DLT pilot regulation

Highlights

• The regulation allows for financial instruments to be dematerialized, traded, cleared and settled in a blockchain-based infrastructure, without the need to apply the requirements of MIFID, MIFIR and CSDR, which may pose practical or interpretative difficulties in the blockchain reality
• Since the regulation allows many derogations from MIFID, MIFIR, CSDR, the regulation applies only to the financial instruments listed in the regulation and to the amount limits provided for each of them separately (stocks, bonds, units in collective investment undertakings)
• Only the entities listed in the regulation (investment firms, depositories, operators of regulated markets – existing and new) can benefit from the exemptions provided for in the regulation, but for no longer than 6 years (the period calculated for each provider separately) and only on the basis of an authorization from its supervisory authority specifying which authorizations the institution can use.
• The regulation introduces 3 new categories of entities: MTF DLT (DLT-based multilateral trading facility), SS DLT (DLT-based settlement system), TSS DLT (DLT-based trading and settlement system). Activities in these forms benefit from the Community passport.
• The most important derogations from the current capital market regulations are the possibility of combining trading and settlement activities in a single entity (TSS DLT ), participation of retail investors in trading without the obligation of intermediation of investment firms, no need for MIFIR reporting, settlement of transactions by e-money tokens, no need for a securities account. Taking advantage of the exemptions requires the provider to apply compensatory measures that the supervisory authority deems appropriate.
• The privileges of the DLT pilot regulation are available only for activities performed on the DLT infrastructure. Although the regulation does not mandate the use of any specific blockchain and does not even indicate a preference for private vs. public solutions, intrinsically the provider must demonstrate that the IT solutions used are not a classic database, but the use of DLT technology.
• The regulation amends the MIFID definition of a financial instrument, emphasizing that an instrument is also one issued using DLT technology.
• DLT financial instruments may be offered on a crowdfunding platform within the meaning of Regulation 2020/1503 on European providers of crowdfunding services for business ventures (REDUFS; see more).

Time order

• June 2, 2022: Regulation published in the Official Journal of the EU (go to text)
• June 22, 2022: certain provisions of the regulation enter into force in all countries of the European Economic Area
• March 23, 2023: the regulation is in force as to the essentials; by that date, member states should also adopt and implement provisions implementing the revised definition of a MIFID financial instrument (the DLTR amends the MIFID Directive in this regard, implemented in Poland mainly by the Act on Trading in Financial Instruments)
• May 13, 2023: entry into force of an amendment to the Trading Act to expand the definition of a financial instrument to include financial instruments issued through distributed ledger technology
• June 12, 2023: the draft law on amending certain laws in connection with ensuring the development of the financial market and the protection of investors in the market entered the Parliament
• August 29, 2023: the Law of August 16, 2023 on amending certain laws in connection with ensuring the development of the financial market and the protection of investors in that market published in the Official Journal of the Republic of Poland
• September 29, 2023: entry into force of most of the provisions of the Law of August 16, 2023 on amending certain laws in connection with ensuring the development of the financial market and the protection of investors in this market

DLTR - financial instruments handled by DLT

Definition of the financial instrument supported by the DLT

The DLT Pilot allows trading on the DLT MTF or DLT TSS only in DLT-supported financial instruments, i.e. those that, as defined in the DLT Pilot, are issued, registered, transferred and stored using distributed ledger technology.

Primary and secondary tokenization

The regulation with its scope covers both primary tokenization, i.e., a financial instrument is immediately issued using distributed ledger technology, and secondary tokenization, which involves converting a financial instrument issued in a traditional manner into a DLT-supported financial instrument by registering such an instrument with SS DLT or TSS DLT

Financial instruments traded on DLT-based market infrastructures

While a DLT-supported financial instrument can be any financial instrument, in order to take advantage of the exemptions provided for in the DLT Pilot Regulation, operators of market infrastructures based on distributed registry technology may allow only certain types of financial instruments to be traded or registered on these infrastructures:

• equities with a market capitalization or tentative market capitalization of less than EUR 500 million
• bonds, other forms of securitized debt, including depositary receipts in respect of such securities, or money market instruments, with an issue size of less than EUR 1 billion, excluding those that contain a derivative or that are structured in a way that makes it difficult for the client to understand the risks involved
  units in collective investment undertakings whose market value of assets under management is less than EUR 500 million

Limits

The total value of financial instruments handled by DLTs that are traded or registered in MTF DLTs, SS DLTs or TSS DLTs may not exceed EUR 6 billion. If this value is exceeded, operators of DLT-based market infrastructures are obliged to implement a transition strategy (exit strategy) and transfer financial instruments handled by DLT to traditional market infrastructures. If this threshold is exceeded, operators of DLT-based market infrastructures may not admit or register new DLT-supported financial instruments. If the total value of financial instruments handled by DLT exceeds the €9 billion threshold, operators of DLT-based market infrastructures are obliged to implement a transition strategy.

DLTR - new market infrastructures

DLT Pilot introduces three new categories of service providers: MTF DLT, SS DLT and TSS DLT.

MTF DLT

MTF DLT is a multilateral trading platform where only financial instruments supported by DLT are admitted to trading. MTF DLT can be operated by an investment firm (brokerage house) or a market operator (company operating a regulated market). In principle, an MTF DLT operator is subject to the requirements of the MIFID Regulation and MIFIR. However, it can obtain an authorization from the local supervisory authority to allow retail investors to participate in trading without the need for them to use professional intermediaries, as well as exempt it from the transaction reporting requirements of Article 26 of MIFIR.

SS DLT

SS DLT stands for settlement system, which :

• settles transactions on financial instruments handled by DLT against payment or delivery
• enables pre-registration of financial instruments handled by DLT
• enables the provision of custody services for DLT-supported financial instruments

SS DLT may be operated by a central securities depository. In principle, the SS DLT operator is subject to the requirements of the depository regulation, although the DLT Pilot provides numerous exemptions from these requirements. The most important of these, which require mention here, are, first of all, the possibility of exempting the operator running the SS DLT from the obligation to use a securities account, the concept of dematerialization, as well as allowing the settlement of transactions concluded on the MTF DLT or TSS DLT by means of e-money tokens.

TSS DLT

New under capital market regulations is the TSS DLT. The DLT Pilot defines a TSS DLT as a DLT-based MTF or a DLT-based SS that combines the services provided by a DLT-based MTF and a DLT-based SS. Special authorization to operate a TSS DLT may be granted to an investment firm, a company operating a regulated market or a central securities depository. An entity applying for a special permit to operate a TSS DLT is must simultaneously meet the requirements provided for both an MTF DLT operator and an SS DLT operator. Similarly, however, it may also apply for the same exemptions as those entities.

With regard to an entity that applies for a special conduct to operate a TSS DLT and also applies for an authorization to operate an investment firm, a company operating a regulated market or a central securities depository, the supervisory authority does not examine whether it meets the requirements under the MIFID Directive or the Depository Regulation for which the applicant is applying for an exemption under the DLT Pilot Regulation.

Special requirements for DLT-based market infrastructures

The DLT Pilot requires operators of DLT-based market infrastructures to have detailed documentation related to their operations. The regulation obliges operators to have, among other things:

• a business plan
• regulations and procedures governing the rights and obligations of DLT-based market infrastructure operators, rules for the provision of services and settlement of disputes, as well as protection measures in the event of insolvency
• documentation related to the distributed registry technology used by operators
• IT and cyber security documentation

Due to the peculiar nature of the regulation, which acts as a pilot system, its scope is limited in subject matter and time. Until March 2026. The European Securities and Markets Authority (ESMA) will submit a report to the European Commission on the operation of DLT-based market infrastructures on the basis of which the Commission will decide whether to extend, make permanent or end the DLT Pilot.

Due to the limitations mentioned above, operators of DLT-based market infrastructures must have a transition strategy (exit strategy) prepared and ready for implementation. A transition strategy is triggered when:

The threshold for the maximum total value of DLT-based financial instruments traded on a DLT-based infrastructure or registered in a DLT-based settlement system – EUR 9 billion – is exceeded
The operator of the DLT-based infrastructure will have its authorization revoked
DLT-based market infrastructure has ceased operations

Distributed register technology in DLTR

The DLT Pilot laconically addresses the issue related to distributed registry technology itself. The regulation defines such terms as:

• distributed registry technology – technology that enables the operation and use of distributed registries
• distributed registry – a repository of information that maintains a record of transactions and is shared within a set of DLT network nodes and synchronized between DLT network nodes, using a consensus mechanism
• consensus mechanism – rules and procedures based on which agreement is reached between DLT network nodes on the approval of transactions
• DLT network node – a device or process that is part of the network, which has a complete or partial replica of the records of all transactions in the distributed registry

The DLT Pilot does not make any specific requirements or recommendations as to the DLT-based technology market infrastucture operators use. Whether the technological solutions they use will be adequate in light of the requirements for operators of DLT-based market infrastructures under the relevant legislation is left to be determined by the European legislature to the local supervisory authorities competent to conduct administrative proceedings on the granting of these permits, the DLT Pilot said.

Implementation of the DLTR regulation

DLT Pilot, as an EU regulation, theoretically does not require implementation into national legal orders, but due to its matter and requirements for the issuance and trading of financial instruments, practical use of the solutions provided by DLT Pilot is not possible without appropriate modification of national legislation. Proposed amendments to the legislation unblocking the application of the DLT Pilot on the Polish market were presented in the bill on amendments to certain laws in connection with ensuring the development of the financial market and the protection of investors in this market in the version dated May 12, 2023. The main changes in this regard affected the Law on Trading in Financial Instruments, and to a lesser extent also the Law on Public Offering or the Law on Prevention of Money Laundering and Financing of Terrorism, among others. The provisions in the amendments implementing the DLT Pilot in the course of parliamentary legislative work were not modified. The law, in connection with ensuring the development of the financial market and the protection of investors in the market, was published in the Official Gazette of the Republic of Poland on August 29, 2023.

Definitions

The proposed amendments introduced the definitions of MTF DLT, SS DLT and TSS DLT into the Trading Act. Due to the national specificity of naming a multilateral trading facility (MTF DLT), a multilateral trading facility based on DLT (MTF DLT) has been defined by as an ATS (alternative trading system) based on DLT. At the same time, in order to clearly prejudge that, as a matter of principle, the same rules will be applied to the DLT ATS as to the classic ATS, the legislator decided to indicate in the definition of the ATS that the DLT-based ATS is also an alternative trading system.

The law also included a definition of a DLT-supported financial instrument, according to which it is a DLT-supported financial instrument within the meaning of Article 2(11) of the DLTR Regulation (i.e., a financial instrument that is issued, registered, transferred and stored using distributed ledger technology), listed in Article 3(1) of the DLTR Regulation (i.e., meeting the subject and amount criteria provided in that provision), registered in a DLT account or in the DLT records.

Speaking of the definition of a financial instrument handled by a DLT, it should be mentioned that on May 13, 2023, Article 9 of the Law of April 14, 2023, on Amendments to the Law on Investment Funds and Management of Alternative Investment Funds, the Law on Bonds, the Law on the Bank Guarantee Fund, the Deposit Guarantee System and Forced Restructuring and Certain Other Laws, which implements the amendment to the definition of a financial instrument in MIFID introduced by the DLT Pilot, entered into force. According to Article 2(1a) of the Trading Act, financial instruments may be recorded by means of distributed ledger technology used by a DLT-based market infrastructure operator, as defined in Article 2(5) of the DLT Pilot, under the rules set forth in its provisions. It should be noted that the change to the definition of a financial instrument in MIFID was the addition of the phrase “including instruments issued using distributed registry technology” to Article 4(1)(15) of MIFID, which previously stated that a financial instrument “means instruments specified in Annex I, Section C.”

DLT account and DLT records

The legislator decided to introduce two new constructs into the Trading Law: the DLT account and the DLT registry, in which securities that are financial instruments handled by DLTs are registered in the SS DLT or TSS DLT. A DLT account is a classic securities account, only that it is maintained using distributed ledger technology outside of a securities depository, if the account allows for the identification of persons who have rights in those securities that are financial instruments handled by the DLT and separates securities belonging to different persons. It should be noted here that the definition of a DLT account was not introduced in the DLT Pilot – it is a creation of the Polish legislator.

The DLT Pilot provides that an entity operating a SS DLT or TSS DLT may obtain an exemption from the obligation to maintain a securities account – a system that allows the identification of securities, persons entitled to those securities, as well as the number of securities to which that person is entitled has been referred to by the drafters as a DLT record.

The amending law also indicates that when other provisions speak of securities accounts, they should also be understood to mean DLT accounts and DLT records. This treatment should be assessed as correct, as it resolves potential doubts that may arise under other laws referring to the concept of a securities account.

Registration and trading on DLT infrastructures

According to the changes, only securities registered in DLT accounts or DLT records can be traded in the DLT ATS or DLT TSS. Thus, it is not possible to trade traditional financial instruments on these infrastructures. Also excluded is trading on the DLT ATS or TSS DLT in shares of a company whose shares are admitted to organized trading other than the DLT ATS or TSS DLT (on a regulated market or in a traditional alternative trading system) or the company is seeking admission of the shares to organized trading. Importantly, the legislature decided to exclude the dematerialization requirement for securities registered in DLT accounts or DLT records.

With regard to the registration of shares of the same company and bonds of the same series, the legislator decided not to allow the so-called partial registration – registration of part of the securities in a classical securities depository and part in SS DLT or TSS DLT. It was resolved that shares of the same company and bonds of the same series registered in a DLT account or DLT records cannot be simultaneously registered in a securities depository. It is also not possible to register shares of the same company and bonds of the same series simultaneously in the DLT account and in the DLT records.

An analysis of the changes made to the registration and trading of securities that are financial instruments handled by DLTs leads to the conclusion that the legislator has, in fact, created a new regime for trading in such securities that is separate from the classical one.

Secondary registration

The legislator has allowed for the so-called secondary registration of DLT financial instruments. Secondary registration involves the conversion of a financial instrument that was issued in the traditional manner into a DLT-supported financial instrument by registering it with the SS DLT or TSS DLT. At the same time, the scope of DLT secondary registration has been significantly limited by the legislature – only the shares of a non-public company registered in the shareholder register can be subject to secondary registration. Secondary registration of DLT requires a resolution of the company’s general meeting. As of the date on which the shares are deregistered from the shareholders’ register, they are registered in either the DLT-based SS or the DLT-based TSS, the records in the shareholders’ register become ineffective, and the corresponding records in the DLT accounts or in the DLT register become effective.

ASO DLT, SS DLT or TSS DLT licensing

The legislator did not choose to regulate the licensing process of ATS DLT, SS DLT and TSS DLT in detail, referring in this regard to the pilot regulation. It has limited itself to indicating that in the event that an entity that does not have a brokerage, regulated market or central securities depository license applies for a special license to operate a DLT ATS, SS DLT or TSS DLT, such entity shall also apply to the FSA for a license to operate a brokerage, regulated market or central securities depository, and in the event that this license is denied, the license to operate a DLT-based market infrastructure shall also be denied. Bearing in mind the content of the DLT Pilot, it should be remembered that in such a situation the supervisory authority does not assess whether the applicant meets the requirements for which it seeks exemption under the provisions of the Pilot Regulation.

The amended regulations also include within the scope of the license to operate a SS DLT or TSS DLT the possibility to issue electronic money to be used for the settlement of transactions concluded on the ATS DLT or TSS DLT. The drafters also indicated that in relation to such entities, Section IIIA of the Payment Services Act – issuance and redemption of electronic money – should be applied accordingly. In view of the content of Article 6(8) of the Payment Services Law, which excludes the application of the Payment Services Law (and therefore of Section IIIA of the Payment Services Law) to payment transactions made within a payment system or within a securities settlement system referred to in the Law on Settlement Finality, there may be some doubt as to the legitimacy of introducing a provision mandating the SS DLT or TSS DLT to apply Section IIIA of the Payment Services Law accordingly.

Exit strategy

In detail, the legislator decided to regulate the issue of exit strategies, i.e. strategies for reducing the operations of a given DLT-based market infrastructure, transitioning from a given DLT-based market infrastructure or ceasing its operation. In this regard, the amended regulations authorize the operator of a DLT-based market infrastructure to act on behalf of the issuer and take various actions, including concluding an agreement with the NDS to register shares in the depository (or, if the NDS refuses, an agreement to maintain a shareholder register), concluding an agreement to perform the function of an issuing agent (in the case of bonds that are financial instruments serviced by DLT), or submitting an application for the introduction of financial instruments to trading in the ATS (in the case where financial instruments serviced so far by ATS DLT are to be introduced to classic market infrastructures). The entity operating the ATS to which instruments withdrawn from trading from DLT-based market infrastructures are to be introduced has the right to object to such introduction if it considers that the introduction threatens the security of trading or the interests of participants.

Other

• Authorization to operate a securities settlement system under the Law on Settlement Finality has been included in the scope of authorization to operate a SS DLT or TSS DLT
• No requirement to obtain PFSA authorization for the withdrawal of shares listed on a DLT-based multilateral trading facility if the withdrawal is for the purpose of listing on a classical ATS as a result of a transition strategy
• Designation of the PFSA as the competent authority under the DLT Pilot Regulation
• The possibility for the PFSA to impose a fine on a DLT ATS, SS DLT or TSS DLT up to PLN 20,750,000 or up to an amount equivalent to 10% of the total annual revenue for violations of the DLT Pilot Regulation
• Payments from the investor compensation system do not cover lost financial instruments recorded in DLT accounts or DLT records
• No obligation to use an issuance agent if bonds will be registered in DLT accounts or DLT records
  SS DLTs and TSS DLTs obligated institutions under the AML Law to the extent that they maintain DLT accounts or DLT records

DLTR - table of contents

I. Subject, scope, definitions

II. Financial instruments

(a) catalog of financial instruments admitted to trading or registered in the DLT-based market infrastructure

b) limits on the value of financial instruments handled by DLT

III. Requirements and exemptions for operators of DLT-based market infrastructures

(a) MTF of DLTs

(b) SS DLT

(c) TSS DLT

IV. Special requirements for DLT-based market infrastructures

(a) documentation about the blockchain technology used

b) documentation about the services provided by the platform operator

c) an elaborate, ready-to-implement transition strategy

V. Special authorization to operate DLT-based market infrastuctures

(a) MTF DLT

(b) SS DLT

(c) TSS DLT

VI. Supervision of DLT-based market infrastructures

(a) cooperation between operators of DLT-based market infrastructures and competent authorities and ESMA

(b) designation and notification to the Commission of the designation of competent authorities by Member States

VII. Reports

(a) ESMA report on the activities covered by the DLT Pilot

(b) Commission decision on the future of the DLT Pilot regulations

(c) ESMA’s annual reports

VIII. General provisions

(a) amendment to MIFIR, depository regulation, MIFID

(b) entry into force – twentieth day after publication

(c) application from March 23, 2023, with exceptions

DLTR - FAQ

1. What problem does the regulation solve?
   • The management of financial instruments in the European Union has long been regulated in such a way as to limit the risks most important to this trading. For this reason, the trading and settlement of financial instruments is essentially unbundled (cf. stock exchanges, alternative trading systems such as Newconnect vs. securities depositories), the intermediation of an investment company in trading is mandatory (cf. accounts at brokerage houses).
   • All of the above provide security for trading, but this comes at a price: relatively high costs, the presence of intermediaries, relatively long clearing and settlement times.
   • Native functionality of distributed registries (DLTs) overcomes all the above limitations. However, the design of DLTs is ill-suited to meet the above requirements. Capital market players have long been interested in using DLT capabilities, but have not done so on a larger scale due to the risk of non-compliance.
   • The regulation solves the above problems. Existing and new service providers, after obtaining authorization from the FSA or other European Economic Area supervisory authority, may provide trading or depository services using DLT for 6 years, with derogations from the above key requirements of the current legislation. However, as these derogations are important to maximize the maintenance of trading safety and avoid unwanted regulatory arbitrage, the volume of financial instruments is limited, and the provider must justify the need for the derogation and must provide mitigating measures.
2. What entities can benefit from the regulation’s exemptions?
   • Only licensed investment firms and regulated market operators. A brokerage bank must obtain a separate FSC permit for the activities specified in the regulation. Existing entities receive in essence a derogation permit. New entities receive a principal permit along with a derogation permit.
3. What categories of service providers does the regulation provide for?
   • DLT MTF (podmiot nowy lub istniejący): dostawca usług obrotu instrumentami DLT w postaci alternatywnego systemu obrotu
   • DLT SS (podmiot nowy lub istniejący): dostawca usług rozrachunku dla instrumentów DLT
   • DLT TSS (podmiot nowy lub istniejący): dostawca łącznie usług obrotu oraz rozrachunku (łączenie obu funkcji w jednym podmiocie)
4. How does the DLT pilot regulation relate to MICA (the draft Market in Crypto Assets regulation)?
   • The draft DLT pilot regulation and the MICA regulation were published in the same package. While work on the pilot regulation has ended and the regulation is in vacatio legis (it finally enters into force on March 23, 2023), work on MICA is prolonged.
   • The MICA project and the DLT pilot regulation practically do not intersect. The MICA regulation will not apply to financial instruments, nor will it apply to any other classical financial services (deposits, payment services, etc.). Meanwhile, the DLT pilot regulation applies only to selected financial instruments, indicated explicitly in the body of the regulation (stocks, bonds, UCITS, etc.), provided that these instruments are in the form of a DLT instrument from start to finish.
5. What is the relationship of the DLT pilot regulation to the so-called Crowdfunding regulation?
   • According to the crowdfunding regulation, a crowdfunding platform allows raising capital through financial instruments and loans. Financial instruments under the DLT Pilot Regulation regime will therefore be able to be publicly offered on a crowdfunding platform, but without the platform’s ability to secondary trade in these instruments (unless it obtains DLT MTF or DLT TSS authorization in parallel with the crowdfunding authorization).
6. In what money does settlement occur?
   • Under certain conditions, settlement can take place with commercial bank money, including in the form of tokens, or with tokens that are electronic money (a reference to the category of so-called stablecoins that MICA will introduce).
7. Does the permit use the so-called EU passport?
   • Yes, DLT MTF, DLT SS, DLT TSS permits are valid throughout the EEA, for 6 years after issuance.
8. What happens after the pilot is completed?
   • Financial instruments must be transferred to the classical capital market infrastructure. For this purpose, when applying for DLT MTF, DLT SS, DLT TSS authorization, the applicant must submit a so-called transition strategy. In the field of MTF, the applicant should submit agreements with the authorized trading entity. As for SS, the applicant should submit agreements with an entity authorized for settlement, with the depository to conclude such agreements on a non-discriminatory basis, and the fees charged should be related to the costs incurred.

DLTR - what we deliver

DLK offers comprehensive services to entities seeking authorization to operate MTF DLT, SS DLT or TSS DLT from the development of the concept and basic rules for trading and settlement on DLT-based market infrastructure, through the submission of the application with supporting documentation to the FSA, and legal support in ongoing operations.

Detailed information on DLK’s legal support for conducting DLT Pilot activities can be found here.