The EU’s pilot regime for market infrastructure based on distributed ledger technology recently came into effect. Head of Debt Capital Markets & Listing, Daragh O'Shea examines how the pilot regime is intended to promote the uptake of distributed ledger technology in the financial sector and how it is hoped it will lead to new innovations in market infrastructure. We also explore the opportunities for Irish companies issuing debt securities.

The EU’s pilot regime is intended to promote the uptake of distributed ledger technology (DLT) by allowing operators of market infrastructure, such as trading platforms and securities settlement systems, to apply for some exemptions from financial services regulations that would otherwise be inconsistent with systems utilising DLT.

The pilot regime identifies three types of market infrastructure:

• DLT MTFs, which are trading platforms for DLT financial instruments
• DLT settlement systems, which are settlement systems for DLT financial instruments, and
• DLT trading and settlement systems that are hybrid systems, which combine the services performed by trading platforms and settlement systems.

Investment firms and market operators authorised under MiFID II, and central securities depositories, authorized under the Central Securities Depositories Regulation (CSDR), may apply to their national competent authorities for permission to operate such DLT infrastructure. As part of the approval process, the relevant firms, market operators and central securities depositories can request the temporary disapplication of certain provisions of CSDR and MiFID II for a period of up to six years.

Central to the pilot regime are DLT financial instruments which are financial instruments that are issued, recorded, transferred and stored using DLT. Only certain limited categories of DLT financial instruments are eligible to be admitted to trading on or recorded on DLT market infrastructure.

The eligible DLT financial instruments consist of:

• Shares, the issuer of which has a market capitalisation, or a tentative market capitalisation, of less than €500 million
• Bonds and other forms of securitised debt, including depositary receipts for such securities, or money market instruments, with an issue size of less than €1 billion, excluding those that embed a derivative or incorporate a structure which makes it difficult for the client to understand the risk involved, and
• Units in authorised UCITS, other than structured UCITS, the market value of the assets under management of which is less than €500 million.

Benefits of DLT

As the use of DLT in the financial sector is still in its infancy, it is too early to forecast how exactly the technology will develop and evolve. Despite this uncertainty, there is a general consensus, and optimism, among commentators about the benefits that may be delivered by the new technology. Potential benefits may include the following:

• Reduced settlement cycles - It is anticipated that the use of DLT could reduce settlement cycles significantly from the current timeframes of days to eventually being near instantaneous.
• Intermediary elimination - The use of DLT may allow issuers to interact directly with investors and remove the need for intermediaries in the settlement cycle. This promises to simplify the issuance process and reduce the associated cost.
• Increased access - The ease of issuance and reduced costs promised by DLT are likely to increase market access by making debt issuances feasible for smaller enterprises.

Use of DLT by issuers of debt securities

One category of market participant to whom the new platforms will be of interest are issuers of debt securities. Interested issuers will need to be aware that, while the pilot regime provides some limited regulatory exemptions for the operators of market infrastructure, issuers will need to continue to comply with their local securities laws. Issuers considering participating in any new platform will need to ensure they understand how the platform operates so they can satisfy themselves that they will remain compliant with their local requirements.

Irish legal framework for DLT

While some European jurisdictions have introduced legislation specifically to enable issuers to use DLT, there are no immediate plans yet to do so in Ireland. However, despite this lack of specific legislation, the existing Irish legal framework is already well-equipped to accommodate DLT securities.

While it is too early to forecast how exactly the new platforms will operate, a common feature is likely to be the elimination of paper forms and a transition to dematerialised securities. Traditionally Irish debt securities have been issued in paper form, either as registered securities or bearer securities. These paper forms are either issued directly to investors or in global form to a nominee to accommodate their holding through securities settlement systems.

Despite this traditional approach, there is no Irish legal imperative for debt securities to be represented by a paper instrument, and it is becoming increasingly common for debt securities to be issued in dematerialised form. This transition has been driven in part by the requirements of CSDR.

With effect from 1 January 2023, Article 3(1) of the CSDR requires issuers of debt securities which are admitted to trading on EU markets to arrange for the securities to be represented in book entry form as “immobilisation” or subsequent to a direct issuance in dematerialised form. In response, Irish issuers who commonly have their securities admitted to trading for technical reasons have begun to issue in dematerialised form.

As dematerialised securities do not have any physical form that can be possessed, they are necessarily issued in registered form rather than bearer form. Details of the securities and their holders are recorded on a securities register maintained by or on behalf of the issuer. It should be relatively straightforward for dematerialised registered securities to be adapted for use with DLT infrastructures. The distributed ledger could serve as the securities register or the basis on which the securities register can be generated.

Comment

Despite this generally favourable legal environment, it will remain important for Irish issuers considering participating in new platforms to carefully review their operation. Irish issuers will need to ensure that the mechanics of the platform are consistent with the applicable requirements of Irish company law. These include requirements relating to the maintenance of securities registers and formalities for registering transfers of securities. None of these matters are likely to present significant obstacles for Irish issuers but are factors that will need to be considered.

The introduction of the pilot regime is a positive step in ensuring that European capital markets can take full advantage of the opportunities offered by the digital age. While specific Irish legislation in relation to DLT would be welcome, Irish issuers are well-positioned to benefit from any innovations delivered by the new technology.

For more information, contact a member of our Debt Capital Markets & Listing team.

The content of this article is provided for information purposes only and does not constitute legal or other advice.