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On April 3, 2024, the European Securities Market Authority (ESMA) sent an update letter to the European Commission and other EU institutions on the uptake of distributed ledger technology by financial market infrastructures in the context of the DLT Pilot Regime (Regulation (EU) 2022/8581 ).
This letter was sent and published instead of an interim report that ESMA is required to publish (see Article 15 of the DLT Pilot Regulation). ESMA must publish annual interim reports to (i) inform market participants on market functioning, (ii) address misconduct by DLT market operators, (iii) clarify Regulation applications, and (iv) update guidance based on DLT evolution.
The first such report was expected to be published by March 24 2024. However, since the DLT Pilot Regime entered into force on March 23 2023, no DLT market infrastructure has been authorised. This is concerning, as the regime was meant to facilitate innovative DLT projects, but the opposite seems true.
ESMA attributes the slow uptake to the regime’s novelty. Yet, if we review the DLT ecosystem in the EU, we can reasonably easily determine numerous potential applicants. Besides the zero granted permissions, what is even more concerning is that there were only four official applications (one DLT TSS and one DLT MTF in Germany, one DLT SS in the Czech Republic, and one DLT TSS in the Netherlands). The respective NCAs are currently assessing these applications.
The fact that no DLT operators were granted permission to operate within the first year of their application and only four applications across the whole EU were submitted should prompt immediate attention from the European authorities, researchers, and the market. Indeed, ESMA itself has identified some challenges.
Identified Challenges by ESMA
- Innovative Solutions for Cash Settlement – In the absence of central bank digital currencies, the DLT Pilot Regime offers the opportunity for innovative cash settlement solutions, such as tokenised commercial bank money or e-money tokens. However, delays in MiCA authorisations have made it challenging for applicants to find cash leg providers. DLT SS/TSS operators can settle payments using e-money tokens issued by credit institutions.
- Custody through Self-Hosted Wallets – Custody through self-hosted wallets in the DLT Pilot Regime requires further clarification. The regime covers a subset of financial instruments under MiFID II, while MiCA deals with non-financial crypto-assets, including e-money tokens. Regulatory expectations for custody services in DLT market infrastructures and the roles of entities, particularly regarding non-custodial “self-hosted wallets,” need to be clarified to address potential overlaps with MiCA or MiFID II custody services.
- Interoperability between DLT and traditional market infrastructures, as well as among DLT infrastructures, poses significant challenges. Due to technological and operational complexities, DLT MTF operators struggle to find authorised DLT TSS or DLT SS or access traditional CSDs.
- Investor Protection – The DLT Pilot Regime allows NCAs to grant retail investors access to DLT market infrastructures under certain conditions, bypassing the MiFID II “obligation of intermediation.” This requires additional investor protection measures due to the complex interaction between MiFID II and the DLT Pilot Regime. Retail investor access is limited to non-complex financial instruments, and further clarity is needed for consistent implementation across the EU. ESMA has requested the Commission’s interpretation of these issues, including the treatment of pre-emptive subscription rights for shares on DLT platforms.
- Competitiveness vis-à-vis Third-Country Regimes – Uncertainty about the DLT Pilot Regime’s duration and low thresholds for DLT financial instruments undermine its competitiveness. Public assurance of the regime’s extension and greater threshold flexibility could attract more applicants and ensure sufficient time for project implementation.
Response from the European Commission
In a letter dated April 3, 2024, European Commission briefly responded to the ESMA’s letter stating that despite the slow start, only four applications are under review, highlighting the regime’s potential. The Commission emphasised the DLT Pilot Regime’s potential for fostering DLT-based market solutions, enhancing efficiency, reducing costs, and mitigating risks. The Commission reiterated its commitment to resolving implementation challenges and clarified that there is no expiration date for the regime, with no plans for termination. The Commission’s focus remains on supporting innovation in financial markets. Thus addressing only one concern that ESMA stipulated.
Additional Considerations for ESMA
Besides the challenges identified by ESMA, there are additional concerns that might have caused the extremely limited number of applications. Undoubtedly, a significant barrier is the complexity and interoperability of the application process, which deters potential applicants. However, there may be a misalignment in the target audience – the operators. On one hand, the DLT Pilot Regime aims to foster innovation and enhance the DLT landscape. Yet, except where specific exemptions apply, most operators remain regulated by existing frameworks like MiFID II, MiFIR, MAR, or CSDR. This ultimately means that only regulated operators qualify to operate DLT market infrastructure. Any new operators will still need to obtain all the necessary permissions under the applicable law, with minimal exceptions, which is contrary to the idea of a sandbox.
The DLT Pilot Regime, intended to spur innovation, inadvertently favours established, regulated entities due to its complex application process and regulatory requirements. To truly foster innovation and support new entrants, it may be necessary to simplify the application process, reassess the regulatory framework, and open the DLT regime for unregulated operators. This will ensure the regime meets its original purpose of creating a more inclusive and innovative environment for DLT market infrastructures.
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