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By Frank Mausen (Partner) , Philippe Noeltner (Senior Associate) and Miao Wang (Counsel) from Allen & Overy as featured in Insight Out Magazine #25
The European Union (EU) has acknowledged the potential of distributed ledger technology (DLT) by adopting the DLT Pilot Regime[1]. With this legislative initiative, the EU is leading the pack of major economic hubs seeking to boost capital markets and fund product offerings. The DLT Pilot Regime comes into effect on 23 March 2023.
What are DLT and the DLT Pilot Regime about?
DLT is a system for recording and sharing data across a network of nodes, without relying on a central authority or intermediary. DLT enables consensus, transparency and security among network participants, and can support various applications such as cryptocurrencies, smart contracts, and digital financial assets (like digital fund units solely residing in DLT networks).
This rapidly evolving technology is revolutionising the way financial assets are issued, traded and custodied. The tokenisation and digitalisation of financial assets is on the path to adoption by established market players. For instance, several high-profile bond issuances have been carried out successfully over recent years relying solely on DLT networks[2].
Due to a complex gap in the EU legal framework, however, it has not been possible to trade such digital financial assets on trading venues which have deep liquidity. It has also not been possible to settle trades on these instruments in the traditional clearing systems that are home to the overwhelming majority of financial products. These two factors have been seen as the shackles preventing digital financial instruments from being actively traded.
The EU intends to tackle these structural issues with the DLT Pilot Regime. This legislative framework will allow certain market infrastructure operators (Multilateral Trading Facilities (MTF) and Central Securities Depositaries (CSD)) to use DLT in their operations under certain conditions. Under the DLT Pilot Regime, these operators are granted exemptions from certain provisions of EU legislation such as the Markets in Financial Instruments Directive II (MiFID II) and the Central Securities Depository Regulation (CSDR) to use DLT in their operations. This will enable trade and post-trade services to be provided by these players for digital financial assets under a clear legal framework.
As such, certain investment funds[3] will be able to capitalise on the technological and operational benefits of DLT while still having access to these services of DLT market infrastructures. Luxembourg, as the funds hub of Europe, is well positioned to reap the benefits of the DLT Pilot Regime.
What’s in it for the Luxembourg funds industry?
We anticipate that DLT may offer multiple potential benefits for fund industry players, such as:
- Automating and decentralising various tasks that normally require human intervention through smart contracts, such as debt servicing, AML/KYC compliance, and certain investor reporting and communication.
- Providing instant and consistent visibility of deal flows for all the participants in the fund industry value chain.
- Saving the time and costs incurred by the reconciliation activities between different parties, as the transactions are verified and recorded directly on the distributed ledger.
- Serving as a single source of truth where all the information is consolidated and consistent.
- Increasing significantly operational efficiency by eliminating the necessity to manually coordinate with various intermediaries or to wait for the processing of outstanding orders before the publication of net asset value (NAV).
DLT is also built for resistance to fraud and hacking, and to facilitate real-time visibility into ownership and transaction history. These are interesting focus points for investors and funds alike.
All these advantages of DLT improve the efficiency and reduce the costs of intermediaries and back-office functions for fund structures. This, in turn, will enhance their competitiveness and the market position of fund hubs embracing this tech-offering. Moreover, the use of DLT for issuing and trading funds units also has the potential to improve the investor experience, by enhancing liquidity, accessibility, transparency and efficiency.
In other words, the DLT Pilot Regime creates a safe and secure environment for both investment funds and investors while fostering innovation and growth through the DLT ecosystem.
Looking towards the future
Tokenising fund units requires initial technical and operational resources, expertise, and coordination, as well as compliance with high standards of cybersecurity and interoperability. It involves the selection and implementation of suitable blockchain protocols, a token standard, and issuance platform, as well as the integration and alignment of the tokenisation process with the existing fund structure, governance and administration. Moreover, careful scrutiny from the regulatory and legal perspectives is needed including, for example, the fund interests distribution rules, the regulatory functions of relevant parties in the fund ecosystem (e.g. depositary, authorised independent auditor, and administrative agent), as well as any potential contractual restrictions (e.g. restriction on transfer of interests) imposed in fund documents.
Luxembourg law firms and tech-providers have developed interesting tokenisation solutions to assist issuers on such projects.
The DLT Pilot Regime is an opportunity not to be missed by the Luxembourg investment funds ecosystem.
[1] Regulation (EU) 2022/858 of the European Parliament and of the Council of 30 May 2022 on a pilot regime for market infrastructures based on distributed ledger technology, and amending Regulations (EU) No 600/2014 and (EU) No 909/2014 and Directive 2014/65/EU (Text with EEA relevance).
[2] These recent high-profile digital bond issuances include the following:
https://www.eib.org/en/press/all/2021-141-european-investment-bank-eib-issues-its-first-ever-digital-bond-on-a-public-blockchain
https://www.eib.org/en/press/all/2022-448-eib-innovates-further-with-project-venus-the-first-euro-denominated-digital-bond-on-a-private-blockchain
https://www.eib.org/en/press/all/2023-030-eib-issues-its-first-ever-digital-bond-in-british-pounds
https://www.santander.com/en/press-room/press-releases/santander-launches-the-first-end-to-end-blockchain-bond
https://www.abnamro.com/en/news/abn-amro-registers-first-digital-bond-on-public-blockchain
[3] Pursuant to Article 3(1)(c), eligible fund units are shares or units in UCITS, excluding structured UCITS, the market value of the assets under management of which is less than EUR500 million.
