In September 2020, the European Commission adopted its Digital Finance Package, an initiative aiming at strengthening the EU’s competitiveness in the field of new financial technologies, which includes legislative proposals on crypto-assets and digital resilience.
In fact, the largest portion of the current framework for financial regulation has been designed for traditional financial products and services without taking into account the increasing importance of new technologies in the field and, in particular, the emergence of distributed ledger technology (“DLT”). On one hand, such inadequate financial regulations potentially preclude or restrain the development of DLT and its use in the financial environment by imposing unnecessary obstacles while, on the other hand, some emerging risks that are related to DLT may be ignored completely.
In view of this inadequacy of regulatory framework, the European legislator has issued Regulation (EU) 2022/858 of 30 May 2022 on a pilot regime for market infrastructures based on distributed ledger technology (the “Pilot Regime” or the “Regulation”), which has been published in the Official Journal of the European Union on 2 June 2022.
What’s the objective of the Pilot Regime and how does it differ from MiCAR?
While the Pilot Regime, as well as the proposed regulation for Markets in Crypto-assets (“MiCAR”), have both been created in the context of the Digital Finance Package their material scope is not the same.
The Pilot Regime applies to crypto-assets that are financial instruments within the meaning of Directive 2014/65/EU of 15 May 2014 on markets in financial instruments (“MiFID II”), i.e. to crypto-assets that would normally be subject to financial regulations. In contrast, MiCAR creates a regulatory framework for all other crypto-assets, i.e. crypto-assets that are not financial instruments (within the meaning of MiFID II) such as cryptocurrencies, which would otherwise be unregulated as they do not fall within the scope of traditional financial regulation.
With the introduction of the Pilot Regime, the European legislator addresses the inadequacy of the current regulatory framework with regard to crypto-assets (that qualify as financial instruments).
The Regulation establishes a so-called “sandbox” regime, i.e. a testing environment with a set of exemptions to legal obligations under the existing regulatory regime which are deemed to be too restrictive for authorised financial market infrastructures which use DLT to provide trading or settlement services, or a combination of such services, for crypto-assets (that qualify as financial instruments). It allows to create a temporary framework for a limited number of regulated entities to operate such infrastructures without prematurely amend the current financial regulatory framework.
The central idea is to promote the development of DLT in the financial environment by allowing certain market participants to be temporarily exempt from specific requirements under the general regulatory regime while preserving a high level of investor protection, market integrity, financial stability and transparency, and avoiding regulatory arbitrage and loopholes.
What is the scope of the Pilot Regime?
The Regulation sets forth requirements and exemptions for DLT-based market infrastructures, i.e. (i) multilateral trading facilities, (ii) securities settlement systems, and (iii) trading and settlement systems.
As already previously discussed, the Pilot Regime only applies to financial instruments within the meaning of MiFID II and which are:
- shares, the issuer of which has a market capitalisation (or a tentative market capitalisation) of less than EUR 500 million;
- bonds and other forms of securitised debt with an issue size of less than EUR 1 billion (excluding those that embed a derivative or incorporate a complex structure); or
- units in collective investment undertakings, the market value of the assets under management of which is less than EUR 500 million.
Furthermore, the aggregate market value of all the financial instruments that are admitted to trading or that are recorded on such market infrastructure must not exceed EUR 6 billion at the moment of admission to trading or initial recording.
Where the aggregate market value of all the financial instruments that are admitted to trading on a DLT market infrastructure or that are recorded on a DLT market infrastructure has reached EUR 9 billion, the operator of the DLT market infrastructure is required to activate a specific transition strategy in accordance with the requirements set out in the Regulation.
What does it mean to be subject to the Pilot Regime Regulation?
Operators of market infrastructures that intent to implement DLT in their business model can apply to their national competent authority (“NCA”) to be submitted to the Pilot Regime in order to benefit from certain exemptions under the standard regulatory regime.
The relevant NCA can grant such permission for up to six years under the Regulation while being also entitled to impose to the applicant certain requirements and safeguards to address novel types of risk if deemed necessary.
The Pilot Regime is optional and eligible market participants are free to choose whether they want to be subject to the Regulation or not. The legislator also emphasises that the Regulation is equally addressed to incumbent institutions as well as to new entrants.
The Pilot Regime is also “passportable,” which means that an authorisation obtained in one EU member state is valid throughout the EU’s single market and, thereby, pursue their activities in any member state of the European Economic Area.
What is the outlook for the Pilot Regime?
The raison d’être of the Pilot Regime is to create a temporary testing ground for DLT in the financial sector. It gives the opportunity to the market participants as well as to the regulators to learn about this new technology and the challenges that come with it. Even in the scenario where the EU decides to extent the temporary regime under the Regulation, in our view, the emergence of DLT in the financial environment is inevitable and the permanent implementation of DLT specific provisions in the financial regulatory framework seems certain.
The only question that remains is the timeframe for such development. The answer to this question is not without interest as the European Union tries to ensure its pioneer status in this new and promising technology, while the competition in Asia and across the Atlantic does not sleep.
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