With the EU’s DLT pilot regime now live, Alisa DiCaprio, Chief Economist at R3, examines the impact the programme will have on capital markets and what the launch means for the broader digitalisation of financial services.
Against a backdrop of rising international competition, economic headwinds and technological innovation, jurisdictions across the globe are racing to improve the efficiency of their financial services infrastructure. The European Union (EU) is no exception and has recognised the importance of strengthening its capabilities to move and transact securities and funds across the region. Its Capital Markets Union, for example, aims to streamline investment and savings flowing across member states by providing firms with emerging tools and technologies to improve how capital markets operate.
The EU has just made another significant step forward in this race, going live with its DLT pilot regime on 23rd March 2023.
The regime acts as a ‘regulatory sandbox’ for financial institutions to apply DLT at scale across a range of use-cases, including the issuance, trading, settlement of tokenised stocks, bonds and funds. By enabling firms to explore the benefits of blockchain across the trading lifecycle, March 23rd represents a landmark moment in our understanding of how DLT can benefit European capital markets and be integrated into regulations.
So, with the regime now live, what does its launch mean for capital markets in both the immediate and longer-term and how will the pilot innovate financial services?
Innovation through regulation
Although blockchain is often dubbed as an emerging technology, DLT-based systems for securities settlement are already being used elsewhere. Last year, for example, The Depository Trust and Clearing Corporation went live with its Project Ion platform by leveraging DLT for equities settlement. Designed to adhere to rigorous regulatory standards, the platform has already recorded 160,000 transactions on a peak day and will be able to support faster settlement timeframes of T+1 and T+0.
The EU’s DLT pilot is built on a similar foundation. The pilot regime is designed to facilitate the development of DLT market infrastructure for digital securities. This exercise will help EU regulators understand how to tailor the regulatory framework for the deployment of blockchain technology. Implementation of future-proof regulation to safeguard capital requirements compatible with DLT will play a central role in facilitating a more open, scalable, and secure financial system.
The regime also introduces several safeguards which will heighten market efficiency and strengthen risk management processes. These include custody of assets, a mandatory complaint holder procedure available to investors and rights of the investor against the issuer.
In addition, the pilot’s DLT transaction screen service (TSS) model – which enables the verification of transactions in real-time – will incentivise investment firms and market operators to provide settlement services for securities traded on trading venues. This represents a major opportunity for new players to compete on settlement services, fostering healthy competition to drive stronger return on investment.
A new era for financial markets?
In 2026, the European Commission and European Securities Market Authority (ESMA) will release a report that assesses how well the pilot worked in practice. This report will include a cost-benefit analysis on whether to permanently retain a DLT-based market infrastructure. While some EU countries are moving faster than others in applying DLT regulatory framework, the pilot will provide a crucial building block in harnessing DLT at scale on the wholesale level.
The pilot complements several other initiatives launched by the EU to boost its digital finance agenda. These include the Banque de France’s wholesale central bank digital currency (CBDC) pilots and Switzerland’s fully regulated capital markets infrastructure, SIX Digital Exchange (SDX), both of which are built on DLT-based systems and playing key roles in driving European financial markets into the Web3 era.
Europe is not the only jurisdiction moving the needle closer to a digital economy. The UK, for example, aims to have its Financial Market Infrastructure Sandbox in place by the end of this year. The sandbox will enable financial market infrastructures (FMIs) to experiment with DLT and related technologies, and if successful, will provide the basis for more efficient capital allocation and heightened data transparency across the UK economy.
We should note that the rollout of DLT-based financial market infrastructure will not happen in one big bang moment as several challenges remain. Given the current macroeconomic conditions, banks and FMIs will keep an eye on the costs of deploying new technologies and projects. Likewise, as demonstrated by high-profile industry failures in 2022, supervisors and regulators must ensure that new technological initiatives are interoperable with existing infrastructure.
That said, the EU DLT pilot represents an enormous opportunity for the industry. Collaboration will be key to realising these benefits. To drive a stronger global economy by leveraging the pilot regime and DLT, institutions must work together across their ecosystems, tapping into firms and individuals with regulated market and technological expertise.
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