[ESMA70-460-189] Q&As DLT Pilot Regulation

ESMA has issued a new version of its Q&A document relating to the DLT Pilot Regime.
The update includes following changes – as quoted:
#### Section VII: DLT Financial Instruments
Question 2: Are both of the modalities of issuing DLT financial instruments described below allowed under the DLTR?
1) Direct issuance of financial instruments on DLT, whereby financial instruments are initially and directly issued, recorded, transferred and stored using a DLT;
2) Issuance of existing non-DLT financial instruments in the form of DLT financial instruments as described in recital 3 of the DLTR.
Are other issuance modalities of DLT financial instruments possible under the DLTR?
Answer 2: Both of the described modalities of issuance are indeed possible under the DLTR. That is implied by its recital 3 which explicitly refers to two ways in which financial instruments can be issued on DLT – by digitally representing a financing instrument on DLT and by issuing a traditional asset class in tokenised form.
The former mechanism corresponds to the situation described under 1) of the question, whereby a financial instrument begins its lifecycle by being issued directly on a DLT market infrastructure using DLT.
The latter mechanism corresponds to the situation described under 2) of the question, whereby an existing non-DLT financial instrument is recorded and thereby represented in tokenised form on a DLT, and continues its lifecycle as a DLT financial instrument. In such a case, the token serves as the main reference point for further events relevant to the lifecycle of that instrument, such as trading and settlement.
However, since the DLT Pilot regime is meant to enable DLT Pilot participants to flexibly experiment with DLT in organizing trading and settlement of financial instruments, it cannot be excluded that DLT Pilot participants might put forward models that do not clearly fit into the two modalities of issuance of DLT financial instruments described above. The legal feasibility of each contemplated model should be assessed on a case by case basis.
Question 3: Is partial tokenisation allowed under the DLTR? Does the DLTR apply to situations where not the entirety of an issuance of financial instruments is tokenised, but where, for example, only part of an issuance is registered with a DLT SS/TSS? In other terms, can financial instruments which have been regularly issued and subsequently partially tokenised be registered with a traditional CSD in their entirety, and be partially registered with a DLT SS/TSS for the tokenised portion?
Can the tokenised part be issued by another party than the issuer of the original financial instruments?
Can a financial instrument recorded in a traditional CSD be fungible with one recorded in a DLT SS/TSS (having both the same rights and obligations)?
For bonds, can one option be to consider the tokenised financial instrument as different from the original underlying financial instrument, similar to the “depositary receipts” model, in accordance with Article 3(1), point (b), of the DLTR?
Answer 3: Partial tokenisation should be understood as part of the total issuance of a given financial instrument being issued as a DLT financial instrument, i.e. using distributed ledger technology, with the other part of the issuance of that instrument existing as a traditional financial instrument, without reliance on DLT. The DLTR does not explicitly prohibit partial tokenisation of an issuance. Moreover, when laying down the conditions for allowing derogations from CSDR in its Article 5(2), the DLTR acknowledges in point (b)(ii) of that Article the possibility for only a part of an issuance to be recorded on a distributed ledger. Where the tokenisation pertains to only a part of an existing issuance that is already registered with a CSD, the operator of the DLT SS or the DLT TSS is to ensure the integrity of the issue in accordance with Article 37 CSDR or Article 5(2), point (b), DLTR, whichever is applicable.
The DLTR does not explicitly address the question on whether any entity other than the issuer can tokenise part of an issuance. However, as noted, the DLTR does not exclude tokenisation of existing financial instruments by DLT market infrastructures. Nevertheless, any such tokenisation should occur whilst fully respecting any contractual obligations between the CSD where the financial instruments are registered prior to tokenisation and the issuer, the CSD and the participants of the securities settlement system operated by it, as well as applicable Union and national law.
The notion of fungibility is not defined in the DLTR, nor is defined in the legislative acts that underlie it – CSDR and MIFID II. In its usual meaning of the word, fungibility means that the two assets are interchangeable and of equivalent value. In case financial instruments with the same economic and legal features are partially registered with a traditional CSD and partially with a DLT SS or a DLT TSS, they should be considered fungible in the economic and legal sense. However, from an operational perspective, it might be the case that that the register of a traditional CSD and that of a DLT financial infrastructure are not technically linked in such a way that they ensure seamless interchangeability.
Regarding the question whether a tokenised bond can be regarded as different from the original underlying financial instrument, the DLTR does not specify what is the relationship between the ‘underlying’ financial instrument, i.e. the instrument that was issued, recorded, transferred and stored outside a distributed ledger, using traditional financial infrastructure, and the DLT financial instrument that came into existence through tokenisation. However, DLT market infrastructures participating in the pilot are to ensure that any DLT financial instrument onboarded on their systems belong to one of the categories of instruments referred to in Article 3 DLTR to be eligible for the pilot, and that the creation of such instruments is done in accordance with applicable law. Furthermore, irrespective of the arrangement in place, the issuer CSD for the underlying bonds and the operator of the DLT SS or the DLT TSS are to be always able to ensure the integrity of the issue in accordance with Article 37 CSDR or Article 5(2), point (b), DLTR, whichever is applicable.
Question 4: Does Article 3(1), point (c), of the DLTR require that a UCITS fund should be an ETF in order to be eligible?
Answer 4: Under MIFID II, units in UCITS funds fall under the category of financial instruments referred to in Section C point (3) of Annex I to that Directive, so-called units in collective investment undertakings. Under Article 3(1), point (c), DLTR, that category of financial instruments is eligible to be admitted to trading on a DLT market infrastructure, or be recorded on a DLT market infrastructure provided that those units in collective investment undertakings are covered by Article 25(4), point (a)(iv), MIFID II and that the market value of the assets under management of that fund is less than EUR 500 million. There are no requirements in Article 3(1), point (c), DLTR that would require that a UCITS fund also needs to be an exchangetraded fund within the meaning of Article 4(1), point (46) MIFID II in order to be eligible for the DLT Pilot Regime.
Question 5: Should ETFs or other collective investment undertakings represented by shares be considered as units in collective investment undertakings, rather than shares (transferable securities), thus falling into the bucket specified in Article 3(1), point (c), DLTR, and hence assessed against the criteria in Article 25(4), point (a), of MiFID II?
Answer 5: Collective investment undertakings represented by shares fall within Article 3(1), point (c), DLTR. Article 3(1), point (c), DLTR refers to „units in collective investment undertakings covered by Article 25(4), point (a)(iv), of Directive 2014/65/EU”. Since Article 25(4), point (a)(iv), of Directive 2014/65/EU refers to both “shares or units in UCITS” and considering the similar nature of shares and units in collective investment undertakings, shares in collective investment undertakings fall under Article 3(1), point (c), DLTR. They do not fall under Article 3(1), point (a), which concerns shares, which are transferable securities. Likewise, ETFs which are defined in Article 4(1), point (46), MIFID II as funds “of which at least one unit or share class is traded throughout the day on at least one trading venue and with at least one market maker” fall within Article 3(1), point (c), DLTR when they are UCITS using units or shares.
Question 6: Are SFT transactions (SFTs) admissible on a DLT MTF/TSS? In particular, should Article 3(1), point (b), DLTR, which excludes instruments “that embed a derivative or incorporate a structure which makes it difficult for the client to understand the risk involved” be read as also excluding complex transactions like SFTs?
Answer 6: Securities financing transactions are not admissible within the DLT Pilot. The DLTR provides under Article 3 for a limitative list of DLT financial instruments that can be admitted to trading on a DLT market infrastructure. Securities financing transactions do not fall within any of the categories of that limitative list. Furthermore, securities financing transactions usually consist of multiple transactions and are used to secure funding and gain leverage.
Enabling such transactions on DLT market infrastructures would be contrary to the strict limitation on the types of financial instruments that can be admitted to trading or recorded on DLT market infrastructure in accordance with Article 3 DLTR. The objective of such a limitation was to enable DLT-based experimentation with financial instruments which are more easily understandable by investors and less complex to handle by DLT market infrastructure, to preserve investor protection, market integrity and financial stability, as set out in recital 3 of the DLTR.
The fact that the DLTR enables retail investors to have direct, disintermediated access to DLT market infrastructures and instruments offered by them, makes the objective of ensuring investor protection and limiting the type of transactions eligible for the DLT Pilot even more important.
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#### Section VIII: DLT Market Infrastructures
Question 1: Are DLT MTFs permitted to organise trading off-chain in relation to DLT financial instruments?
Should it be mandatory for a DLT MTF to operate its matching engine with a DLT technology?
Answer 1: The DLTR does not require that a DLT MTF organises trading of DLT financial instruments on the blockchain (on-chain), which is a type of distributed ledger. Indeed, Article 2, point (6), DLTR defines DLT MTFs as a multilateral trading facility that only admits to trading DLT financial instruments. Article 2, point (11), DLTR defines DLT financial instruments as financial instruments that are “issued, recorded, transferred and stored using distributed ledger technology”. That definition does not entail that DLT financial instruments are to be traded using DLT, but rather that the DLT are to be used for maintaining accounts and records pertaining to the title over a financial instrument and to facilitate the transfer of such titles between market participants.
Since a DLT MTF is allowed to organise trading off-chain, it is free to operate its matching engine using technology that does not leverage DLT.
Question 2: Should an entity that applies for a permission to operate a DLT TSS provide both the DLT MTF and DLT SS services? Under which circumstances can an entity apply for the permission to operate a DLT MTF, without the need to operate a DLT TSS? Who can perform the settlement of transactions in DLT financial instruments, together with the initial recording of DLT financial instruments or the safekeeping services in relation to DLT financial instruments, in case an entity applies for the permission to operate a DLT MTF and not a DLT TSS?
Answer 2: In Article 2, point (10), of DLTR, a DLT TSS is defined as a DLT MTF or DLT SS that combines services performed by a DLT MTF and a DLT SS. Therefore, an entity that applies for a permission to operate a DLT TSS is to perform both the DLT MTF and DLT SS services.
An entity can apply for the permission to operate a DLT MTF, without the need to operate a DLT TSS when that DLT MTF does not provide settlement services in DLT financial instruments against payment or against delivery together with initial recording services or safekeeping services in relation to DLT financial instruments.
In case an entity applies for the permission to operate a DLT MTF and not a DLT TSS, any entity who is licensed as a DLT SS, DLT TSS or CSD and with whom the DLT MTF has set up access arrangements in accordance with Article 53 of CSDR may perform the settlement of transactions in DLT financial instruments, together with the initial recording of DLT financial instruments or the safekeeping services in relation to DLT financial instruments.
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#### Section IX: Cash Settlement
Question 1: Should ‘e-money tokens’ under the DLTR be interpreted under the MiCA definition of ‘e-money tokens’?
Could settlement in e-money tokens be used by DLT MI operators even before MICA starts applying?
Does the issuer of the e-money tokens have to be authorised under EMD? Is it correct that a DLT SS/TSS operator does not need an authorisation as a credit institution or payment services institution if it uses e-money tokens for cash settlement that are issued by a duly authorised institution?
Would e-money tokens used for settlement on a DLT market infrastructure be allowed to be issued on a distributed ledger other than that used by the DLT market infrastructure?
Answer 1: Until proposed Regulation on Markets in Crypto-assets (MICA) is adopted and applicable, e -money tokens referred to in Article 5(8) of the DLTR should be interpreted to mean electronic money that has been issued in compliance with Directive 2009/110/EC (E-money Directive, EMD). Electronic money tokens issued in that manner may be used by operators of DLT market infrastructures even before MICA applies. However, once MICA starts applying, the notion of e-money tokens under the DLTR should also be interpreted in light of that Regulation, which will comprehensively regulate the issuance and use of e-money tokens.
The issuer of e-money tokens should be authorised under the EMD as an electronic money institution or as a credit institution under Directive 2013/36/EU.
In accordance with Article 5(8), fifth subparagraph, of DLTR, services related to e-money tokens that are equivalent to the services listed in Section C, points (b) and (c) of the Annex to CSDR, must be provided by the operator of a DLT SS or a DLT TSS in accordance with Title IV of the CSDR or by a credit institution. Furthermore, Article 5(8) DLTR explicitly permits that e-money tokens are used by a DLT SS or a DLT TSS as a means of settlement of transactions related to DLT financial instruments under certain conditions.
The DLTR does not require that e-money tokens used for settlement on a DLT market infrastructure must be issued on the same distributed ledger as the one used by the DLT market infrastructure to trade or settle DLT financial instruments. Therefore, DLT market infrastructures are free to use distinct distributed ledgers for the ‘cash’ and the ‘asset’ leg of the transaction.
Question 2: Do the applicants to the DLT SS/DLT TSS status need to apply for the exemption from the application of Article 40 of CSDR, as set out in Article 5(8) of DLTR, whenever they use tokenised money, independently of whether it is central bank tokenised money or commercial bank tokenised money?
Answer 2: DLT SS/TSS applicants need to request the exemption from Article 40 of CSDR, as set out in Article 5(8) of DLTR, for settling the cash leg of a transaction differently than as laid down in Article 40 CSDR. That in particular means that an exemption will be necessary if the cash payments are not settled through accounts opened with a central bank of issue of the relevant currency or accounts opened with a credit institution in accordance with Title IV of CSDR.
The notion of account should be understood as being technology-neutral in this context.
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#### Section X: Exemptions from CSDR
Question 1: Are DLT SS or DLT TSS and their participants exempted from the provisions of Article 9 of CSDR on internalised settlement regarding transactions settled on a DLT SS or a DLT TSS duly authorised under DLTR?
Answer 1: Yes. DLT TSS are expressly exempted from the application of Article 9 CSDR under Article 6(1), point (b), of DLTR. Pursuant to Article 5(1) DLTR, DLT SS are only subject to those requirements applying to a CSD operating a securities settlement system under CSDR, thereby excluding Article 9 of CSDR. Like participants of CSDs, participants of DLT SS or DLT TSS are not subject to Article 9 of CSDR either since they do not internalise the settlement of transactions per se but use DLT SS or DLT TSS for that purpose. Pursuant to Article 11(4), point (c), DLTR, DLT SS and DLT TSS are nevertheless subject to reporting requirements similar, apart from the frequency, to those laid down in Article 9 of CSDR.
Question 2: Would a DLT financial instrument traded on a DLT MTF be subject to the book-entry form obligation under Article 3 of CSDR unless it is registered in DLT form with a DLT SS/TSS that has applied for the exemption from that Article?
Answer 2: Unless the DLT MTF is authorised as DLT TSS and obtains an exemption from applying Article 3 of CSDR, where a transaction in transferable securities takes place on a DLT MTF, the relevant securities shall be recorded in book-entry form in a CSD.