Market in Financial Infrastructures Regulation and Directive (MiFIR/MiFID II) and Central Securities Depositories Regulation (CSDR).
The exemption from current legislation permits users to trade directly without using a broker, as well as combining trading and post-trade infrastructure to allow CSDs to operate an exchange. This was done to allow processes to run more neatly on a DLT-based system.
There are conditions to the exemptions that should also inform instrument choice. For example, ESMA has set value limits within the market infrastructure to avoid any potential market risk posed by the relaxation of certain rules in the Pilot Regime.
2) Choose technology that meets regulatory requirements
For participants, the choice of DLT is open, but it must comply with existing Regulatory Technical Standards (RTS) for transparency and data reporting requirements.
After consulting with stakeholders about whether DLT-based trades should have different requirements, ultimately, ESMA issued a report that confirmed it was not necessary to amend the RTS but also acknowledged that additional guidance would be forthcoming, for example, on the interpretation of “transferrable securities.”
Participants in the pilot will need to ensure that the technology they use is compatible with any rule changes and meets regulatory standards. As additional guidance is issued, this will also need to be taken into account.
3) Get to know your counterparties
There are many sandboxes and pilots taking place across other jurisdictions, but the EU’s DLT Pilot Regime is unique because it focuses specifically on allowing MTFs and CSDs to begin implementing a DLT-based market infrastructure.
Participants will need to identify the exact role of the institutions, issuers, and clients that will operate in the DLT market infrastructure and present business plans to national regulators as part of the approval process.
4) Make use of the settlement coin provision
The relaxation of settlement rules means participants can use tokenised cash instead of central bank money. Current regulations require settlement to take place via central bank money where possible, but under the Pilot Regime, settlement coins will take their place.
ESMA describes settlement coins as “commercial bank money in a tokenised form” or “e-money” (this language mirrors the EU’s Markets in Crypto-Assets regulation). Although this provision has received little discussion, this suggests that participants will be able to adopt tokenised settlement assets that reference single fiat currency.
The introduction of tokenisation will reduce the need to adjust cash accounts at the same time as the security settlement, thereby enhancing the efficiency of the Delivery vs Payment process. Overall, this provision will allow participants to test their own digital currency as well as test the underlying DLT infrastructure itself.
One giant leap for DLT
The DLT pilot regime is a hugely promising first step in the introduction of bloc-wide DLT applications for the trading and settlement of securities. The pilot also complements Europe’s ongoing efforts to advance DLT-based projects, such as the Banque de France’s wholesale central bank digital currency (CBDC) pilots and Switzerland’s fully regulated capital markets infrastructure, SIX Digital Exchange (SDX).
Although some EU countries are more advanced than others in introducing a DLT regulatory framework and conducting tests of central bank digital currency, the DLT Pilot is a key part of the EU’s aim to enhance the competitiveness of European financial markets.
Participating financial institutions that take these four steps into account will be best placed to realise the efficiency benefits that this technology can bring to capital markets.
*Dr. Alisa DiCaprio is an expert on digital economy issues and prior to joining R3, was chair of the Fintech Committee at the US Department of Commerce. As chief economist at R3, Alisa provides economic advice on developments in blockchain, digital assets, Central Bank Digital Currencies (CBDCs), trade and payments.
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