The Digital Securities Sandbox: a new model for trading and settlement in the UK?

On 3 April 2024, the Financial Conduct Authority (FCA) and the Bank of England (BoE) published a consultation paper setting out their proposals to implement and operate the new Digital Securities Sandbox (DSS). The DSS is the first sandbox for financial market infrastructures (FMIs) to be introduced by HM Treasury (HMT) using powers granted to it under the Financial Services and Markets Act 2023 (FSMA 2023). Participants in the DSS will be able to use new technologies such as distributed ledger technology (DLT) to issue, trade and settle securities, including both shares and bonds, subject to a modified regulatory regime for five years while a permanent regime is developed.

What is the rationale behind the DSS?

The current post-trade environment requires many manual steps to be taken over a period of time, involving multiple entities. This process is time-consuming and cumbersome, and it introduces elements of settlement and credit risk. New technologies such as DLT could streamline these processes and reduce the number of intermediaries, the systemic risks, and the costs involved, resulting in a system that is safer, cheaper, and more efficient. However, existing legislative requirements may prevent market participants from adopting these new technologies.

FSMA 2023 gave HMT the power to make provision for FMI sandboxes through statutory instruments. The DSS was introduced by HMT through the Financial Services and Markets Act 2023 (Digital Securities Sandbox) Regulations 2023 (DSS Regulations), which came into force on 8 January 2024. 

The DSS Regulations created the temporary framework for the BoE and FCA to implement and operate the sandbox within which FMI providers and market participants will participate. The purpose behind the DSS is to enable the government and regulators to test new technologies in a real-life scenario subject to a modified regulatory regime for a limited period of time, and then make changes on a permanent basis.

Among other things, the DSS Regulations made targeted modifications to the following UK legislation:

• the assimilated Central Securities Depositories Regulation (UK CSDR),
• the Financial Services and Markets Act 2000,
• the Uncertificated Securities Regulations 2001 (USRs), and
• the Companies Act 2006.

The DSS Regulations also gave the regulators the powers to:

• establish an application process,
• make arrangements for joint supervision of the DSS and oversight of participants,
• make, modify and disapply rules for DSS participants, and
• impose limits on overall activity in the DSS.

The consultation paper sets out in more detail how the regulators propose to exercise these powers and maintain the DSS. The document includes:

• an outline of the regulators’ proposed approach to the operation of the DSS, including the BoE’s rules and fee regime, and
• draft guidance for potential applicants.

What activities are permitted in the DSS? 

Sandbox entrants will be able to carry out the following activities incorporating the new technologies being tested:

• operating a trading venue (either a recognised investment exchange (RIE), a multilateral trading facility (MTF) or an organised trading facility (OTF)), and 
• the activities of a central securities depository (CSD), specifically settlement, maintenance and notary.

Activities ancillary to those permitted activities and other connected activities can also be subject to the sandbox arrangements.

The existing framework set out in the UK CSDR does not provide for the issuance and settlement of digital securities. HMT therefore temporarily modified the UK CSDR to allow the use of new technologies in the DSS. It also created a new category of firm—the Digital Securities Depository (DSD)—for purposes of the DSS.

The intention of the BoE and the FCA is that companies should be able to issue securities in the DSS, and market participants should be able to trade those securities, while benefitting from the new technologies. 

What assets can be issued, traded, and settled in the DSS?

The instruments in scope of the DSS are set out in Regulation 3(7) of the DSS Regulations. They are referred to as ‘FMI sandbox instruments’ in the DSS Regulations and as ‘digital securities’ in the BoE/FCA consultation paper. There is a wide range of assets which can be issued, traded, and settled in the DSS: 

• transferable securities (such as equities and corporate and government bonds),
• money-market instruments (such as commercial paper and certificates of deposits),
• units in collective investment undertakings, and
• emission allowances. 

Notably, neither derivatives nor unbacked crypto assets (such as BitCoin and Ether) have been included in the scope of the DSS. 

Unless otherwise specified by the regulators, market participants can use securities in the DSS for the same purposes as other securities, such as in securities financing transactions or as collateral. Although derivatives cannot be traded or settled in the DSS, market participants can write derivative contracts outside the sandbox based on securities in the DSS. 

What type of company can participate in the DSS?

Regulation 3(2) of the DSS Regulations sets out which FMI entities are eligible to participate in the DSS. These entities must be established in the UK and be one of the following: 

• an RIE that is not an overseas investment exchange,
• a recognised CSD, or
• an investment firm which has a Part 4A permission to operate an MTF or an OTF.

The BoE and the FCA also have the discretion to allow other entities established in the UK to apply to participate. They have indicated that the DSS will be open to existing financial institutions as well as new entrants, regardless of size, provided they are legal persons established in the UK and obtain the necessary authorisation or permissions before engaging in any regulated activity.

Given that entities must be established in the UK to be eligible, UK branches of foreign entities that would otherwise fit the eligibility criteria will not be eligible to apply. Groups and consortiums may apply, provided they operate the FMI through a single UK entity. 

As is the case outside the DSS, CSDs operating within the sandbox will be supervised by the BoE, and trading venues will be supervised by the FCA. Trading and CSD activities can also be combined into one hybrid entity, which will be jointly supervised by both regulators.   

As part of the application process, both the BoE and the FCA propose to require firms to identify any regulatory or legal barriers or obstacles that currently prevent them from operating their optimal business model outside the DSS because they are unable to use developing technology such as DLT. In its original consultation in July 2023, HMT noted that these barriers or obstacles were mostly likely to arise in the case of CSDs. The FCA considers it unlikely that firms only intending to operate a standalone trading venue (as opposed to a hybrid entity) will require any regulatory modification in order to operate and will therefore not be eligible to join the DSS. Therefore, trading venues will only be eligible to participate in the DSS as part of a hybrid entity, though financial instruments issued and settled in the DSS can be traded on trading venues outside the DSS.

How does an entity apply to participate in the DSS?

An eligible entity wishing to participate in the DSS must apply to the relevant regulator—either the BoE (in the case of CSDs) or the FCA (in the case of trading venues). The exact application requirements will depend on the regulator. 

If an application is successful, the applicant will be designated as a sandbox entrant. Each sandbox entrant will be provided with a sandbox approval notice (a SAN), which will set out the specific activities which the entity can carry out in the DSS. 

How will the DSS operate?

The key financial stability risk of the DSS is the potential for large-scale failures in the recording, trading, and settlement of securities, which could have a wider market impact. The BoE proposes to make the supervisory and regulatory requirements for DSDs proportionate to the financial stability risks they pose, given their scale and the technology they use. The requirements will therefore be lower when an entity first enters the DSS and will increase in proportion to the financial stability risks as firms scale. The BoE will impose temporary limits on a DSD’s activities in the early stages when the requirements are lower.

The BoE will also impose aggregate limits on the activities that DSDs can carry out within key sterling asset classes, as follows: 

The limits are expressed as ranges so that the BoE can manage limits for individual DSDs within the overall capacity and ensure that financial stability risks are contained as it learns more about the risks of the activities within the DSS. The BoE plans to limit the scope of the DSS to sterling-denominated assets only and for settlement to take place only in sterling, though it may review this restriction as the risks in the DSS become clearer.

The management of limits within the DSS will vary depending on the asset class and other characteristics of a security, such as tenor or credit rating. The BoE may consider imposing limits for other asset classes as well, to the extent necessary. 

The FCA does not propose to modify the regulatory framework for trading venues operating within the DSS. The FCA intends to manage any risks to market integrity by ensuring operators of trading venues inside the DSS meet the same standards as operators outside of it.

Stages of the DSS 

For DSDs, the lifecycle of the sandbox will be split into different stages of permitted activity, reflecting the BoE’s approach to managing financial stability risks. As sandbox entrants move from one stage to the next, the amount of permitted activity will increase, and the entity will also be subject to higher regulatory requirements. This glidepath will allow firms to scale up and eventually graduate to a permanent regime when they meet the relevant standards.  

A sandbox entrant wishing to be a DSD will first enter a testing stage, in which it can test its systems and engage with the regulators but cannot yet conduct live business. Once a sandbox entrant has demonstrated to the BoE that it meets the relevant requirements, it will become a DSD. At that point, it will be allowed to go live. 

Each DSD can choose which financial instrument it wants to trade and/or undertake notary, maintenance or settlement activities in. For key sterling asset classes, the DSD will be allocated a portion of the overall capacity of the DSS, known as its ‘go live limit.’ When the DSD demonstrates that it can meet higher regulatory requirements, it will be allowed access to higher limits.

In the final stage, the DSD will exit the sandbox and operate under a new, permanent regime. The BoE has drafted ‘end state’ rules that are broadly equivalent to the regulatory standards of the UK CSDR and the USRs. In due course, the regulators will work with HMT to determine whether it would be appropriate to introduce a separate regime for non-systemic DSDs.

How do the DSS and EU Pilot Regime compare?

The DSS is not the only regime looking to incorporate new technologies into the capital markets. In March 2023, the EU’s pilot regime for market infrastructures based on DLT (the EU Pilot Regime) was launched. Both regimes aim to test new technology in a controlled environment, however, the DSS is considered to have a wider scope. This is for three reasons: 

Given the broader scope of the DSS, it will be interesting to see whether it has a more successful start than the EU Pilot Regime. The EU Pilot Regime has had a low uptake to date, with only four official applications submitted over the past 12 months (though the European Securities and Markets Authority has estimated that eight more applications may be submitted during the course of 2024). 

Next steps

The deadline for responses to the BoE/FCA consultation paper is 29 May 2024. After a review period, the regulators will issue a formal response and publish final rules and guidance. The DSS is expected to open for applications in summer 2024.