As the EU’s Distributed Ledger Technology Pilot Regime goes live today, AFME discusses whether it will truly enable innovation in capital markets.
Finance and innovation have always been closely linked, and historically, technology has played a key role in modernising systems for consumers and markets. Financial services has continued to evolve at pace with the development of new technologies. In recent years, distributed ledger technology (DLT) has been identified as a key innovation that could transform capital markets.
DLT is a framework and protocol that combines database technology and cryptography, allowing multiple participants to each maintain their own copy of records in a shared dataset and make updates to it. All copies remain consistent through computerised consensus mechanisms rather than through a trusted third party. DLT implementation could be used in almost any industry that collects and uses data. For financial services, it could generate substantial efficiencies across the securities lifecycle, improve the resiliency of market infrastructure, reduce settlement risk and ultimately change the way market participants interact with one another.
However, the legislative and regulatory framework governing EU securities markets was designed prior to the advent of these new technologies and did not envisage the potential use of DLT in traditional capital markets. In order to investigate what legislative changes might be needed for DLT to be used in capital markets, the EU launched the DLT Pilot Regime (DLT PR) back in 2022 as part of its digital finance package.
The DLT Pilot Regime is an example of a regulatory sandbox, which allows established market participants and new entrants to test products in a controlled environment. It enables them to find out whether a particular technology can be implemented in a new and innovative way, while still meeting the appropriate regulatory outcomes and risk tolerances. Under the DLT PR, entities will be able to apply for temporary exemptions from certain requirements of existing European financial legislation which have been deemed 'incompatible' with the use of DLT in order to provide issuance and post-issuance services (including trading and settlement) through DLT-based market infrastructures.
As the EU DLT PR goes live today, the question arises as to whether the sandbox goes far enough. Does it truly allow for the necessary experimentation, innovation and the potential development of new infrastructures and a different ecosystem?
Approaches around the globe
The EU is not the only jurisdiction looking at how DLT could shape the future of capital markets. The UK Treasury is also looking at establishing sandboxes that would enable financial market infrastructures and other designated parties to test and adopt new technologies and practices by temporarily suspending, amending, or even applying certain laws. The UK Financial Market Infrastructures (FMI) sandbox has the potential to be much broader and could involve participation beyond Multilateral Trading Facilities (MTF) and Central Securities Depositaries (CSDs), however the UK Treasury has yet to consult on exactly what shape the sandbox will take.
In Asia, the Philippines is using a test-and-learn approach, which represents an alternative to the regulatory sandbox. In this strategy, regulators can use tools like letters-of-no-objection or case-by-case waivers to give innovators access to a regulatory-free environment while allowing oversight over the testing process and to step in when results become more apparent.
Additionally, the Monetary Authority of Singapore (MAS) is running both a FinTech Regulatory Sandbox that enables experimentation with innovative financial products and services, as well as Project Guardian which supports collaboration with the financial industry to test the feasibility of applications in asset tokenisation and DeFi. The Hong Kong Monetary Authority also has a Fintech Supervisory Sandbox which includes both regulatory tech (regtech) use cases as well as a small fraction of DLT projects.
Comparing these approaches, it is evident that the EU has been bold with the EU Pilot Regime initiative. Positively, the EU has been able to put effective measures in place faster than other regions to facilitate experimentation with DLT in trade and post-trade processes. The EU has gone further, faster, and may have a distinct first-mover advantage, gaining valuable knowledge and first-hand experience of how DLT can be applied in securities markets.
However, while bold, there are aspects of the EU DLT PR that may not encourage broad engagement in the sandbox from market participants. Throughout the DLT PR consultation process, AFME has raised concerns about the relatively low thresholds on both the size of permitted issuances of DLT-based securities and the market capitalisation of the issuer, as well as the process for authorisation following the sandbox exercise. There is still a lack of clarity on what the roll off to the real-world would look like and this could see participants disincentivised from investing time and money in new and innovative projects with an uncertain future.
Where are we now?
Market participants have keenly followed the legislative process and developments around the DLT pilot regime. The regime is an important step in facilitating DLT experimentation in capital markets. Many believe that the digitalisation of capital markets could represent a transformation comparable, if not greater, in scale and significance to the shift from physical to electronic securities.
Nonetheless, there are certain challenges with the EU DLT Pilot Regime and its sandbox. The divergence and inconsistency across the EU for the regulatory treatment of digital securities and their legal status under national securities laws could limit the effectiveness. For example, in Germany, Luxembourg and France there are local regulatory regimes capturing digital securities which are different in approach and not harmonised.
While the EU regulatory framework is designed to be technologically neutral, it has been constructed with traditional financial market infrastructure in mind. Therefore, there are concepts in regulations that are inconsistent with DLT environments. The DLT PR goes some way to address this, by providing derogations from certain regulatory requirements. This is an understandably pragmatic approach, but ultimately may leave little room for a more ambitious reimagining of how capital markets infrastructure is organised, and how networks of participants are connected.
Overall, the ability to successfully transform financial legislation to support the use of DLT across financial services will depend on how broadly the sandbox is used by industry participants and what the level of uptake is. The more participants adopt new and innovative structures, the better these structures can be applied successfully in the real world within the appropriate legislative and regulatory parameters, and the greater the benefits that can be derived from new technology.
However, true success for the DLT PR, which launched today will depend on whether the industry believes that a sandbox experiment will be beneficial. It will also depend on whether the parameters are open enough for them to be truly innovative in meeting regulatory requirements, rather than just using the new technology within an identically structured ecosystem.
A robust digital economy will thrive within an appropriate regulatory perimeter. It will be interesting to see what the uptake of the DLT sandboxes will be and how capital markets participants continue to innovate and implement new technologies.