Nicholas Pratt looks at the launch of Esma’s DLT Pilot Regime and what it could mean for the evolution of Europe’s digital assets market.
On March 23, the European Securities and Markets Authority (Esma) launches its long-awaited DLT Pilot Regime. While its imminent arrival has been broadly welcomed in terms of providing legal certainty for certain players in digital assets and the outlines of a regulatory framework, there is some scepticism as to whether it will encourage more involvement from issuers and investors.
For the sceptics, it is not so much a brave new world and more like a cautious update of the existing centralised ecosystem, which provides a chance for the established market infrastructures like central securities depositaries (CSDs) and exchanges to experiment with the blockchain but does little for the digital or crypto-native upstarts looking to break into the market.
The pilot is part of a package of measures introduced by the European Commission in 2020 under the banner of the Digital Finance Package, which also includes the Markets in Crypto Assets (MiCA) regulation.
The pilot launch is a “hugely significant step” for tokenisation, according to James Haskell, chief operating officer of Etrading Software, the company responsible for developing the Digital Token Identifier (DTI).
Broadly speaking, it is a mechanism for expanding existing market regulations such as MiFIR [the Markets in Financial Instruments Regulation] to cater for the growing digital assets market.
In Haskell’s view, this will accelerate tokenisation because it will provide reassurance for institutional investors who want to see the same levels of transparency, control and fairness for digital assets that exist for traditional securities.
Essentially it is a tangible step to demonstrating the benefits of blockchain-issued securities and moving from theory to practice.
“It is a very important milestone,” says Haskell. “It allows market infrastructures to use blockchains. The participants in the pilot will be allowed limited exemptions. For example, exchanges and MTFs [multilateral trading facilities] will allow members to trade directly rather than via a broker or for a CSD to act as an exchange under the DLT Trading and Settlement System designation.”
Blockchain issuanceThe pilot will enable participants to test how securities could be issued and traded via the blockchain and with certain intermediaries removed from the process in a way that satisfies regulators via certain compensatory measures.
One of those measures is the Digital Token Identifier (DTI). In traditional bond issuance, there is an identifier for the issuer (ISIN), the location (MIC) and the depositary. In tokenisation, the asset is converted into a digital token on a blockchain, and the contract is stored on a blockchain. A new third party is being introduced to the market infrastructure, but these blockchains are largely unregulated.
This is where the DTI comes in, says Haskell. “It recognises the digital asset and uniquely and unambiguously links the instrument to the blockchain. Without it, we would have a knowledge gap. I see it as a permanent fixture. It is designed to be interoperable with all the other identifiers. So, it is a huge benefit for the institutions and market participants.”
The primary objective of the Pilot Regime is to see whether and how DLT can improve the functioning of market infrastructures, says Laurent Marochini, head of innovation at Societe Generale Securities Services (SGSS) Luxembourg.
“The main beneficiaries of these potential improvements will primarily be issuers and investors in security tokens, as well as asset managers who are both issuer and investor.”
“The main beneficiaries of these potential improvements will primarily be issuers and investors in security tokens, as well as asset managers who are both issuer and investor. In addition, asset servicers, as service providers for issuers and for investors, will have to be able to process security tokens,” says Marochini.
“The Pilot Regime is, therefore, an important milestone as it will enable the secondary market to be used for more tokenised products and allow asset managers and investors to increase the variety of products. As a result, they should see the benefits of the tokenisation, similar to the reduction of the settlement cycle and the efficiencies this has created as a whole.”
Whether it will lead to more DLT-based infrastructures, Marochini says it will depend on whether the pilot is successful or not. “As this is an experiment, the European legislator has limited the amount of security tokens that can be issued during the Pilot Regime and, therefore, indirectly, the number of DLT infrastructures,” he says. “On the other hand, this limitation will cease at the end of the Pilot Plan, after three or six years.”
If the pilot is successful, it will accelerate the use of tokenisation, says Marochini. “That said, tokenisation goes far beyond the framework of the Pilot Regime, namely that unlisted securities, which do not have an obligation to pass through market infrastructures, can already be tokenised.”
Societe Generale, through its subsidiary SG FORGE, has, for example, already issued several tokenised bonds, says Marochini. “The interest for us is to eventually have market, and especially post-market, infrastructures that can manage both listed and unlisted securities. If successful, we strongly believe that the Pilot Regime can accelerate the pace of tokenisation and a cash-on-chain solution like a wholesale central bank digital currency (CBDC), which will be a key determining factor,” he adds.
Gauging asset managers’ and investors’ interest in the DLT Pilot regime before its commencement is difficult, says Eliane Meziani, senior adviser – public affairs at French asset servicing provider Caceis. According to Méziani, pilot regimes are typically designed to reveal areas with more legal or regulatory clarity. In the cryptoassets world, there are several such grey areas, including the classification of cryptoassets and the custody and issuance of these assets. “The relevant use cases that will undoubtedly emerge from this sandbox will make it possible to answer these questions and to understand these players’ interest in DLT better,” says Méziani.
Barriers to entryHowever, when asked if the pilot regime will lead to developing new DLT-based infrastructures, Méziani is doubtful, mainly because access at this experimental stage is limited to specific market infrastructures such as CSDs and any authorisation requests must be made through it. “Barriers to entry such as high initial set-up costs will clearly favour existing infrastructures already used for traditional assets,” she says.
“A key factor in a successful uptake of DLT in the funds and trading world is the existence of a secondary market where investors can purchase securities or assets from other investors, which in turn requires establishing multilateral trading facilities for tokens,” says Méziani. “The pilot regime is taking things in the right direction for such developments to take place.”
Not everyone sees the DLT Pilot Regime and the EU’s package of digital asset regulations as a major milestone that will accelerate tokenisation. For Luc Falempin, chief executive of Tokeny, the Luxembourg-based tokenisation platform, it does not address the decentralisation argument.
While it will provide some legal certainty in terms of tokenised securities being defined as securities, the DLT Pilot is aimed squarely at the market infrastructure players in the traditional centralised market, argues Falempin. “Yes, it will encourage more issuance of tokenised assets, but I don’t expect it to result in greater liquidity or greater investor interest in the short term.
“A key factor in a successful uptake of DLT in the funds and trading world is the existence of a secondary market where investors can purchase securities or assets from other investors, which in turn requires establishing multilateral trading facilities for tokens.”
“Anyone issuing tokenised securities on a public exchange still has the same obligations that come with public issuance with the same intermediaries. The DLT Pilot won’t drastically change anything,” says Falempin.
In essence, it is a TradFi versus DeFi argument and whether technology like DLT and the blockchain is better used to make the existing model slightly more efficient or to enable entirely new operating models and market infrastructure.
The traditional centralised market, with exchanges and CSDs, has worked well for many years. In contrast, the private markets are currently far less efficient and would benefit far more from tokenisation and DLT, especially when investor interest in private assets is increasing. Consequently, Falempin would like to see greater use of DLT in these private markets where the impact could be transformative.
Additional stepsWhile market participants may have different views on the significance of the DLT pilot, they all agree that additional steps will be needed if tokenisation is to take off.
Firstly, the pilot and any subsequent changes to regulation or market infrastructure resulting from the pilot will need to be consistent with similar projects, such as the UK’s Financial Market Infrastructure Sandbox.
Secondly, says Marochini, all stakeholders need to be mobilised, from asset managers to central banks. “Not only do you need infrastructures adapted to DLT, but you also need issuers to issue in tokenised form and investors to decide to invest in this new category of securities.
According to the CSDs, there will also be a need for coordination between all the different market players and, hopefully, some form of network effect to avoid a fragmented clearing and settlement landscape populated by hundreds of individual DLT market infrastructures.
A successful DLT initiative, say the CSDs, will be driven by the whole market’s needs and not the ones of individual entities or specific market segments.
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