More than a year after Europe’s DLT Pilot Regime came into force in March 2023, not a single platform has been approved. The European Securities and Markets Authority (ESMA) recently revealed that four applications are pending. One of those is from Germany’s 21X, the only one of the quartet that has applied for a DLT trading and settlement systems (DLT TSS) license. If approved, this would allow it to both operate a secondary market (DLT MTF) and run the settlement systems (DLT SS).
“We were the first DLT TSS applicant in Europe. We do have a first mover advantage that we are hoping to realize,” 21X CEO Max Heinzle told Ledger Insights.
Traditionally there’s a strict separation between the exchange and the central securities depository (CSD). So the DLT Pilot Regime is relaxing this requirement for TSSs. Another traditional finance (TradFi) requirement is that exchanges can only deal with brokers and not retail users directly. The DLT Pilot Regime supports direct consumer access provided the operator offers consumer compensation and a couple of other restrictions.
Some of the big banks have raised concerns about the low transaction limits and restricted timeframe of the Regime. However, last week Commissioner Mairead McGuinness wrote to ESMA saying, “there is no expiration date for the DLT Pilot Regime.” New legislation would need to be passed to terminate the Regime, and the Commissioner said, “at this stage, no proposal to terminate the regime is envisaged.”
EU allows public blockchain DLT infrastructures
However, the activity limits are just fine for businesses that aim to deal with issuances for SMEs, such as 21X. Although the company is also expecting some of the world’s largest asset managers to list funds on 21X.
It plans to match, trade and settle on chain, using its own central limit order book (CLOB). Polygon is the chosen blockchain.
That’s one major difference between the DLT Pilot Regime and the UK’s Digital Securities Sandbox – the European initiative allows public blockchains. 21X also claims to have a solution to public blockchain frontrunning, otherwise known as Maximal Extractable Value (MEV). One could see that would appeal to regulators (more on that later).
21X was ahead of the curve, submitting the first iteration of its application just days after the enactment in March 2023. If you recall, ESMA only published some of the reporting requirements in October 2023. As a pioneer, this means that 21X and the regulators – Germany’s BaFin and Europe’s ESMA – had a bit of an iterative learning curve. For this process 21X was advised by law firm YPOG and KPMG Germany.
While there’s much talk today about real world asset tokenization of alternative assets, 21X is keeping it simple by supporting digital bonds and funds.
On chain DLT needs a settlement asset
Given that the entire process is on-chain, an obvious question is: What is used for settlement? 21X said it will use tokenized e-money from a licensed e-money institution. On the 21X website, Monerium is listed as a partner and the company ticks these boxes. However, 21X was reluctant to name the e-money launch partner, implying it may be someone else. We’d also speculate that several companies have applied for EU e-money licenses under MiCA. So it could be one of those new licensees given they are starting to be granted. For example, BCB Group received approval a couple of weeks ago.
One fun fact is that the Chairman of 21X, Alexander Höptner, is also the incoming CEO of AllUnity. That’s the stablecoin joint venture between Deutsche Bank’s DWS, Galaxy Digital and Flow Traders. However, AllUnity is only likely to launch its stablecoin in 2025, and it’s clear that 21X is hoping to launch this year, subject to regulatory approval. That makes the AllUnity stablecoin an unlikely launch candidate.
21X as an open platform for various service providers
While there might be a single launch stablecoin provider, 21X is planning to provide options on many fronts. “We have an open market infrastructure and also an open market approach,” said Heinzle. “So what we are looking for is to enable tokenization service providers.”
When you start thinking about the scope of service providers and other partners, there’s a wide variety. So there are buy-side and sell-side users, listing agents, brokerage platforms, tokenization platforms, fund administration firms and custodians. Plus, in Germany there are crypto registries under the local eWpG laws, which has similar legal waivers to the DLT Pilot Regime.
The registries are low hanging fruit, with a reasonable number of issuances in Germany waiting for a secondary market. On Friday the Cashlink registry said it would partner with another DLT Pilot Regime candidate, FINEXITY, although FINEXITY has yet to submit its license application.
On the custody side, given these are digital versions of traditional assets, there’s a good chance future custodian partners might be banks. However, the platform will also support self custody.
21X says it has already signed several memorandums of understanding (MoUs) and letters of intent (LoIs), including with some heavyweight players. However, it won’t name names until its license is in place, other than IDnow, which will help with customer identification for the onboarding process.
The German company 21X is a subsidiary of Liechtenstein-based 21.finance AG, which has pivoted since its founding. In 2018 Bank Frick took a 25.1% stake and the following year it started tokenizing traditional securities as security tokens. It distributed the tokens in Germany, Austria, Switzerland and Liechtenstein. Subsequently, it evolved into a SaaS tokenization solution before focusing on developing a DLT TSS. To date it has raised €10 million just for the DLT TSS and is about to embark on another funding round.
How 21X addresses frontrunning
Circling back to Europe’s support of public blockchains, before the Ethereum Merge in September 2022, MEV or frontrunning resulted in losses of around $675 million for Ethereum users. Post Merge, one set of research pegs the losses at $1.4 billion (at current ETH prices), and another reckons it was $350 million in 2023.
With regulators already wary about public blockchains because of a lack of control, MEV doesn’t help.
However, around 90% of Ethereum validators use MEV systems, compared to only around 1% of Polygon’s, according to 21X.
While there are numerous ways to thwart frontrunning, the most effective one involves permissions, as found in most regulated infrastructures.
Frontrunning through MEV is more prevalent on DeFi automated market makers (AMMs) where there’s an open formula for pricing trades. In contrast, 21X has a central limit order book (CLOB). Rather than using existing attack programs, different code would be required. That’s because an attacker needs to consider the open orders instead of using the AMM’s formula.
Nonetheless, the orders are in a public memory pool so they are exposed to attackers. Tactics such as tight slippage settings or high gas usage help to make it less attractive for frontrunners.
However, the most effective tool is to use participant allow listing. The combination of known exchange participants and market surveillance means offenders will be banned from the exchange. In fact, a regulator could order 21X or the issuer to seize the frontrunner’s on-exchange assets.
While there are existing DLT secondary markets such as Switzerland’s SDX, 21X could be the first to launch a combined regulated exchange and settlement solution on-chain. With the launch of each new trading venue, the future becomes clearer.
Jeffrey Hartjes, the 21X project manager for the DLT Pilot Regime application, commented, “Everyone knows how traditional finance works. Not many know or have a vision of how (the) DLT financial markets of tomorrow work.”
