From ledgerinsights

Last week the Association for Financial Markets in Europe (AFME) outlined its European vision and policy recommendations for DLT and tokenization. This is in response to a call for submissions by the EU’s capital markets Directorate, FISMA. The paper makes recommendations that address some key issues holding up the development of tokenization in the European Union.

One of the critical suggestions relates to CSDR, the regulations that govern central securities depositories (CSDs). Today CSDs perform critical functions including securities issuance, acting as record keepers and providing settlement infrastructures. However, a DLT can provide the record keeping function. Smart contracts can perform functions such as paying interest or dividends. Plus, DLT supports delivery versus payment, which can eliminate settlement risks without the need for a centralized counterparty (CCP).

CSDR is incompatible with DLT, tokenization?

Countries such as Germany, Luxembourg and Italy have passed DLT friendly laws. We frequently report on issuances under Germany’s electronic securities law, eWpG, where securities issued via a decentralized registry don’t require the use of a CSD. Instead, a registrar ensures the DLT is keeping tabs and other related tasks. It’s significantly less arduous to become a registrar versus a CSD. That’s because the registrar only performs one aspect of a CSD’s role under CSDR.

However, you won’t see any eWpG securities publicly traded. Why? Because the CSDR regulation requires publicly traded securities to be registered with a CSD. So while you can issue securities under eWpG, they can only be traded over the counter (OTC).

This is why the digital asset-savvy Boerse Stuttgart, Germany’s second largest stock exchange, is setting up a digital securities exchange, BX Digital, in Switzerland rather than Germany. AFME makes precisely this argument – that the EU will lose its current advantage in tokenization to other jurisdictions if it doesn’t evolve quickly.

A related point is that the CSDR treats CSDs as a monolith. By contrast, IOSCO-CPMI Principles for Financial Market Infrastructure (PFMI) outline separate functions: these include a CSD (issuance and maintenance), securities settlement system (SSS), and notary functions. Hence, AFME argues that because roles are separated with DLT, the CSDR as it stands cannot work for tokenization. It believes there’s a need for a new regulatory regime, much like MiCAR for crypto-assets.

However, these two changes are amongst the medium term strategies, because even if regulators start now, a new legal regime isn’t likely to come into force before 2029.

DLT Pilot Regime suggestions

AFME also made shorter term recommendations regarding the DLT Pilot Regime, many of which it has previously outlined. The Pilot Regime came into force in March 2023, relaxing certain requirements, but only one entity has been approved so far. Under the Regime, it’s possible to operate a combined trading and settlement system. Plus, an exchange can deal directly with retail clients rather than requiring brokers as intermediaries.

Currently the DLT Pilot Regime supports three types of authorizations – as a multilateral trading facility (DLT MTF), as a settlement system (DLT SS) or both (DLT TSS). However, any entity that wants to provide a settlement system has to be a CSD. Hence, it’s no surprise the only authorized entity so far is Prague CSD approved last month.

AFME argues that requiring registration as a CSD is too onerous. Many banks would be interested in providing a DLT SS but not becoming a CSD. The authors also note that the UK’s Digital Securities Sandbox doesn’t have this requirement. Again, AFME is concerned that the EU could lose out to a competing jurisdiction.

The DLT Pilot Regime has quite low caps on activities, which make it unattractive for larger entities. Hence, AFME requests higher caps. It also wants securities issued under the Regime to be eligible as central bank collateral.

The big picture vision

The report starts off by building a vision of a tokenized future and identifies several key benefits.

There’s considerable soul searching in Europe about how to keep innovation within the EU, rather than startups emigrating to the United States. A key part of that is funding, and AFME argues that by using DLT to create a capital markets union it will make it easier for startups to raise capital locally. That’s one of several potential upsides.

The AFME paper is an evolution of previous policy recommendations it outlined earlier this year.