EU tokenization trials: progress, or indecision?
There has been movement in the two key distributed ledger trial programs ongoing in the EU, so it’s time for an update.
If you’re interested in more detail on the differences between the two initiatives, I did a deep dive a few months ago. Below, I’ll briefly summarize the programs while updating on where they are.
ECB wholesale DLT trial wraps up
The ECB wholesale DLT trial was led by the European Central Bank, and aimed to test inter-bank settlement mechanisms for on-chain issuance of digital bonds. The trial kicked off in May and ended at the end of November.
According to the central bank, over 64 institutions, including central banks, commercial banks and clearing houses, participated in more than 40 issuances, largely of bonds and commercial paper. Most were actual bonds whose issuance and secondary trading was settled in fiat central bank money, with a connecting mechanism between the digital ledger and the payment network. Some issuances, cross-border FX trials and intra-day repo tests were settled with a mock wholesale CBDC.
The ECB will convene with participants in January to discuss next steps.
I’m not feeling particularly hopeful. We could see the ECB decide that, since connecting distributed ledgers to fiat payment rails worked fine, there’s no reason to go through the considerable upheaval and cost of launching an onchain version of central bank money. Preparations are underway for a digital euro, but with a retail user base in mind. And stablecoins won’t necessarily help, since official guidance is that central bank money should be used for interbank settlement.
Put differently, we could see the ECB curtail distributed ledger functionality by removing one of the main value propositions, that of having money and assets on the same ledger. True, blockchains can make issuance more efficient and save on initial costs – but without a change in securities regulation, many processes will need to be duplicated, reducing any cost benefit. This would most likely dampen issuer interest, which the ECB could use as evidence that no-one really cares about distributed ledgers.
Hopefully I’m wrong. The ECB was the first major economy central bank to undertake bloc-wide testing of tokenization rails and settlement mechanisms. It may decide to press ahead with the development of a wholesale central bank digital currency for settlement purposes, which would make tokenization and cross-border payments a whole lot more efficient. Although for now it seems convinced that the retail market really needs a CBDC (bewildering, but there you are).
Also, it’s tempting to think that the US gathering momentum on tokenization and most likely pulling ahead in both big-name experimentation and regulatory support would galvanize the EU into upping its commitment to developing new asset technologies, especially given the burning need for a unified capital market to harness liquidity and market size. But the EU unfortunately has a justified reputation for putting form over function, political grandstanding ahead of practicality, and anyway, it has some more existential issues likely to erupt next year.
EU DLT Pilot shows a glimmer of life
The other main EU distributed ledger trial, still ongoing, is the EU DLT Pilot Regime. This falls under the securities regulator ESMA, and involved the drafting and approval of a new albeit temporary legal framework that would suspend many of the arcane securities rules currently hampering tokenization experiments.
The aim is to allow a much wider range of experimentation than the ECB wholesale DLT trials. Participants will be able to test issuance and services for public as well as private blockchains, will be able to settle in stablecoins without registering with a central securities depository (CSD), and will be able to launch and operate on secondary markets without the restrictions limiting traditional market experimentation.
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I wrote not long ago that, 18 months after the trial kicked off back in March 2023, there were still zero authorized participants.
Thankfully, that has finally changed. Better late than never.
As far as I know, there are now two entities with the necessary approval to join the regulatory carve-out.
The two entities so far are the Czech central securities depository CSD Prague, which plans to test a distributed ledger settlement system based on R3’s Corda blockchain, with a view to opening up the range of entities that can directly participate.
The other is German startup 21x, which plans to launch an exchange and settlement system on Polygon next quarter. The Pilot Regime will allow it to register trades onchain, without going through a CSD.
Sure, two isn’t many, especially since blockchain advantages depend on a network of users. And there’s just over a year left in the program.
But there are apparently many applicants in the pipeline, crawling through the labyrinthine bureaucracy that are European approvals. And we have to hope that the trial period will be extended? If not, at this pace, there’s not much point to the whole thing.
There may not be much point, anyway, given the unreasonable restrictions on volumes (making it not worth the effort for large institutions) and the precariousness of the investment (firms are required to migrate any test services to traditional rails at the end of the trial period).
This is likely to limit participation to startups and smaller traditional institutions, which the EU could point to as evidence of a lack of interest in the potential.
Still, something is better than nothing, and even if the DLT Pilot Regime ends up being benched due to structural impediments, the learnings will serve to shape future trials and projects. Of course, meanwhile, the EU could well have lost what forward-looking advantage it may have had, as other jurisdictions take a more supportive approach to market innovation.
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(This is an excerpt from my Crypto is Macro Now newsletter, a ~daily publication where I look at the impact of crypto on the macro landscape. If you’re not a subscriber and you’re interested in seeing beyond the crypto impact noise, I hope you’ll consider becoming one!)