It has been five years since the UK Financial Conduct Authority pioneered the idea of a regulatory sandbox in the financial sector—a controlled space with relaxed rules, in which businesses can test and validate innovative products, services and business models with the support, and under the close supervision, of an authority for a limited period of time. Since then, many jurisdictions worldwide have enthusiastically copied the concept in multiple variations, depending on their respective needs and capabilities. However, supra-national institutions like the European Union have been reluctant to endorse the idea so far.
This may now be about to change though. In September 2020, the European Commission published a Digital Finance Package including a so-called DLT Pilot Regime, which is in effect a regulatory sandbox for certain providers of distributed ledger technology (DLT) and blockchain services. Following consultations with various stakeholders and national authorities, the Commission concluded that the use of DLT in finance was worth supporting, and that the application of the current regulatory framework to DLT-based business models poses a number of significant problems. With the establishment of a regulatory sandbox, it hopes to reconcile those two conflicting findings. For the complicated multi-level legal framework of the European Union, this proposal represents unchartered territory and is a landmark decision.
Ideas as to how a regulatory sandbox could work in the EU setting have long been debated. The discussion has revolved around the key issue of how national regulators may deviate from a regulatory framework that is overwhelmingly written on an EU level. However, several Member States have been creative in finding ways to effectively make use of the (little) leeway the EU framework offers or have simply put the focus of their respective sandbox on individual guidance for fintech startups. The idea of a pan-European sandbox however has mostly—for various reasons—been dismissed. Against that backdrop, the DLT Pilot Regime marks a turning point. In this post, we will shed some light on the details of this proposed sandbox, including its architecture, design and limitations.
The DLT Pilot Regime is a regulatory sandbox for DLT market infrastructures providing trading and settlement services for DLT-transferable securities. More specifically, it is open for market participants running ‘multilateral trading facilities’ or ‘securities settlement systems’ using DLT. Moreover, such actors have to be authorised as an investment firm or a market operator under Directive 2014/65/EU (MiFID II) or as a Central Securities Depository under Regulation 909/2014 (CSDR). If those requirements are met, the actor can apply for specific permission under the Pilot Regime, the consequence of which is the actor’s temporary exemption from certain rules. In order to be granted this permission, the applicant has to fulfil a number of special requirements under the Pilot Regime, which concern limitations on the securities, which are (going to be) traded on the market infrastructure (Art.3), as well as general requirements to avoid risks raised by the use of DLT (Art.6).
The applicant can request to be granted exemptions from certain rules that constitute an obstacle to their use of DLT. If all requirements are met, the national competent authority (NCA) can then—for a time period of up to six years—grant permission including the respective exemption(s). It can also impose additional requirements and safeguards to address novel types of risk, depending on the business plan of the applicant, as far as the NCA deems appropriate. The granted permission is valid for the whole EU market (‘passport’). In certain cases, the permission can be withdrawn (Art.7(6)), or—if either external conditions or the business plan of the applicant changes—adjusted.
With regard to the architecture, there are multiple points to consider. First, to give effect to the Pilot Regime, the Commission chose the instrument of a regulation, which means that the requirements and exemptions therein would be directly applicable in all EU Member States. While ensuring a harmonised framework for the sandbox, this would not provide for any flexibility to accommodate for the different situations of Member States, nor would it allow room for regulatory competition among jurisdictions for the best sandbox concept. Admittedly, making amendments to legislation at the EU level is, in the end, the only way to substantially create room for experimentation by enabling national regulators to permit genuinely individual exemptions. To make up for the lack of adaptability, the Pilot Regime could give more discretionary powers to national regulators. Instead, the Commission chose to set out a definitive list of possible exemptions in the DLT Regulation itself, leaving little scope for national authorities to experiment with any other exemptions. Adjusting those exemption powers in the future—be it for experimentation or responding to new market developments—will hence still require a change to the regulation itself, as it would be necessary to go through the regular EU lawmaking process.
Secondly, in executing the sandbox, the Commission mostly relies on the NCAs. However, a closer look might suggest that a large share of substantial decision-making power could yet be centralised at the EU level. According to the exemption procedure envisioned in the proposal, first a market infrastructure seeking a rule exemption should apply at the competent national authority, after which the Member State’s authority shall notify the European Securities and Markets Authority (ESMA) and provide it with all relevant information on the application (Art.7(3)). Within three months, ESMA provides the authority with a non-binding opinion, including a recommendation on each of the requested exemptions and on any additional safeguards it deems necessary. The same procedure applies when withdrawing or changing a permission (Art.7(6) and Art.9(3) respectively). That is—as explicitly stated in the proposal—to promote consistency in the application of the Regulation by Member States’ authorities. In the course of this process, ESMA would consult with other national authorities and take into account their views. This procedure, along with the aforementioned implications of choosing a regulation (including an exhaustive list of exemptions) suggests that the Commission envisions a strongly centralised version of a sandbox, with little leeway for national authorities (with the exception of the actual operation of the sandbox). Given the prominent role of ESMA in the decision-making process, it remains to be seen how ‘non-binding’ their opinion will in fact be and to what extent the NCAs will deviate from it. Arguably, the formally ‘soft’ nature of ESMA’s role can be attributed to constitutional obstacles in the EU (Meroni).
Thirdly, despite the relatively rigid sandbox framework, the Commission visibly placed value on establishing an institutionalised learning process involving all participants, namely the DLT market infrastructures, the NCAs, and ESMA. Apart from the comprehensive notification and consultation obligations between the NCAs and ESMA (as mentioned above), ESMA informs authorities on a regular basis of developments in sandboxes in other Member States, such as granted (or refused) permissions/exemptions or findings from the operation of the sandbox (Art.9(5)). The sandbox participants also closely cooperate with their competent authority and provide regular reports (including on difficulties in applying certain regulations), on which ESMA is to organise discussions (recital 39). The findings drawn from those experiences and discussions are ultimately supposed to inform a greater understanding of the impact of DLT and the (potential) need for changes in the regulatory framework. In this context, ESMA is thought to play a coordinating role, acting as the pivot point where information is aggregated and (again) distributed as well as serving as a place for communication between all actors involved. Gaining experience and knowledge about relevant technologies, including their risks and the fitness of the regulatory framework in responding thereto, makes this element one of the key features of the sandbox, the importance of which will become even greater in view of the accelerating change and increasing technologisation of the financial sector. However, the value of the mutual learning process would be even greater with a more experimentation-friendly concept of a sandbox, including wider (more discretionary) remit for national authorities and perhaps a broader scope in terms of potential participants (as for example proposed in our concept of a ‘Guided Sandbox’).
In sum, the DLT Pilot Regime proposal is a (big) step in the right direction, towards a more innovative way of lawmaking and a more dynamic regulatory framework. In an era of unprecedented pace of change, this is in fact an essential step, if regulation (and regulators) is to not become detached from market realities. However, looking at the Commission’s concrete proposal, the execution appears to be somewhat cautious. The sandbox would effectively only be open for incumbents (and not startups), would entail significant limitations for its participants and would lack flexibility when it comes to the ability to allow for any additional regulatory exemptions. This leaves the DLT sandbox proposal lacking both adaptability and dynamism, which will diminish the learning process, and hence falls short of exploiting the full potential of some of its key features. Nonetheless, an actual proposal being on the table in the first place represents a good first step and will hopefully inspire lawmaking in other areas.
Wolf-Georg Ringe is Professor of Law & Finance and Director of the Institute of Law and Economics at the University of Hamburg as well as a Visiting Professor at the University of Oxford.
Christopher Ruof is Research Associate at the University of Hamburg.