DLT Pilot Regime: Implementation in Bulgaria is Coming?
Introduction
Regulation (EU) 2022/858 on a pilot regime for market infrastructures based on distributed ledger technology (the “DLT Pilot Regime”) was published in the EU Official Journal in June 2022 and applies from 23 March 2023. On 10 May 2023, the Bulgarian government filed with the Parliament a bill aimed to facilitate the application of the DLT Pilot Regime in Bulgaria (the “Bill”).
The DLT Pilot Regime is part of the Digital Finance Package containing measures proposed by the European Commission in September 2020 with an aim to stimulate the digital revolution in the EU financial sector and turn Europe into a global digital player. It is believed that with the use of distributed ledger technology (“DLT”), a digital capital market has the potential to offer an additional source of capital to issuers and market benefits such as reduced settlement cycle, automation of payments of principal and interest, a simpler ownership and custody structure, greater security and transparency and others.
What is DLT
DLT is a decentralized peer-to-peer data storage system where participating computers (known as nodes) hold and maintain identical copies of the ledger. Data integrity is achieved through public-private key cryptography so that an individual node cannot tamper with information recorded in the ledger by rewriting the transaction. In simpler words, distributed ledgers are a new method of recording transactions in a shared way, which permits new manners for rendering financial services whilst ensuring transparency and making unauthorized changes to those records more difficult.
The most notable form of DLT is blockchain technology. Blockchains are currently under examination for their possible use in different sectors including the financial industry and its market infrastructures.
The DLT Pilot Regime
The DLT Pilot Regime aims to foster the process of integration of DLT into European financial services legislation (which, in general, is not particularly favorable to the use of DLT), whilst maintaining investor protection, financial stability and transparency.
A unique feature of the DLT Pilot Regime is that it creates a testing environment in which market participants can experiment with new technology for a period of up to six years under the scrutiny of supervisory authorities.
DLT Financial Instruments
The DLT Pilot Regime focuses on the use of DLT in the trading and post-trading of crypto-assets that qualify as financial instruments (tokenized securities or security tokens);* such financial instruments being issued, recorded, stored and transferred by way of using DLT (“DLT Financial Instruments”). However, as a first step, the DLT Pilot Regime amends the definition of “financial instruments” under Directive 2014/65/EU on markets in financial instruments (“MiFID II”) to provide that financial instruments (such as stocks, bonds and units of investment funds) can also be issued by means of DLT.** Therefore, like traditional financial instruments, DLT Financial Instruments are now also governed by MIFID II, Regulation 600/2014 on markets in financial instruments (“MIFIR”) and other EU financial services regulations.
However, the types of DLT Financial Instruments in the scope of the DLT Pilot Regime are limited and include: (a) shares in an issuer with a market capitalization of less than EUR 500 million; (b) bonds with an issue size of less than EUR 1 billion; and (c) units in UCITS where the market value of assets under management is less than EUR 500 million.
DLT Market Infrastructure
The DLT Pilot Regime specifies the framework to apply for authorizations and possible exemptions from existing regulation to operate three different kinds of DLT market infrastructures (“DLT Market Infrastructures”):
- DLT multilateral trading facilities (“DLT MTF”) operated by an investment firm or a regulated market operator that only admit DLT financial instruments to trading;
- DLT settlement systems (“DLT SS”) operated by a central securities depository (“CSD”) as defined in Regulation (EU) No 909/2014 on central securities depositories (“CSDR”) which settle transactions in DLT Financial Instruments and which allow the initial recording of DLT Financial Instruments or the provision of safekeeping services regarding DLT Financial Instruments; and
- DLT trading and settlement systems (“DLT ТSS”), which combine the services performed by a DLT MTF and a DLT SS and are operated either by an investment firm, a regulated market operator, or a central securities depository.
Exemptions and additional requirements
The DLT Pilot Regime provides for temporary and optional (for operators of DLT Market Infrastructures) disapplication for up to 6 years from provisions in MIFID II, MIFIR and CSDR that could preclude or limit the use of DLT, such as:
- the obligation of intermediation under MiFID II, in order to provide direct access to DLT MTFs for retail investors under certain conditions and to enable them to deal on their own account;
- certain transaction reporting requirements under MiFIR, provided that the DLT MTF fulfills certain conditions;
- measures to prevent settlement fails and to address settlement fails; settlement finality;
- rules related to dematerialized form, transfer orders, securities accounts, recording of securities in book-entry form***, segregation of assets; and
- the cash settlement requirements provided for in the CSDR in favor of more innovative payment solutions (e.g., e-money tokens), in case that the DLT SS settles on the basis of delivery versus payment.
On the other hand, in order to preserve a high level of investor protection, market integrity, financial stability and transparency, the DLT Market Infrastructures must comply with some compensatory measures as set out in the EU Pilot Regime, including, among others, rules for functioning the DLT used, the existence of IT and cyber arrangements relating to the use of DLT, measures for the protection of client funds.
Authorizations
Autorised markets participants and new entrants wishing to operate a DLT Market Infrastructure will need to apply to obtain specific authorization with a limit of maximum six years from the relevant national competent authority. Not surprisingly, the Bill designates the Financial Supervision Commission as the Bulgarian competent authority. The Bill sets out also the fees for applying for authorization in the following amounts: EUR 5,128 for DLT MTF; EUR 7,692 for DLT SS; and EUR 10,256 for DLT TSS.
The DLT Pilot Regime also comes with a European passport allowing DLT Market Infrastructures to be operated throughout the EU.
Conclusion
The European Commission expects that the experience gained from the application of the DLT Pilot Regime will help legislators to identify proposals for an appropriate more stable regulatory framework that will succeed the DLT Pilot Regime, while regulators and market participants gain valuable knowledge about the application of DLT. It will be interesting to see to what extent firms in Bulgaria and in other EU countries will make use of the DLT Pilot Regime.
By 24 March 2026, the ESMA will present a report to the European Commission on the effect of the DLT Pilot Regime, based on which the Commission will determine its future, e.g., its extension or abolishment, or the adoption of permanent legislation for the use of DLT.
* Another part of the Digital Finance Package is the Regulation on Markets in Crypto-assets, which sets forth a bespoke regime for previously unregulated crypto-assets such as crypto-currencies.
**Corresponding amendment is proposed by the Bill into the Bulgarian markets in Financial Instruments Act.
***Accordingly, the Bill proposes a carve-out from the Bulgarian law requirement that the issuance and transfer of dematerialized securities has effect from their registration as a CSD.
This article has been prepared for the purposes of general information only and does not constitute legal advice with respect to any particular subject or situation. For specific legal advice, you should contact an attorney-at-law. Stoeva, Tchompalov & Znepolski is not responsible for any legal action undertaken on the basis of the information contained herein.