DLT-TSS pilot regime: What opportunities the EU regulation offers for financial market participants

What does the new DLT pilot regime regulate? And why?

The DLT pilot regime is in addition to the DORA (Digital Operational Resilience Act) and the MiCA (Regulation on Markets in Crypto Assets) another initiative of the European Union to promote the digitization and liberalization of financial markets. After a legislative process lasting almost two years, on June 2, 2022, the Regulation 2022/858 of the European Parliament and of the Council on a pilot scheme for DLT financial market infrastructures published. The new regulation will apply for three years from March 23, 2023, with the option to extend it for a further three years. Their aim is to promote innovation and adoption of new financial technologies by reducing regulatory barriers, while reducing risks for consumers and institutions and maintaining market stability.

For example, in the area of security tokens (tokenized investments). In recent years, there have been numerous issues of security tokens worldwide, which were classified as transferable securities under current financial market regulations. However, there was no listing of tokenized securities on regulated stock exchanges and multilateral trading systems. The background is that listing a security in trading on organized markets requires it to be recorded in the securities register of a central securities depository. Since tokenized securities do not contain a document, but only a number of tokens whose transfer and custody by the respective holder themselves is possible almost immediately, security tokens are not practicable for the traditional system with intermediaries, such as banks and stock exchanges.

For this reason, the EU has launched a new regulation: A Pilot regulation for market infrastructures based on distributed ledger technology. The DLT pilot regime allows the responsibilities of market participants and central securities depositories to be combined under certain conditions in order to achieve the practicability of trading and settlement of DLT financial instruments on the regulated market. The regime is thus intended to pave the way for decentralized capital market infrastructures and give further impetus to the transformation of the European financial market. This is because the regulation opens up new fields of activity and business models based on DLT technology for players on the capital market, such as investment companies, market operators and central securities depositories.

DLT financial instruments can be used via a Distributed Ledger are emitted, transmitted and stored. Crypto assets are among the most important DLT applications. In addition, the regulation distinguishes between three so-called “permit conditions”: DLT-MTF (Multilateral Facility Trading), DLT-SS (Settlement System) and DLT-TSS (Trading and Settlement System).

What is DLT-MTF (Multilateral Trading Facility)?

Put simply, an MTF is a trading system for financial instruments for which there is no official market (such as a regulated stock exchange). MTFs were created in response to the Markets in Financial Instruments Directive (MiFID), which were introduced by the European Union in 2007, and aim to create a more competitive and integrated financial market. MTF trading systems must therefore be properly regulated and approved. They are also required to define rules that are the same for all participants and to work accordingly. These include:

• Price calculation
• Ensuring that transactions are carried out properly
• Contractual processing of transactions

The Tradegate trading platform was the first MTF in Germany.

What are the benefits of the DLT-TSS (Trading and Settlement System)?

The third and last new “permitting requirement” of the EU regulation is particularly relevant: The DLT-TSS combines the activities of a trading system (DLT-MTF) with those of a settlement system (DLT-SS). The DLT pilot regime thus enables DLT securities to be traded and settled from a single source. The option to operate a DLT-TSS is open both to investment firms licensed to operate an MTF and to central securities depositories.

The DLT market infrastructures defined by the EU represent a “regulatory sandbox” that enables young, innovative companies such as FINEXITY in particular to try out a trading venue for tokenized financial instruments based on distributed ledger technology for a specific customer base and period of time. With licensing under the EU pilot regime, companies secure both a knowledge advantage over competitors and a valuable first-mover bonus when it comes to attracting partners for their business model.