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The launch of the regime of tokenization of financial instruments in the EU with the DLT Pilot Regime opens a market that appears to have considerable potentials.
On 23 March 2023, the Regulation (EU) 2022/858 (so-called DLT Pilot Regime) finally came into force, which means that market infrastructures are allowed to apply for authorization on the tokenization of financial instruments on digital ledger transaction (DLT) platforms in accordance with the provisions of the DLT Pilot Regime. Moreover, the European Securities and Markets Authority (ESMA) issued its latest guidelines regarding the applications for the authorization to manage a market infrastructure based on DLT.
The DLT Pilot Regime is based on the interest of the European Union in exploring, developing and promoting the adoption of transformative technologies in the financial sector, including the adoption of the DLT.
To enable the development of financial crypto-assets and DLT while ensuring investor protection, market integrity, and financial stability, the DLT Pilot Regime allows certain market infrastructures to be temporarily exempted from specific requirements of financial legislation, facilitating the creation of solutions for both trading and settling transactions, with reference only to a limited number of financial instruments (shares, bonds etc.). For these purposes, the functions typically performed by multilateral trading facilities and securities settlement systems are merged in the pilot regime’s specialized market infrastructure based on distributed ledger technology, called DLT TSS.
The DLT Pilot Regime defines “tokenization of financial instruments” as a process that involves the conversion of traditional financial asset classes into digital tokens that can be stored, transferred and traded on distributed ledgers. This process is expected to revolutionize the financial sector by improving efficiency in the trading and post-trading processes.
The adoption of tokenization has the potential to reduce costs and increase the speed of transactions. Moreover, the decentralised nature of distributed ledgers allows for more secure and transparent transactions and, since tokens can be designed to represent fractional ownership in the underlying asset, market accessibility would be increased. As a result, tokenisation is expected to enhance market liquidity, reduce counterparty risk, and promote innovation in the financial sector.
In addition, tokenization can take many forms, including the creation of digital representations of financial instruments on distributed ledgers (that are far less frequent use cases) or the issuance of traditional asset classes in tokenized form.
The potential benefits of tokenization are not limited to the trading process; the use of smart contracts, which can be programmed to execute automatically upon the occurrence of specific events, can reduce the need for intermediaries in post-trading activities (i.e. clearing and settlement).
One of the critical aspects that could be found within the provisions of the DLT Pilot Regime, is the process of the authorization released only by national authorities; particularly, it should be noted that the application process for authorization to be admitted to the European experimental regime may imply a non-binding opinion provided by ESMA. As such, different access regimes and parameters may be established by each national authorities, potentially resulting in uneven access to the regime across different member states.
One of the most significant developments is the admission, in compliance with the requirements provided by the DLT Regime Pilot, of natural persons as members in the execution of transactions within DLT market infrastructures. In this regard, some doubts were raised in the Q&A process by ESMA; for example, under Article 26(5) of MIFIR, Trading Venues must report to the competent authority all the information on transactions in traded financial instruments that were executed by a firm and not by a natural person. For this reason, ESMA suggested that national authorities shall ask for compensative measures, such as adapting the templated provided by the actual Regulatory Technical Standards (RTS 22) on the reporting of transactions to competent authorities and populate the relevant Legal Entity Identifier (LEI) section with the national ID of the relevant natural person executing the transaction.
In the most recent ESMA guidelines, economic operators have highlighted some uncertainties in terms of (i) the clarity of the definition between DLT permissioned and permissionless; (ii) the definition of the institution of the so-called “transition strategy” provided for in Article 7(7) of the DLT Pilot Regime; and (iii) the clarity of the requirements provided for the access to market infrastructures by natural persons.
With respect to the above points, according to ESMA, a permissioned DLT grants more control in terms of admission to the network and performance of any action on the DLT, whereas in a DLT permissionless environment participants are free from reading data and interacting on the DLT. Secondly, according to ESMA, the requirements of good reputation provided by the DLT Pilot Regime and sufficient knowledge of the DLT, that are both required to be admitted as natural person in executing the transactions within the DLT market infrastructures, depend both on the possible presence of pending charges, warnings from regulatory authorities etc., and on the assessments carried out by the national authorities on the technical skills of the natural person (e.g. previous experience in the field of tokenization, DLT projects etc.).
We will see the developments of this market that seems to have massive potentials. On the same topic, you can find interesting the following article “The tokenization of a € 60 million bond on a blockchain“.