What the EU’s sandbox for blockchain-based tokenized securities means for the industry’s future

7 MIN READ
SHARE  

When it comes to blockchain, a key interest for the financial industry is the tokenization of securities such as stocks, bonds, and derivatives. Unfortunately, the ability for financial services to utilize blockchain has been hampered by legislation that pre-dates the emergence of distributed ledger technology (DLT). With the European Union’s green-light on a pilot program for blockchain-based tokenized securities, however, all that is poised to change.

Even though the technology is still very new, blockchain is bringing a wave of innovation to financial markets– and this isn’t being ignored by regulators. Recently, the European Union (EU) proposed a new pilot program for blockchain-based tokenized securities, proving that regulators not only understand what’s happening in the industry but understand the potential benefits of blockchain enough to make legislative changes to facilitate its innovation. 

Referred to as the “pilot regime for market infrastructure based on distributed ledger technology”, the program allows financial markets in the EU to use DLT for the tokenization of conventional financial instruments such as stocks, bonds, and UCITs (the EU version of mutual funds). It will also allow for settlement in different currencies, including the preferred central bank money as well as tokenized commercial bank money, e-money tokens, and fiat-backed stablecoins. 

Recognizing blockchain’s benefits

So far, it’s been difficult for market participants in the EU to implement solutions utilizing blockchain due to regulatory reasons. With crypto-assets qualifying as “financial instruments” under EU regulation, they’ve been subject to EU securities market legislation, which is so stringent and restrictive that it prevents the financial industry from capturing many of the benefits of tokenization. Even so, the EU has made explicit that it understands these benefits. 

“DLT can bring a number of potential benefits in the provision of financial services, including reduced complexity, improved end-to-end processing speed, strengthened network resilience, and reduced operational and financial risks”, said Johan Van Overtveldt, Lead MEP and Chair of the European Parliament’s Budget Committee. 

Recognizing that current securities legislation pre-dates the existence of DLT and could hamper innovation– ultimately preventing market participants from capturing the technology’s many benefits– the European Commission proposed the pilot regime. The regime effectively creates a legal framework for regulatory sandboxes for companies looking to test blockchain in the creation, management, trading, and post-trading of securities. 

The European Council and European Parliament have both given the green-light on the pilot program, meaning it could be officially passed by parliamentary vote as early as March 2022. It’s expected to last at least three years, with potential extension or modification upon review every three years thereafter or permanency if future legislation is passed.

Facilitating future innovation

A sandbox is a testing environment bringing together regulators, companies, and tech experts who wish to test innovative solutions and identify problems in their deployment. The EU’s pilot program for blockchain-based securities is essentially a sandbox allowing market participants to utilize blockchain to trade and settle transactions in certain financial instruments in crypto-asset form.

The sandbox gives companies more freedom to experiment with blockchain-based solutions for securities by exempting them from existing rules that otherwise prevent such solutions from being implemented. Assisting this innovation is the program’s wide inclusivity; it permits newcomers to participate insofar as they comply with the same rules as established regulated entities. 

These permitted exemptions are however constrained by certain financial limits. The requirements will be waived for stock issuance for up to €500m, bonds for up to €1b, and corporate bonds for up to €200m for corporate bonds. They will also be subject to an overall limit of €6 billion for any financial market infrastructure (FMI), of which 3 types are allowed (DLT based trading venues, settlement services, and combinations of both). 

By widening what’s permissible under EU legislation, the pilot program not only facilitates further innovation within the industry in a legal way but also cements the importance of bringing blockchain technology to financial markets on a faster timeline. The EU clearly notices it’s more of a question of when and not if.

Towards a regulatory framework 

When it comes to getting ahead of the securities market, it’s clear that those who approach tokenization in the right way will come out on top. The EU’s pilot program looks promising on this front: it’s legal, properly regulated, and initially limited in a way that protects investors and wider financial markets.

As mentioned, the pilot program provides a regulatory sandbox where existing legal requirements are waived to allow for the issuance of certain financial instruments on DLT. For example, existing legislation requires separating trading venues and post-trade operations, including settlement and central security depositories (CSDs). Within the pilot, however, this functionality can be combined with blockchain infrastructure. 

The pilot also allows retail investors to access DLT platforms to take advantage of the peer-to-peer environment, which is very different from existing trade models involving intermediary brokers (a result of regulation requiring that stock markets and trade venues deal only with institutions). To mitigate risk and protect consumers, however, the pilot requires the DLT platform provider to be financially responsible for hacking and cyber attacks. 

By creating a legal environment for experimentation, the EU shows that as a regulatory body, it recognizes its own role in shaping the future of securities and that this isn’t a responsibility it takes lightly. Further, by implementing EU-wide rules pertaining to blockchain, the EU shows it values harmonizing regulations around the technology and providing legal certainty around its applications to avoid fragmentation between its member states. It is, in effect, bringing Europe closer to a more robust regulatory framework around securities on the blockchain– perhaps one that other nations and regions might begin to model.  

Ultimately, the pilot program not only demonstrates the EU understands that the potential benefits of blockchain are lost under the current legislation, but is willing to modify or implement new legislation to enable financial markets to utilize the technology in a careful, legal, investor-friendly way. In other words– the EU understands the importance and value of blockchain for the industry, and it’s willing to work with the industry to advance it further.

Polymath is a blockchain technology provider. Polymath is not a broker-dealer, funding portal, trading platform or otherwise engaged in the business of trading in securities or providing advisory services regarding the issuance, buying or selling of securities. Polymath is not making any recommendation or giving any advice with respect to any company or proposal discussed in this communication.

 

Related Posts

GUIDE

Security Token Custody: The Challenges and Opportunities

Security tokens come with a unique set of requirements. While they’re intended to bring efficiency and automation to capital markets, digital asset custodians often face scalability and efficiency issues when handling them on public blockchains.

This guide dives deep into the challenges surrounding security token custody and how a purpose-built blockchain can overcome them.

Security-Token-Custody-Guide-