Distributed ledger technology (DLT)
Distributed ledger technology (DLT) is commonly understood as a means of saving information through a distributed ledger, i.e., a repeated digital copy of data available at multiple locations (ESMA’s Advice of 9 January 2019 on Initial Coin Offerings and Crypto-Assets, ESMA50-157-139, p. 42).
5 October 2023
16 December 2022
Questions and Answers on the implementation of Regulation (EU) 2022/858 of the European Parliament and of the Council of 30 May 2022 on a pilot regime for market infrastructures based on distributed ledger technology, ESMA70-460-189
In turn, the European Commission Proposal of 24 September 2020 for a Regulation of the European Parliament and of the Council on a pilot regime for market infrastructures based on distributed ledger technology (COM(2020) 594) defines a ‘distributed ledger technology’ or ‘DLT’ as “a class of technologies which support the distributed recording of encrypted data”. DLT is built upon public-key cryptography, a cryptographic system that uses pairs of keys: public keys, which are publicly known and essential for identification, and private keys, which are kept secret and are used for authentication and encryption.
The term ‘blockchain’ is sometimes used interchangeably with a DLT, but, as observed in the Final Report of October 2018 of the U.K. HM Treasury, Financial Conduct Authority and the Bank of England (Cryptoassets Taskforce), blockchain refers rather to a specific way of structuring data on a DLT platform. The said document refers to a DLT in this context as “a type of technology that enables the sharing and updating of records in a distributed and decentralised way. Participants can securely propose, validate, and record updates to a synchronised ledger (a form of database), that is distributed across the participants”.
Published in September 2020 the European Commission Proposal for a Regulation of the European Parliament and of the Council on a pilot regime for market infrastructures based on distributed ledger technology (COM(2020) 594) seeks to provide legal certainty and flexibility for market participants who wish to operate a DLT market infrastructure by establishing uniform requirements for operating these.
It was intended that permissions granted under the Regulation allow market participants to operate a DLT market infrastructure and to provide their services across all EU Member States.
Concise overview of main assumptions of the European Commission's legislative proposal is included below:
Article 1 defines the subject matter and scope. In particular, the draft Regulation establishes operating conditions for DLT market infrastructures, permissions to make use of them and the supervision and cooperation of competent authorities and ESMA. The Regulation applies to market participants (either investment firms, market operators or central securities depositories, CSDs) permissioned in accordance with Article 7 or Article 8.
Article 2 sets out terms and definitions, among others: ‘DLT market infrastructure’, ‘DLT multilateral trading facility’ or ‘DLT MTF’, ‘DLT securities settlement system’ and ‘DLT transferable securities’.
Article 3 describes the limitations in terms of DLT transferable securities that can be admitted to trading on, or recorded by, DLT market infrastructures. For shares, the market capitalisation or the tentative market capitalisation of the issuer of DLT transferable securities should be less than EUR 200 million; for public bonds other than sovereign bonds, covered bonds and corporate bonds the limit is EUR 500 million. DLT market infrastructures should not admit to trading or record sovereign bonds. In addition, the total market value of DLT transferable securities recorded by a CSD operating a DLT securities settlement system, or by a DLT MTF where allowed to record such DLT transferable securities, shall not exceed EUR 2.5 billion.
Article 4 sets the requirements for a DLT MTF, which are the same as for an MTF under Directive 2014/65/EU and specifies the exemptions possible under the Regulation.
Article 5 sets the requirements for a CSD operating a securities settlement system, which are the same as for a CSD under Regulation (EU) No 909/2014 and specifies the exemptions possible under the Regulation.
Article 4 and Article 5 contain a limited list of exemptions that DLT market infrastructures can request and the conditions attached to such exemptions.
Article 6 sets the additional requirements applicable to DLT market infrastructures to address the novel forms of risks raised by the use of DLT. DLT market infrastructures must provide all members, participants, clients and investors with clear and unambiguous information on how they carry out their functions, services and activities and how these are different from a traditional MTF or CSD. DLT market infrastructures must also ensure that overall IT and cyber arrangements related to the use of DLT are adequate. Where the business model of a DLT market infrastructure involves the safekeeping of clients’ funds or DLT transferable securities, or the means to access these, they must have adequate arrangements to safeguard such assets.
Article 7 and Article 8 set out the procedure for the specific permission to operate a DLT MTF and a DLT securities settlement system respectively and include details on the information that must be submitted to the competent authority.
Article 9 defines the cooperation between the DLT market infrastructure, competent authorities and ESMA. DLT market infrastructures must inform competent authorities and ESMA of, for example: proposed material changes to their business plan including critical staff, evidence of hacking, fraud or other serious malpractice, material changes in the information contained in the initial application, technical or operational difficulties in delivering activities or services covered under the permission and any risks to investor protection, market integrity or financial stability that may have arisen and were not foreseen at the time the permission was given. Where notified of such information, the competent authority may request the DLT market infrastructure to submit an application for another permission, exemption or take any corrective measure it deems appropriate. The DLT market infrastructure is obliged to provide any requested information to the competent authority which granted the permission and ESMA. The competent authority, after the consultation of ESMA, may recommend corrective measures to the DLT market infrastructure to ensure investor protection, market integrity or financial stability. The DLT market infrastructure needs to detail how these have been accommodated. In addition, the DLT market infrastructure shall produce and submit a report to the competent authority and ESMA detailing all of the information above including potential difficulties in applying EU financial services legislation. ESMA shall, on a regular basis, inform all competent authorities about the aforementioned reports produced by DLT market infrastructures and exemptions granted in accordance with Article 7 and Article 8, monitor the application of these exemptions and submit an annual report to the Commission on how they are applied in practice.
Article 10 details, that at the latest after a five-year period, ESMA will produce a detailed report on the pilot regime to the Commission. On the basis of ESMA’s assessment, the Commission will produce a report including a cost-benefit analysis on whether the pilot regime should be maintained as it is or amended, whether it should be extended to new categories of financial instruments, whether targeted amendments to EU legislation should be considered to enable a widespread use of DLT and whether the pilot regime should be terminated.
Article 11 indicates that the regulation shall enter into application 12 months after its entry into force.
Regulation (EU) 2022/858 of the European Parliament and of the Council of 30 May 2022 on a pilot regime for market infrastructures based on distributed ledger technology, and amending Regulations (EU) No 600/2014 and (EU) No 909/2014 and Directive 2014/65/EU has been published in the EU Official Jornal on 2 June 2022.
DLT Market Infrastructure
As underlined by Verena Ross, the ESMA Chair (“Building safe digital financial markets: a collective effort”, ISLA 30th Annual Securities Finance & Collateral Management Conference, 21 June 2023, Lisbon) one of the key elements of the DLT Pilot Regime is that it will allow disintermediation and direct access for retail investors to trading and settlement platforms - a possibility which was not foreseen in MiFID II or CSDR.
The DLT Pilot Regime will also allow for the creation of a new and more integrated type of Financial Market Infrastructure (FMI) merging trading and settlement (DLT trading and settlement system).
DLT Pilot Distributed Ledger Technology offers a very diverse range of use cases which are not all within the scope of Regulation on markets in crypto-assets (MiCA) but can also be applied to more traditional sectors. Applied to financial instruments, it can make settlement cycles quicker, more efficient, and more transparent because it requires fewer intermediaries and enables greater automation. To capitalise on these benefits, financial entities interested in testing the new technology may apply for the DLT Pilot Regime, which entered into application in the EU in March 2023. The DLT Pilot Regime provides the legal framework for trading and settlement of transactions in cryptoassets that qualify as financial instruments under MiFID II. The DLT Pilot Regime facilitates the set-up of new types of market infrastructures, such as a DLT multilateral trading facility, a DLT settlement system, as well as a combined DLT trading and settlement system. In addition to established investment firms, market operators or CSDs, new entrants may also apply for the DLT Pilot Regime. Under the DLT Pilot Regime, National Competent Authorities (NCAs) will authorise and supervise firms, while ESMA will have an important coordination and convergence role. For example, ESMA has issued and will continue to issue guidance on several aspects of the DLT Pilot Regime and will be able to give opinions on the national authorisations.
As of June 2023 the first two official applications were submitted and around 15 other potential applications were in the pipeline for the second half of 2023 and the beginning of 2024.
The DLT Pilot Regulation introduces three categories of the so-called “DLT Market Infrastructure”: DLT Multilateral Trading Facilities (DLT MTF), DLT Trading and Settlement Systems (DLT TSS) and DLT Settlement Systems (DLT SS). DLT Market Infrastructure can request limited exemptions from specific requirements in EU legislation (MiFID II, CSDR), provided they comply with the conditions attached to those exemptions and compensatory measures requested by the relevant national authority (NCA). The permission to operate a DLT Market Infrastructure may come in addition to an authorisation as a CSD or as an investment firm (or regulated market) or can be granted to new entrants that will have to meet the relevant MiFID II/ CSDR requirements, except those for which the applicant requests, and has been granted, an exemption.
A DLT SS is a settlement system, operated by a CSD that settles transactions in DLT financial instruments. It may require exemptions from some definitions under CSDR (dematerialised form, transfer orders, securities account) as well as from rules on recording of securities, integrity of issue, segregation of assets, measures to prevent and address settlement fails, outsourcing, conduct of business, settlement finality, cash settlement or access between CSDs, and between CSDs, trading venues and CCPs, and might not be designated as a securities settlement system under the Settlement Finality Directive, provided that appropriate compensatory measures are in place.
A DLT TSS is a DLT market infrastructure operated by an investment firm or a market operator or by a CSD that combines the activities of both a DLT MTF and a DLT SS, and as such may apply for exemptions available both to a DLT MTF and a DLT SS, associated with relevant compensatory measures.