If the European Union is to avoid a fate as a regulatory fly-over zone for digital assets – that some in the industry feel it risks becoming – then it must deploy every tool available to foster innovation. Among the most important of these tools is the distributed ledger technology pilot regime.
Launched in June 2022, the regime was intended to evaluate DLT as a basis for settlement systems. Three years on, it has failed to deliver. Only three infrastructures have received authorisation to operate DLT trading and settlement systems in that time and even they have hosted little in the way of live transactions.
Attributing the lack of take-up of the pilot regime to any lack of interest in the European digital asset market would be a mistake. Europe has plenty of cryptoasset service providers, market infrastructures firms, banks and fintechs who aspire to offer financial services on DLT.
Rather, the failure of the pilot regime should be blamed on its design. Perhaps this is because, at the time of its creation, incumbents preferred to suppress DLT innovation than pursue it. The result was a regime neutered and ineffectual that those determined to innovate with European digital assets simply steered around, rather than embraced.
That it badly needs fixing has become clear to the alphabet soup of European supervisory institutions, who have begun writing letters and reports to each other, detailing the regime’s drawbacks and suggesting solutions. These began in April 2024 with a letter from the European Securities Markets Authority to the European Commission, which responded a month later. This year, French and Italian supervisors collaborated on a position paper, and the Commission launched a targeted consultation, which included a section on the pilot regime.
Fixing the pilot regime
What was so wrong with the pilot regime that nobody wanted to use it?
The first problem was confusion about the duration. There was a widespread belief that the pilot regime was slated to end after three years. This disincentivised participation since potential applicants were reluctant to put resources into developing infrastructure for a regime with no lifespan beyond 2026. The Commission’s May letter attempted to dispel this idea, pointing out that the regime would only end if a new legislative was adopted specifically to do so and that, as of May 2024, no such proposal was envisaged. In this case, the problem was not the design, but a failure to communicate the Commission’s long-term commitment to encouraging DLT-based innovation in capital markets.
A second major problem with the pilot regime was the size cap. Market participants were unwilling to develop DLT platforms for a regime that capped the volume at €6bn, since it would be impossible for participants to do enough volume to generate a return on their investment. Pilot regimes are, by definition, for experimental technology and, as such, limiting the damage they can do by keeping the size limited is appropriate. However, the Commission provided no pathway to full uncapped adoption and so, once again, market participants decided not to pursue an area for which regulatory support seemed so lukewarm.
Third, the Commission must broaden its approach on cash settlement in the regime as a matter of urgency. At present, the pilot regime permits the use of e-money tokens only if they are issued by credit institutions, not by e-money institutions. ESMA identified this as an obstacle to adoption. The new version of the pilot regime must permit settlement in Markets in Crypto-Assets Regulation-licensed, euro-denominated stablecoins. As well as improving the efficiency of pilot regime projects by providing easy access to cash on-chain, this would provide a shot in the arm for European stablecoins – much needed in the face of US promotion of the instrument.
The long-term solution for cash settlement in DLT-based generations of European capital markets will surely be central bank money. For a stablecoin to achieve the requisite scale would mean that its reserves sucked up all Europe’s safe assets. The Deutsche Bundesbank’s trigger solution and the Banque de France’s wholesale CBDC can fulfil that role in the long term, but as an immediate step to energising digital innovation in Europe, stablecoin use must become a component of the pilot regime.
There are a host of other legal and technical issues that need addressed. Among other things, the Commission must clarify the way custody rules apply for self-hosted wallets; it must support interoperability between DLT market infrastructure and traditional market infrastructure; and it must examine the way in which the Central Securities Depository Regulation applies to assets that can be transferred between traditional and DLT-based infrastructure.
The technical details of the regime design matter, but perhaps not as much as the overall regulatory pose. Europe has a well-earned reputation for regulating innovation out of existence. If it seeks to shake that off, the new pilot regime must signal Europe’s commitment to fostering innovation in DLT and, above all, an understanding of what it will take for European businesses to compete with their American counterparts.
Lewis McLellan is Head of Content, Digital Monetary Institute, OMFIF.
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