The Bank of England and FCA have published a joint consultation paper on the UK Digital Securities Sandbox (DSS). The DSS is intended to support novel market infrastructure models that are not permitted under existing law or regulation. In January, the government empowered the regulators to run the DSS and apply modified rules within it. This paper now reveals how the sandbox is likely to operate and provides a short window for feedback. The deadline for responses is 29 May 2024.

Joint consultation paper

The Bank of England (BoE) and FCA have published a joint consultation paper outlining how they intend to operate the UK Digital Securities Sandbox. 

The DSS is the first FMI sandbox to be created by the Treasury pursuant to new powers under FSMA 2023. It is intended to support new models for trading and settling securities based on developing technologies (such as distributed ledger technologies) that would not be permitted outside the sandbox. 

The Treasury had already laid the foundations for the DSS in the DSS Regulations and accompanying Explanatory Memorandum, as outlined in our previous blogpost. The regulators’ consultation paper provides more insight into matters such as timing, process and rules, and provides a short opportunity for feedback.

Ten things we’ve learnt 

Listed below are ten new things we’ve learnt from the consultation paper. Some of these confirm what we already expected but others shed new light on the opportunities offered by the DSS.

1. Timing. The regulators plan to launch the DSS this Summer, after issuing a final report on the consultation, which closes on 29 May. They expect the first cohort of applicants to enter the DSS in Autumn (although they will have to clear a further hurdle to conduct live activity, as discussed below). The relatively short timeline may suggest that fundamental changes in approach are not anticipated at this stage. The regulators acknowledge that they are unlikely to anticipate all novel barriers and issues before the DSS opens and say they intend for the rules to evolve over the life of the DSS.
2. Eligible applicants. The consultation confirms that the regulators intend to allow unregulated entities to apply to the DSS. Applicants do still need to be established in the UK and obtain relevant authorisations or permissions before conducting live activity. For CSD activities (notary, maintenance or settlement), this means becoming designated as a DSD (Digital Securities Depository) under the DSS. For operation of a trading venue, this means obtaining an authorisation or exemption under the general regulatory framework. Firms already authorised may (or may not) require a variation of permission. Consortia can apply but only through a single UK entity.
3. Activities. Although the DSS Regulations allow for applications to operate a trading venue only (i.e. without also offering notary, maintenance or settlement services), the FCA says it does not anticipate that such applications would be accepted. This is because no particular barriers or obstacles to operating a digital securities trading venue have been presented to it, and because the current framework already accommodates non-systemic trading venues. The expectation is therefore that direct participants in the DSS will always be undertaking some form of CSD activities.
4. Stages. The proposals outline five stages for firms: (1) initial application; (2) testing; (3) go live; (4) scaling; and (5) operating outside the DSS under a new permanent regime. The five stages are separated by four “Gates”. 
   
   When firms enter stage 3, they will be subject to the Gate 2 rules in respect of their CSD activities. Among other things, these turn off certain requirements of the general CSD regulatory regime that are aimed at systemic financial market infrastructures. For example, the system will not need to be designated for settlement finality purposes, capital requirements will be less prescriptive and bank applicants will not need to segregate CSD activities in a separate legal entity. The quid pro quo is that they will be subject to highly restrictive limits (e.g. the volume of corporate bonds that may be recorded on a stage 3 DSD is capped at £900m). 
   
   In stage 4, individual limits will be eased while regulatory standards are tightened. No limits are proposed to apply in stage 5, but firms must be fully authorised and compliant under the permanent regime. 
   
   The aim of the staging and gating framework is to provide a “glidepath” to a successful exit on a permanent legislative footing.
5. Rules. The consultation paper includes two sets of draft modified rules for DSDs – Gate 2 rules (as referred to above) and “end-state” rules. A separate set of Gate 3 requirements is also contemplated, but these are yet to be developed. 
   
   The end-state rules reflect the current expectations for the permanent regime that will apply to successful DSDs. Like the Gate 2 rules, they are derived from the existing regulatory framework for CSDs and incorporate modifications to address known obstacles and barriers for digital structures. Notably, they allow for a single entity to operate a combined trading and settlement system. 
   
   It is anticipated that these rules may evolve to address learnings during the life of the DSS. The prospect of the Treasury developing a separate lighter touch regime for non-systemic DSDs is also contemplated, and may provide an alternative option for exiting DSDs.
   
   Operating a trading venue will be subject to the same rules that apply outside the DSS.
   
   While the DSS Regulations empower the regulators to tailor rules for specific business models, the regulators note that the bar for this will be high, and they cannot guarantee that any tailored modifications will flow through to a permanent regime.
6. Review points. The BoE plans to hold two “review points” during the life of the DSS. It currently expects the first to take place 15 – 18 months post-launch and the second, 30 – 40 months post-launch. During these windows, DSDs will be able to apply to increase their limits and progress to stage 4. To do so, they will need to demonstrate they can meet the more onerous Gate 3 requirements. Limiting the windows for progression to stage 4 is intended to help the BoE allocate capacity within the DSS in a fair and prudent way. 
7. Overall limit. Initially, the BoE intends to limit the scope of assets within the DSS to GBP-denominated assets only. It has proposed overall capacity limits on the volume of established, key sterling asset classes. These include gilts (£8 – 13.1bn), corporate bonds (£17 – 28bn), asset-backed securities (£8 – 16bn), short-term money market instruments (£4.4 – 8.8bn) and FTSE 350 equities (6% of outstanding shares of the issuer). It contemplates that other asset classes may also be traded or settled in the DSS and that any applicable limits will be considered with firms on a case-by-case basis. 
8. Settlement assets. The BoE expects that settlement within the DSS will be required to take place in GBP. It envisages that “commercial bank money with little or no credit or liquidity risk, or equivalent forms of private money” could be used for settlement, while e-money and stablecoins that are not subject to BoE supervision are unlikely to be accepted. In the future, settlement in central bank money may be required as more options become available.
9. Application process and fees. The BoE and FCA authorisation processes will operate in parallel. Firms seeking to operate combined trading and settlement platforms will be able to apply for admission to the DSS via a joint application form for a proposed fee of £10,000. To progress to stage 3, they will need to apply to the BoE for designation within the DSS and, where necessary, to the FCA for authorisation or variation of permission outside the DSS. The BoE has proposed a stage 3 application fee of £40,000 and annual supervision fee of £85,000. The FCA’s existing fee regime for operators of trading venues would continue to apply. 
10.  Exit. Although the consultation paper currently contemplates a single set of end-state rules, it is still envisaged that the Treasury could potentially make permanent changes more than once so as not to hold back fast movers. Once a permanent regime is in place, successful DSDs would need to apply for full authorisation under that regime. The regulators have reiterated that evidence gathered for the purpose of progressing to stage 4 could be used towards the process for acquiring full authorisation. Participants will need to demonstrate they are prepared for a wind down in case they are not able to graduate successfully. 

Feedback

The consultation paper invites feedback on 13 broad questions. These include questions as to the detail of the modified rules that will apply within the DSS and whether they are fit for purpose. This will most likely be the last opportunity to influence the framework in place at the outset of the DSS, although there may remain some opportunities to influence the rules from within. Stakeholders have until 29 May to respond.

View from the EU

Meanwhile in the EU, a letter from the chair of ESMA has revealed that, two years into the DLT Pilot Regime (the EU’s equivalent of the DSS), no DLT market infrastructure has yet been authorised and only four applications have formally been submitted. There may be a number of reasons for the limited uptake, including inflexible volume limits and a lack of a clear route to exiting the pilot onto a permanent legislative footing. These are issues that the UK authorities have sought to address in their approach to the DSS. The market response remains to be seen.