Blockchain technology is like a Swiss army knife that can provide different solutions depending on the problem. Over the past decade, use cases for blockchain technology have grown from money and payments to decentralized exchanges and non-fungible tokens. At this point, it looks like the next big use case for blockchain will be tokenized stocks.
Today, investors can buy traditional stocks like Tesla from cryptocurrency fintech companies like Bitpanda. However, these shares are not stored and traded using blockchain technology. Global cryptocurrency exchange Bittrex allowed investors to trade tokenized stocks such as Apple and Pfizer for a short time, but they stopped trading tokenized stocks shortly after its debut. The reason that cryptocurrency exchanges and traditional exchanges have not enabled tokenized stock trading is that it is still a legal gray area.
To bring legal clarity to tokenized stocks, the European Commission is unleashing a progressive regime in March 2023 that could usher in the “killer app” of blockchain technology. The DLT Pilot Regime, overseen by the European Securities Market Authority (ESMA), will test the full potential of tokenized security trading on blockchain technology. The term “security” can refer to stocks, bonds, private equity and many other types of financial investments. ESMA refers to these blockchain-based securities as “DLT Financial Instruments”, meaning they are financial instruments that are issued, recorded, transferred and stored using distributed ledger technology.
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Both traditional and digital finance companies will be able to experiment with using financial DLT products in a regulated environment. The most powerful aspects of this regime are twofold: First, tokenization and trading of financial instruments can use public and permissionless blockchains or permissioned distributed ledger technology. Second, these DLT financial instruments will not only be available for trading by qualified or professional investors; instead, the regulators will experiment with letting private investors participate in the action.
One of the companies applying for a license to operate under the DLT pilot regulatory regime is 21finance. CEO Max Heinzle called the securities tokenization an “Amazon moment,” saying in an interview that the regulation would boost financial inclusion.
“Cryptosecurities can make finance accessible to 8 billion people with real-time settlement,” Heinzle said. “Cryptosecurities are already expected to make up more than 30% of the digital asset market by 2026 – without even factoring in the impact of the DLT Pilot Regime.”
As part of an experiment with blockchain technology, participants in the DLT pilot regime will be exempted from certain parts of the legislation related to financial services. These pieces of legislation include the Markets in Financial Instruments Directive (MiFID) and the Central Securities Depositories Regulation (CSDR). Under the DLT Trading and Settlement System (TSS), trading and settlement can be offered from a single counterparty, making it particularly interesting in the sense that fewer intermediaries potentially mean lower costs for end users.
However, we have to be very careful here as this does not refer to trading in the common usage of the word. Rather, the DLT TSS will have to comply with the DLT regime, under the purview of ESMA, which means it can only provide a non-discretionary multilateral trading facility. Therefore, participants in the DLT Pilot regime will not allow trading with transparent order books such as cryptocurrency exchanges such as Binance. Instead, the trading platform is non-discretionary.
Regulated banks, as well as young fintech companies and crypto startups that are not yet regulated as financial intermediaries, can already apply for approval. Therefore, after the first three years of the project, ESMA will prepare a report that will serve as a basis for the European Commission. This report in turn will inform both the European Parliament and the European Council. They then decide what measures to take, such as adding financial instruments or increasing or decreasing the limits.
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To participate in the DLT pilot program, new entrants to the financial industry who are not licensed under MiFID or CSDR must obtain special approval from the relevant financial regulators. All this means that cryptocurrency exchanges and service providers can access the sandbox without having to comply with the European Union’s broader financial obligations that traditional institutions must follow.
While ESMA has not yet confirmed participants, financial institutions and trading platforms such as BNY Mellon and Binance have expressed interest in participating.
The DLT trial regime will take effect in March but has been in the making for years, starting with the Digital Finance Package unveiled by the European Commission in 2020. The goal is to implement and encourage the potential of digital finance for innovation and competition, while minimizing risk. The package also included the Markets in Crypto-Assets Regulation, the Digital Operational Resilience Act and a proposal to establish or amend certain EU financial services rules, for example those related to retail payments.
The DLT Pilot Regime project will ultimately serve as a basis for future EU policy on the application of distributed ledger technology to financial markets.
Demelza Hays is the research director at Cointelegraph. Over the past eight years, she has written more than 20 digital asset analytics reports and managed two regulated cryptocurrency funds. She was a Forbes 30 Under 30 recipient in Europe in 2019 and a U.S. State Department Fulbright Scholar from 2012 to 2013. She completed her Ph.D. in business economics from the University of Liechtenstein in 2021. Inspired by her work in wealth management, her dissertation explored the role of cryptocurrency within a diversified portfolio. In her spare time she enjoys hiking, tennis and sailing.
This article is for general information purposes and is not intended to and should not be construed as legal or investment advice. The views, thoughts and opinions expressed here are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.