How can you prepare for the EU’s DLT Pilot Regime?
In December 2021, the final hurdle to implementation of the EU’s proposed DLT Pilot Regime was crossed. This means that in the coming months we can expect approval and enactment, with a launch date in early 2023.
Such a quick pace means banks and FMIs have one year to prepare if they hope to participate.
While the exact outlines of the program are not yet final, we used the draft text to suggest four steps that financial institutions could take that will set them up for success.
Step 1. Evaluate which financial assets are best suited as an initial offering
With several rule changes proposed, some assets may be better suited for a pilot.
Multilateral Trading Facilities (MTFs) and Central Securities Depositories (CSDs) in the Pilot Regime are granted exemptions from several rules currently regulated by the Market in Financial Infrastructures Regulation and Directive (MiFIR/MiFID II) and the Central Securities Depositories Regulation (CSDR). For example, rules related to intermediation, outsourcing, and cash settlement are adapted to track more neatly to a DLT-based system.
With this the EU is signaling that parts of the regulatory framework may need to be adapted slightly. However, the Pilot Regime balances this with the mitigation of potential market risk by setting value limits within the market infrastructures. Regardless, in allowing real and substantial value to be transacted by participants, the EU is giving DLT-based systems room to prove their mettle over that of a mere sandbox.
Step 2. Scope your technology requirements
This will identify what DLT platform will meet regulatory requirements and risk mitigation needs.
In January 2022, the European Securities and Markets Authority (ESMA) began considering what Regulatory Technical Standards related to transparency and data reporting should be adapted for a DLT-based system. These proposals will impact how data flow processes should be designed and will require a DLT platform capable of meeting regulatory standards.
Step 3. Identify your counterparties
These are the institutions, issuers or clients that will use your DLT market infrastructure.
The DLT Pilot Regime is the first of its kind and differs from other sandbox efforts in its focus on a specific use case: allowing MTFs and CSDs to begin implementing DLT-based market infrastructures. As part of the approval process, participants will have to present business plans to national regulators that describe which other financial institutions will participate in the DLT market infrastructure and what role they will play.
Step 4. Consider whether and how settlement coins will be incorporated
With settlement rules relaxed, tokenized cash can replace central bank money.
Current regulations require that settlement occur in central bank money where possible and practical. Yet, the Pilot Regime proposes allowing “settlement coins” to take their place.
The draft text defines settlement coins as “commercial bank money in a tokenized form, or e-money tokens.” This definition is taken directly from the still-pending Markets in Crypto-Assets (MiCA) Regulation. So far, little discussion has been given to this provision, but the spirit of the Pilot Regime language appears to allow room for participants to adopt tokenized settlement assets that reference a single fiat currency.
The use of settlement coins increases efficiencies of a DLT infrastructure by automating Delivery vs. Payment (DvP). This is achieved by reducing the need to adjust cash accounts at the same time as the delivery of securities. Effectively, the provision will allow DLT Pilot Regime participants to not only test DLT infrastructures but their digital currency strategy as well.
These four steps will move interested banks and FMIs closer to readiness for this Pilot Regime. The fact that the DLT Pilot Regime is a key part of the EU’s overall Digital Finance Strategy indicates member states recognize the capability of DLT to increase efficiency, reduce risk, and ultimately, enhance the competitiveness of European financial markets.
This proactive step from the world’s second largest economy could prove a catalyst for what regulatory clarity could unlock in finance. This is not the first time that we have seen innovative DLT regulations come out of Europe. The first fully-regulated capital markets infrastructure, SDX, launched in Switzerland in 2021.
Contact us today to hear how our experience could help your organization map out its digital assets or tokenization strategy.