Digital financial technologies are actively developing, the role of tokenization in the European economic area is growing, and the EU is thinking about creating a comprehensive regulatory framework for risk management and stimulating the development of this innovative area. This article goes to outline main EU policies regarding the tokenization growth from the compliance perspective.
The evocative case is adoption of the Markets in Crypto Assets Act (MiCA) by the European Parliament in 2023, which is one of the first comprehensive regulations aimed at regulating the crypto asset market in the European Union. However, in addition to the MiCA, there is a need for additional regulatory frameworks and practical guidelines to ensure the proper use of tokenization in various sectors of the economy.
Key Features of Tokenization in the EU Economy
Wider access to financial markets. Instead of traditional securities issuance procedures, tokenization allows for the distribution of assets, such as real estate or securities, through the creation of digital tokens that are accessible to small investors.
Ensuring security and transparency. Thanks to DLT (distributed ledger technology), all token transactions are transparent and immutable, which reduces the risk of fraud.
Smart contracts used in tokenization automate the execution of agreements on the payment of dividends, clearing, or other settlements.
Increased liquidity. By dividing assets into tokens, even large and illiquid assets become available for sale on the market. This helps to attract new investors.
The EU is actively implementing experimental approaches to adapt its regulatory framework to new technologies. In particular, the "DLT Pilot Mode" allows testing the use of tokenization in real-world conditions.
DLT pilot regime
EU Regulation 2022/858, or the DLT pilot regime, came into force on March 23, 2023 and allowed market infrastructures to apply for permission to trade tokenized financial instruments on platforms operating on distributed ledger technology (DLT). The DLT pilot regime reflects the EU's interest in exploring, developing and promoting the adoption of innovative technologies in the financial sector, including distributed ledger technology.
The tokenization of financial instruments is expected to open up opportunities for efficiency gains in the trading and post-trade process. However, as fundamental trade-offs related to credit risk and liquidity remain in a tokenized world, the success of token-based systems will depend on how well they interact with traditional account-based systems, at least temporarily.
Important Aspects of the DLT Pilot Regime
The Regulation allows trading, clearing and settlement of tokenized financial instruments on a single DLT platform; simplifying access procedures for new market participants, which promotes innovation; and using smart contracts to automate operations, which increases efficiency and transparency;
In order to stimulate the implementation of DLT, the pilot regime temporarily exempts market infrastructures from certain provisions of regulations such as the MiFID II Directive, the Central Securities Depositories Regulation (CSDR), and the EMIR Regulation. For example, certain reporting requirements or functional segregation of duties may be relaxed for participants in the pilot regime.
The pilot regime applies to a small volume of tokenized financial instruments to avoid risks to financial stability. Participants must ensure investor protection and transparency. It is important that authorization is carried out only by national regulators.
The requirements of the DLT pilot regime for the admission of individuals to participate in transactions within the DLT infrastructure have also been implemented. ESMA recommends that national regulators implement compensatory measures, such as adapting templates in technical standards (RTS 22) for reporting and using Legal Entity Identifier — LEIs or national identifiers for natural persons conducting transactions.
The pilot regime was introduced for 3 years (with the possibility of extension). During this period, the EU will analyse the effectiveness and potential of DLT in financial markets.
The European Securities and Markets Authority (ESMA) has prepared a report on the application for authorization to operate a DLT market infrastructure.
It included templates that should be used by market participants to apply for a special permit to operate any type of DLT market infrastructure (DLT MI) in accordance with the DLT Pilot Regulation (DLTR).
ESMA has also defined on its website who is eligible to apply for a permit:
Authorised investment firms and market operators can apply to operate a DLT multilateral trading facility (DLT MTF);
Authorised central securities depositories (CSDs) can apply to operate the DLT Settlement System (DLT SS);
Both groups can apply to operate a combined DLT trading and settlement system (DLT TSS);
New entrants can apply for temporary authorizations as investment firms/market operators or CSDs, along with an application under the DLT pilot regime.
The Regulation applies to financial instruments within the limits of:
Equities — market capitalization/current market capitalization below 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 (corporate bonds from issuers with a market capitalization of less than EUR 200 million at the time of their issuance do not fall within this threshold);
UCITS — the market value of assets under management is less than EUR 500 million.
The Association for Financial Markets in Europe highlights the following points regarding the significance of the DLT pilot regime:
DLT has significant potential to transform financial markets. This technology can reduce transaction costs, improve settlement speed, increase transparency, and reduce risks by automating processes through smart contracts.
Effective implementation of DLT in Europe's financial infrastructure requires the development of a unified regulatory framework. Current legislation is often not adapted to new technologies, which creates legal uncertainty for market participants.
One of the main challenges for DLT implementation is the lack of standardisation between different platforms. Association for Financial Markets in Europe (AFME) calls on the European Commission to promote interoperable solutions to ensure interoperability between market participants using different technology approaches.
AFME points to the benefits of using smart contracts in DLT to automate complex financial processes such as clearing, settlement, or contractual execution. However, the organisation emphasises the importance of their legal recognition and ensuring compliance with existing regulatory requirements.
Regulators need to find a balance between stimulating innovation in financial technology and ensuring investor protection. This requires a clear definition of the liability of market participants using DLT, in particular in the event of technical failures or cyberattacks.
Companies looking to integrate tokenization into their business models need to consider both EU regulatory requirements and the technical challenges associated with using distributed ledger technology (DLT):
This includes, for example, adaptation to regulatory requirements: Regulation (EU) 2022/858 (the "DLT Pilot Regime") allows for the testing of tokenized assets in a controlled environment. Companies should explore the possibility of using this pilot regime to implement their solutions;
Companies should choose DLT platforms that meet interoperability standards. This will ensure compatibility with other market participants.
Selection of reliable technological solutions with built-in data protection mechanisms and tokens.
Apply operational risk assessment. Companies should implement risk management mechanisms, including recovery strategies in the event of technical failures or misuse.
To date, the cases of successful tokenization implementation include:
LVMH, multinational holding company, uses NFTs to verify goods: The French conglomerate LVMH uses NFTs to verify the authenticity of goods from luxury brands such as Louis Vuitton. In particular, the solution is based on information about the Aura Blockchain Consortium platform created in cooperation between LVMH, Prada, Cartier, and other brands to confirm the authenticity of products using the blockchain. This platform allows the use of NFT and distributed ledger technology to track the supply chain of goods and protect customers from counterfeiting.
RealT — Real estate tokenization: RealT is a platform that allows investors to buy tokenized shares of real estate. Investors receive monthly dividends from the lease, and the process of buying and selling assets is greatly simplified.
To date, the use of cryptoassets that qualify as financial instruments and their DLTs has been accompanied by a number of challenges. The absence of clear requirements for transparency, reliability and security of smart contracts and protocols underlying these assets creates potential risks that are not taken into account by current legislation. The underlying technology may also generate new types of risks, such as those related to the legal validity of tokens or interoperability and fragmentation of systems.
Despite the development of several projects in the field of cryptoasset trading and post-trade services in the EU, their scale remains limited and the number of operating platforms is insignificant. Existing financial services legislation designed for traditional instruments is not sufficiently adapted to the specifics of cryptoassets and DLT technology, which creates barriers to market infrastructure development.
Conclusion
The EU's proactive approach to regulate tokenization, exemplified by the MiCA and DLT Pilot Regime, positions it as a global leader in fostering innovation while ensuring investor protection. As tokenization continues to mature, it is imperative to address the unique challenges posed by DLT technology, such as interoperability and legal certainty. Our team of experienced lawyers can help in striking the balance between innovation and regulation to drive economic growth and launch new opportunities for businesses and investors!
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