A guide to the regulators’ joint consultation on implementing and operating the Digital Securities Sandbox

On 3 April 2024, the Financial Conduct Authority (“FCA”) and Bank of England (“BoE”) published CP24/5, a joint consultation paper (“Consultation Paper”) on a suggested approach to implementing and operating the Digital Securities Sandbox (“DSS”).

The DSS offers firms the opportunity to test and innovate with new technologies like distributed ledger technology (“DLT”) in relation to certain financial services activities, such as issuing, trading, and settling securities. Firms approved to participate in the DSS can operate under a tailored framework of rules and regulations designed to enable these processes. The DSS initiative is slated to span five years and has the potential to pave the way for a revamped, permanent regulatory framework for securities trading and settlement.

The consultation closes to responses on 29 May 2024, after which the regulators will review the feedback and issue a formal response, followed by final guidance and rules. Firms will be allowed to apply for participation in the DSS over the summer of 2024. The Consultation Paper acknowledged the relatively short period of time for firms to respond, noting that it underscored the temporary nature of the DSS rules and the potential for amendments to those rules throughout the DSS’s lifetime.

What is the background to the DSS?

The DSS was established to explore using new and innovative technologies in the financial services industry, including the potential of utilising technology like DLT and the potential benefits in market efficiency, transparency, and resilience which could ultimately generate substantial cost savings for market participants. The DSS will facilitate the testing of how UK legislation needs to change to accommodate digital asset technology and the new practices associated with it by allowing firms to experiment in a “safe regulatory environment” under temporarily modified legislation. This endeavour aligns with the FCA’s objective of maintaining and strengthening the UK's prominent status as a dynamic global financial hub.

The government first consulted on the DSS in July 2023, and confirmed its final approach to implementing the DSS in November 2023. On 18 December 2023, The Financial Services and Markets Act 2023 (Digital Securities Sandbox) Regulations 2023 was laid before Parliament, which is the statutory instrument setting up the DSS. This Consultation Paper follows these developments.

What are the potential models in the DSS?

The DSS Regulations allow for three possible business models:

1. Digital Securities Depository (“DSD”): 
   
   A firm that intends to undertake central securities depository (“CSD”) related activities in the DSS would do so as a “DSD”. CSDs are systemically important entities that centralise and manage settlement risk across major financial markets, and are thus subject to comprehensive regulation and supervision. The current authorisation process for firms wishing to engage in CSD activities is complex and may pose difficulties for new entrants, especially considering that existing regulations assume the use of traditional ledger systems, which may not align with emerging technologies like DLT. DSDs will be regulated by the BoE.
   
   The BoE approach to the DSS aims to tackle these obstacles by adjusting the regulatory requirements for DSDs to be proportionate to the risks they pose to financial stability, taking into account their scale and the technology they employ. Initially, some requirements will be less stringent but will gradually increase as firms’ activities expand. To safeguard financial stability during this transitional period, temporary limits on activity within the DSS will also be imposed. 
    
2. Operating a trading venue: 
    
   The regulatory framework for trading venue operations remains unaltered within the context of the DSS, and trading venue operators within the DSS will be regulated by the FCA.
   
   As highlighted in HM Treasury's consultation response, industry feedback indicated little need for specific alterations to the UK Markets in Financial Instruments Regulation (“MiFIR”) or the broader framework governing trading venue operations. The issues raised were not deemed to present significant barriers unique to the adoption of emerging technologies in trading venue operations.  If a firm believes modified regulations are necessary for its optimal business model, the FCA will assess such applications on an individual basis. By maintaining the existing framework, the FCA aims to facilitate seamless interaction between DSS activities and the broader financial services ecosystem.
    
3. Hybrid entity:
   
   The regime allows for firms to apply as a “hybrid entity”, which combines the activities of both of the above business models into one entity. Where a firm operates as a hybrid entity, it will be regulated by the FCA for its trading venue activities, and by the BoE for its DSD activities. 

What outcomes are the regulators intending to achieve?

The regulators have three overarching aims for the DSS in line with their statutory objectives. These are:

1. Facilitating innovation to promote a safe, sustainable and efficient financial system, by removing potential barriers and obstacles for firms undertaking the activities of a CSD and operating a trading venue.
2. Protecting financial stability, by exploring potential risks to financial stability from the developing technology or modified framework, and how to mitigate them.
3. Protecting market integrity and cleanliness, by understanding potential frictions and issues with integration.

The proposed key design features of the DSS are geared towards flexibility, financial stability, and a smooth transition for participants. Activities within the DSS will resemble those in traditional financial markets, but with an experimental focus. While regulators aim to create a permanent framework based on DSS findings, there is no assurance of participants success outside the sandbox and so it is important for those engaging with DSS participants to be aware of its temporary nature.

What are the regulators’ proposals?

The proposals set out in the Consultation Paper comprise the regulators’ joint approach to:

• The implementation and operation of the DSS.
• The application process to enter the DSS.
• The use of rule-making powers.
• The approach to managing financial stability and market integrity risks in the DSS.
• Supervision and enforcement.

The proposals also include the BoE’s approach to levying fees and managing the limits on activity within the DSS, which we describe in further detail below.

What are the stages of the DSS?

The DSS has various levels of permitted activities, which align with the BoE's strategy for mitigating risks to financial stability. Sandbox participants will encounter a series of "gates" delineating different stages of progression, with the scope of permitted activities expanding at each stage. This structured approach, or “glidepath”, will facilitate the transition of sandbox participants from the DSS to a potential new settlement framework, which will be contingent on meeting requisite standards.

For firms intending to operate as a DSD or a hybrid entity, each stage will entail heightened regulatory requirements in relation to that firm’s DSD activities. Sandbox DSD entities will undergo assessments carried out by the BoE, before the firm will be allowed to “advance” to the next gate and carry on further activities. The criteria for assessment at each “gate” have been set out in Appendix C to the Consultation Paper.

These assessments at each gate are proportionate to the size and risk of the business and may depend on the technology being used and the proposed business models. Regulatory requirements will grow as firms scale. Following a successful supervisory assessment against Gate 2 or Gate 3 rules (as explained in more detail in the table below), those rules will continue to apply until the firm is ready to progress to the next stage, including seeking authorisation under a possible new permanent regime.

With regards to fees, the regulators have proposed a “Pay As You Go” approach to the DSS, which increases in line with the increased risk to financial stability and corresponding supervisory risk at each stage. Most of the proposed fees in the Consultation Paper relate solely to firms intending to be DSDs, as in general, FCA fees to operate a trading venue are not subject to any amendments as part of this consultation process. In practice, this means that while the FCA will not charge a fee for applications to enter the DSS for entrants seeking authorisation to operate a trading venue in the DSS, specifically a multilateral trading facility (“MTF”) or organised trading facility (“OTF”), the current FCA application fees will apply. Firms which are already authorised to carry on regulated activities and which will require a variation of permission to operate an MTF or OTF in the DSS will need to pay the usual lower variation fee of £25,000. We have set these fees out below.

(See table online here)

What will the end state rules look like?

The BoE has outlined its draft DSS rules in Appendix B of the Consultation Paper, including the rules applying to DSDs after Gate 2, and the ‘end state’ rules which are the BoE’s default of what it expects future requirements to look like. With these rules, the BoE intends to highlight the regulatory standards DSDs must meet if they want to operate under a possible new regime. Some end state rules will apply in full, others will be replaced with more proportionate rules, with some disapplied and not replaced in any form.

The BoE has drafted these rules in line with regulatory standards akin to those in the Central Securities Depositories Regulation (“CSDR”) and The Uncertificated Securities Regulations 2001 (“USRs”) with provisions that do not easily facilitate developing technology being adapted to do so. The BoE aims to reintroduce the criteria imposed on firms within its final regulations, concurrently eliminating recognised regulatory obstacles to innovation and implementing certain significant adjustments, all while maintaining the integrity of those regulatory standards.

When a firm passes Gate 1, becoming a sandbox entrant, it will be issued a Sandbox Approval Notice (“SAN”) by the appropriate regulator. A SAN will act as a “visa” for firms in the DSS and will outline the extent of the firm’s approval to participate in the DSS and further confirm: (i) which rules apply to DSDs at that time; and (ii) any modifications or waivers granted by the BoE.

While the regulators have acknowledged it will be difficult to foresee all regulatory barriers, issues and risks posed by such technology, the FCA and BoE believe that such uncertainty will be mitigated by the BoE’s ability to evolve and amend the rules over the life of the DSS. Notably, the rules at Gate 2 and Gate 3 will be less burdensome than the rules effective at a later stage, reflecting the lower levels of risk to financial stability.

In relation to trading venues, the FCA is not consulting on its approach under a new regime, stating that the existing regime does not require any changes at this time. 

Other specific proposals

Capital requirements for DSDs

DSDs will need to adhere to the BoE's DSS rules concerning capital requirements. While the final form aligns with existing requirements for CSDs under CSDR, it will be less prescriptive at Gate 2, allowing DSDs to employ their methodologies for calculating required capital.

DSDs will have to ensure this capital adequately covers risks from DSS activities both in operation and during wind-down. The BoE suggests a minimum capital threshold at Gate 2, which will require a DSD to hold the higher of a) the amount of resources needed to cover all its going concern risks and the cost of wind down or b) nine months' operating expenses for DSS activities.

A DSD subject to FCA or PRA capital requirements resulting from other regulated activity will need to meet these requirements as well as those under the DSS.

Scope of financial instruments

With the notable exception of derivatives, all financial instrument types listed in the Regulated Activities Order (“RAO”) are in scope of the DSS, including:

• Transferable securities such as equities and bonds.
• Money market instruments.
• Units in collective investment undertakings.
• Emissions allowances.

Assets beyond the scope of the RAO, like unbacked cryptoassets such as Bitcoin, are excluded from the DSS. Firms wanting to settle such assets will need to arrange to do so outside the legal entity associated with the DSD. Further, prospective participants in the DSS, should be aware of Article 3 of CSDR and its requirement for transferable securities traded on a trading venue or in financial collateral arrangements to be recorded in a book-entry form at a central depository. In the case of digital securities issued using technologies like DLT, this central depository would be a DSD in the DSS. Both issuers and potential DSDs should assess if their digital securities fall under this requirement.

While digital securities in the DSS can be utilised in various financial market activities such as securities financing transactions or collateral, adherence to market best practices and established legal frameworks is crucial. Regulators may impose restrictions on these uses if concerns about financial stability arise.

Aggregate limits

The BoE is proposing implementing capacity limits for major sterling asset classes. While trading and settlement for additional asset classes will be permitted in the DSS, setting limits for these activities will necessitate further dialogue with firms regarding their proposals and potential implications for financial stability.

Table C in the Consultation Paper outlines overall capacity limits of the DSS. For financial instruments in scope of the DSS regulations but for which a limit is not specified in Table C, the BoE reserves the right to assess the specific use cases and the potential impact on financial stability, and to set limits as required.

Methodology for setting DSS capacity

The aggregate limits in Table C are based on the BoE’s tolerance for settlement failures and outages within the DSS. Given the utilisation of new and untested technologies, the probability of such failures may be higher compared to established financial infrastructure. These failures can undermine confidence, reduce market participation, and disrupt wider market functioning, impacting financial stability.

The BoE's tolerance is calibrated to ensure that severe disruptions in the DSS will not materially affect traditional financial markets, even when combined with typical day-to-day disruptions. 

Regulators believe that limiting the stock of outstanding securities in the DSS is the most effective approach to mitigate financial stability risks. This approach will avoid restricting trading volumes, which could hinder market liquidity and functioning. Additionally, it will allow DSDs to reuse limits when financial instruments mature.

Comment

If you or your firm would like further guidance on the Consultation Paper, the DSS, or digital securities generally, please speak to one of our experts.

Article co-authored by Anna Burdzy, Trainee Solicitor at CMS