Regulators in the UK explain how the Digital Securities Sandbox will work

The Bank of England and the Financial Conduct Authority (“FCA”) have released – 3 April 2024 – a consultation paper on the Digital Securities Sandbox (the “DSS”).  The paper follows HM Treasury’s response to its consultation on the DSS published in November 2023.

The DSS as a new sandbox

The DSS aims to create a ‘sandbox’ so as to allow firms to apply new technologies, such as distributed ledger technology, to the issuance, trading, and settlement of securities such as shares and bonds.  The sandbox offers a modified regulatory framework to facilitate “innovation to promote a safe, sustainable and efficient financial system” while protecting financial stability and market integrity.   It is designed to last for a five-year period to help shape a permanent, technology-friendly securities market regime.

The modified regulations are created by the Financial Services and Markets Act 2023 (Digital Securities Sandbox) Regulations 2023, which came into force on 8 January 2024.  These are the regulations under which the DSS will operate.

The DSS will be jointly supervised by both regulators – the Bank of England and the FCA.

Eligibility

Firms applying will need to be:

• a UK established entity;
• intending to undertake trading and/or notary, settlement and maintenance activities;
• proposing to issue, trade, settle or maintain in-scope assets; and
• highlighting clear regulatory barriers or obstacles preventing the activity outside of the DSS.

A draft guidance document has been published for potential applicants (see Appendix A to the paper).

There is no obligation for firms to operate within the DSS.  But operating a central securities depository or a trading venue outside of the DSS will of course need to comply with existing regulatory requirements.

Application process

Firms will need to apply.  Those who are successful will be able to operate under the modified rules and regulations and undertake activities traditionally associated with central securities depositories (i.e., the issuance, maintenance and settlement of financial securities).  DSS applications will need to go through a series of ‘gates’ leading to evolving stages of permitted activities, and eventually – for those able to pass through all the gates – firms can “graduate from the DSS to a possible new regime if they meet the relevant standards”.

The paper says that firms, “should not assume that passing through gates is automatic as this will depend on their progress against applicable requirements and related supervisory engagement. Firms will need to provide evidence that they are meeting all relevant rules at each stage. Supervisory assessment against the requirements will be 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.”

Changes to the wider regulatory regime

As firms progress towards graduation from the DSS, the existing regime for the issuance, trading and settlement of securities will one day need to be assessed as regards amendments and modifications needing to be made in order to legislate for the resulting new technologies developed in the sandbox.

DSS fees

Section 7 of the paper sets out the fees that will be payable for firms wishing to apply.  There is a fee of £10,000 to go through gate 1 and enter the DSS.  Further fees (which are multiples of the entrance fee) are payable as firms go through the gates.

What can be issued and traded within the DSS

The consultation paper gives the following examples of what could be issued and traded in the sandbox:

• “equities;
• corporate and government bonds;
• money market instruments such as commercial paper and certificates of deposits;
• units in collective investment undertakings (fund units); and
• emissions allowances.”

The “trading and settlement of derivative contracts and of ‘unbacked cryptocurrencies’ such as Bitcoin” are specifically excluded.  Derivative contract settlement is also excluded (although “derivative contracts referring to DSS assets are permitted if settlement is outside the DSS”).

Engagement of third parties by firms in the sandbox

Third parties will be able to engage as normal with firms operating in the sandbox.  These could include companies looking to raise equity or debt finance and traders in securities.

Unless specifically excluded by regulation, all financial market participants will be able to use securities that may be issued from within the DSS.  Those securities could be used as collateral, for instance, or to write derivative contracts where settlement takes place outside of the DSS (and subject to applicable law and regulation in the ordinary way).

Nevertheless, the paper says that the Bank will impose limits on the value of the securities that can be issued from within the DSS.

Consultation period

The closing date for responses to the paper is 29 May 2024.  The Bank and the FCA will then review the responses and “the final guidance and rules will be published and the DSS will open for applications over the summer of 2024”.

Should you be wanting to participate in the consultation triggered by the publication of the paper, the questions raised by the Bank and the FCA are in section 8 of the paper.

This Insight piece was written by Henry Humphreys with input from the HLaw regulatory team.  If you have queries about the DSS and the associated regulations, do please get in touch with a member of the team.

All the thoughts and commentary that HLaw publishes on this website, including those set out above, are subject to the terms and conditions of use of this website.  None of the above constitutes legal advice and is not to be relied upon.  Much of the above will no doubt fall out of date and conflict with future law and practice one day.  None of the above should be relied upon.  Always seek your own independent professional advice.

Humphreys Law