The EU’s proposed pilot regime for digital security infrastructure: a game-changer for security tokens?

The European Commission has proposed a pilot regime to enable regulated institutions to develop DLT-based infrastructure for the trading, custody and settlement of securities. The proposed regime allows for operators to request exemptions from certain regulatory requirements that have previously been identified as obstacles to such development. For the security token market, which has thus far failed to thrive, this could potentially be a game-changer.

Pilot regime for DLT-based market infrastructures 

As part of the European Commission’s Digital Finance Strategy, it has proposed a pilot regime for market infrastructures based on distributed ledger technology (DLT). This would pave the way for certain regulated institutions to develop and test DLT-based infrastructure for the trading, custody and settlement of securities. In this post, we discuss the rationale for, and key features of, the proposed regime.

Regulatory uncertainty as a barrier to development

The potential advantages and use cases for adopting DLT in securities markets have been expounded for several years now, including by a number of regulatory authorities. Cited benefits include a trusted common data source, enhanced resilience, improved transparency and traceability and the potential for automation (with all the efficiencies that that may bring, such as the streamlining of settlement processes). 

Yet, to date there remains very little use of DLT in the regulated financial markets and, as a result, the security token market has failed to thrive. Regulatory uncertainty is often seen as one of the key reasons behind this lack of development, as highlighted in the European Commission’s ROFIEG report. 

The options considered

The Commission identified three options to tackle these concerns.

  • non-binding guidance on the applicability of EU financial regulation to security tokens and DLT;
  • targeted amendments to EU financial regulation; and
  • a pilot regime for the creation and testing of DLT-based market infrastructure.

It is proposing to start with the pilot regime. The idea is that experimentation will help identify all relevant regulatory obstacles and inform more permanent amendments or guidance.

Key features of the proposed pilot regime


Under the proposed regime:

  • authorised investment firms and market operators would be eligible to apply to operate a DLT multilateral trading facility (DLT MTF); and
  • authorised Central Securities Depositories (CSDs) would be eligible to apply for permission to operate DLT securities settlement system (DLT SSS).

Permission to participate

Applications are to be made to the relevant national authority for the applicant. The national authority is required to consult with the European Securities and Markets Authority (ESMA) as part of the decision-making process. Permission granted by that authority would allow the DLT market infrastructure to provide their services across the EU.

Requirements and relaxations for operation

The Regulation sets out the basic requirements for operation, which are similar to those for the equivalent traditional market infrastructures. However, applicants may apply for exemptions from certain requirements that may be problematic in the context of distributed systems, subject to the attached conditions. 

For example, investment firms and market operators may ask to be able to admit to trading DLT transferable securities that are not recorded in a CSD (in accordance with the Central Securities Depositories Regulation) but instead recorded on the DLT MTF’s distributed ledger. This request may be granted by the national authority subject to the DLT MTF meeting certain conditions, relating to factors such as record-keeping, custody arrangements and settlement mechanics (including settlement finality).

Similarly, under an accompanying proposal to amend MiFID II, DLT MTFs are able to request a temporary derogation from obligations to hold securities on an intermediated basis. This would allow them to offer direct access to retail investors, as many distributed networks seek to do. This is subject to conditions in relation to factors such as investor protection and AML/CTF safeguards.

The pilot regime also imposes additional requirements on operators, in order to address the novel forms of risk raised by the use of DLT – for example, in relation to disclosures, cyber-security and custody arrangements.

Eligible securities

Only transferable securities that meet the following conditions may be admitted to trading on a DLT MTF and recorded by a CSD operating a DLT SSS:

  • shares, the issuer of which has a market capitalisation or a tentative capitalisation of less than EUR200m; or
  • convertible bonds, covered bonds, corporate bonds, other public bonds and other bonds, with an issuance size of less than EUR500m.

Sovereign bonds are not permitted.

There is also a limit on the total market value of DLT transferable securities that can be recorded by a CSD or, if applicable, investment firm/ market operator, which is set at EUR2.5bn.

What happens after the pilot period?

After a five-year period (at the latest), ESMA will produce a detailed report on the pilot regime to the Commission. On the basis of this the Commission will decide:

  • whether the pilot regime should be maintained as is or amended;
  • whether the regime should be extended to new categories of financial instruments;
  • whether targeted amendments to EU legislation should be considered; and/or 
  • whether the pilot regime should be terminated.
Next steps

The proposal is now going through the EU’s ordinary legislative procedure. The aim is to have the three regulations in the Digital Finance Package in full effect by 2024. In the meantime, eligible parties may wish to consider working towards an application. Should you need any advice in this regard please do not hesitate to get in touch.