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).
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.
Permissions granted under the Regulation would 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.