The European Securities and Markets Authority (ESMA) is re-assessing some fundamental pillars of the DLT Pilot Regime. If adopted, this would be a strong indicator that the EU is moving toward a more flexible and welcoming regulatory environment for digital securities. Miles O’Connor, who understands how overdue this move is, states that the first framework has come under fire for its shortsightedness and alleged operational limitations. ESMA suggests turning back the clock on punitive, hard, restrictive thresholds and removing the sunset clause. This action demonstrates their commitment to promoting innovation and growth in the digital asset industry.

ESMA's Proposed Changes: A Closer Look

ESMA's suggested revisions address two critical areas: the restrictive thresholds currently in place and the six-year sunset clause that requires platforms to eventually cease operations. Critics claim that current thresholds like the €6 billion cap on platform issuance or the €500 million market cap for equity issuers are too strict. These limitations serve to limit the scalability of many otherwise DLT-based projects. Prompting hope, flexibilities are at the heart of ESMA’s current review. They take inspiration from the UK’s Digital Securities Sandbox which establishes higher limits for larger institutions while calibrating thresholds further based on their demonstrated experience.

Flexible Thresholds: A Path to Proportionality

Shifting to more flexible thresholds has a number of advantages. It allows for a proportionate approach to regulation. The regulations scale to the complexity and risk profile of the project. This helps foster innovation and the market testing of DLT, as companies are not limited by arbitrary boundaries. Moreover, it increases overall competitiveness by allowing market actors to function more efficiently. This, in turn, fosters the development of EU capital markets. Rather than the outright prohibitive thresholds in place today, flexible thresholds allow additional space for market participants to thrive and expand.

Removing the Sunset Clause: A Commitment to Permanence

ESMA’s proposal to remove the six-year sunset clause entirely is a welcome but incomplete step towards providing long-term certainty for DLT platforms. The sunset clause effectively means platforms have to close down their operations at the end of six years. This added layer of ambiguity adds disincentive to invest in an already risky industry. Retaining it, however, is a worrisome signal that the long-term success of digital securities is not their priority. Second, this action encourages platforms to create sustainable business models. On 5 May 2020, 23 EU Member States made an important move. These five (together with the Netherlands) signed a plurilateral treaty to terminate all close to 130 intra-EU bilateral investment treaties (intra-EU BITs) that were in force between them. The Termination Agreement is explicit that sunset clauses “shall have no legal effect” and “are terminated.” This would allow Nations to withdraw from an agreement without notice and in full.

Challenges and Considerations

ESMA’s proposed changes are certainly a step in the right direction. Yet, we should acknowledge the work that remains to be done in order to truly open the floodgates of digital securities in the EU.

  • Interoperability: Assets that reside on one network may not be compatible with other networks, making the transfer of those assets difficult to complete. Differences in zero-knowledge proofs (ZKPs), oracles, virtual machine standards, and contractual language can create challenges for interoperability.
  • Investor Protection: Ensuring adequate investor protection remains a key concern. The reliance on third-party vendors by institutional investors, the lack of harmonized regulatory and legal frameworks, and the need for interoperability solutions all pose potential risks to investors.

Addressing Interoperability

Interoperability will be a key component to achieving the widespread adoption of digital securities. Interoperability, or the ability to easily and quickly move assets across DLT networks, is key to establishing a liquid, efficient market. If interoperability is to be realized, we need to get past technical complexities. These range from incompatibilities in zero-knowledge proofs (ZKPs), oracles, virtual machine standards, and contractual language. Implied interoperability Mandatory interoperability, such as tokens on a public blockchain with many smart contract components. It’s due to the use of smart contracts that trigger when certain live events occur, which leads to the automatic minting of new tokens.

Ensuring Investor Protection

Simply put, investor protection should be the primary focus of any regulatory environment governing digital securities. This lack of clarity leads to divergently defined regulatory and legal frameworks creating uncertainty and potential risks across multiple jurisdictions, especially for investors. We will need clear, precise definitions of all of the key terms involved and risk mitigants. This clarity will determine how we can begin developing a transparent, disciplined, risk-focused, effective digital market infrastructure.

Expert Perspectives and the Path Forward

Not least, experts such as Robin Renwick would argue that ESMA’s suggested amendments could improve regulatory convergence across the EU. One important change would be to give ESMA a more proactive role in evaluating and approving DLT market infrastructures. Worries remain about slow uptake on the DLT Pilot Regime (DLTR). Short-term functional elements like cash settlement, interoperability, and custodial versus self-hosted wallet custody still prevent its day-to-day utility.

The European Commission's targeted consultation on the integration of EU capital markets, which includes a section on the DLTR and asset tokenization, suggests that more fundamental reforms may be considered. Some experts emphasize the importance of creating flexible, compliant standards for DLT, particularly in areas like privacy and environmental sustainability.

Ultimately, ESMA’s proposed changes are only the start — not the answer — to achieving a complete solution. Addressing the remaining challenges, such as interoperability and investor protection, is essential for creating a thriving and sustainable digital securities market in the EU. The move towards flexible thresholds is a testament to this administration’s willingness to embrace change and learn from experience. This flexibility is essential to maintain the cutting edge necessary for innovation and economic development in our dynamic new economy.