UK: Digital Securities Sandbox for financial market infrastructures | Hogan Lovells
What is the rationale behind the Digital Securities Sandbox?
The government touches on the rationale for the Digital Securities Sandbox (DSS) in the Explanatory Memorandum to the Financial Services and Markets Act 2023 (Digital Securities Sandbox) Regulations 2023 (Regulations) creating the DSS, the first Financial Market Infrastructure (FMI) sandbox. Due to the essential services provided and the important role played by FMIs in financial markets, and the ramifications their failure could have on the financial system, FMIs are highly regulated entities in the UK. At the same time, FMIs need to be innovative and to integrate new technologies into their systems and procedures so as to reduce costs, improve performance, and increase effective competition. An example of such developing technologies is the use of distributed ledger technology (DLT) in relation to the digitalisation of financial assets to improve efficiency, resilience and transparency.
In order to enable the adoption of new technologies in connection with FMIs in a manner which is consistent with overall market functioning and stability, HM Treasury conducted a Call for Evidence in 2021 to assess (among other topics) the application of DLT to FMIs. A key issue which was identified in the responses was that the UK legislative framework applicable to FMIs would need to be modified to support the use of these technologies. For example, it was identified that the requirement under the UK Central Securities Depositories Regulation (Regulation (EU) No 909/2014) (the CSDR) for transactions in transferable securities to be settled in book entry form at a Central Securities Depository (CSD) may not be compatible with the use of DLT in the settlement of digital securities Following the launch of a Regulatory Sandbox by the FCA in 2016 and various other legislative developments and reform measures, such as the Edinburgh Reforms which set out the government’s intention to implement the first FMI sandbox in 2023, the government published a consultation for the DSS in July 2023.
Section 13 of the Financial Services and Markets Act 2023 (FSMA 2023) confers a power on HM Treasury to make provision for testing of FMI activities and assessing whether or how relevant legislation should apply in relation to such activities carried out with the use of developing technology. The Regulations were laid before Parliament by HM Treasury on 18 December 2023 following the publication of the consultation response alongside the Autumn Statement in November 2023. The Regulations enter into force on 8 January 2024.
What are the key objectives of the Digital Securities Sandbox Regulations?
The Regulations create the DSS, the first FMI sandbox created by HM Treasury in exercise of its powers under section 13 of FSMA 2023. The DSS enables firms and regulators to test the deployment of developing technologies, such as DLT or technology that facilitates “digital assets” across financial markets.
The Regulations provide for the application, modification and disapplication of existing UK legislation in order to facilitate the live testing of new FMI models and practices with developing technologies (technologies that would otherwise not be permitted or would be substantially more difficult to implement under the existing legal and regulatory framework). The legislative provisions subject to modification under the DSS are set out in a Schedule to the Regulations, referred to as the “FMI sandbox arrangements” and represent an exhaustive list of legislation which will be disapplied or modified for the DSS. The legislation listed includes the UK CSDR (set out in Part 2 of the Schedule), the Financial Services and Markets Act 2000 (set out in Part 3 of the Schedule), the Companies Act 2006 (set out in Part 4 of the Schedule) and the Uncertificated Securities Regulations 2001 (set out in Part 5 of the Schedule). Where modified legislation does not apply, it will be possible to perform non-DSS activities in relation to DSS entities and assets (for example clearing, custody and payments). All other legislation will continue to apply to participants in the DSS in its unmodified form.
The Regulations also create the framework within which the Financial Conduct Authority (FCA) and the Bank of England (BoE) will operate the DSS. The FCA and the BoE will be able to make rules in relation to firms successfully applying to the DSS as “Sandbox Entrants” and other participating entities, or to waive, modify or apply rules when otherwise they would not apply, where appropriate.
What activities and instruments are within scope of the Digital Securities Sandbox?
There are four main activities which fall within the scope of the FMI sandbox arrangements and which may therefore be carried out subject to applied, modified or disapplied legislation in the DSS:
- the first three are the activities of a central securities depository (CSD) and the DSS arrangements must relate to one or more of the following activities: notary (the initial recording of a security in a securities settlement system), settlement (the operation of a securities settlement system), and maintenance (providing and maintaining securities accounts at the top tier level); and
- the fourth is operating a trading venue, specifically a multilateral trading facility (MTF), an organised trading facility (OTF), or a Recognised Investment Exchange (RIE).
The DSS will also allow CSD activities and the operating of a trading venue to be performed within a single entity (existing legislation requires these to be kept separate i.e. to be performed by separate legal entities).
The assets in scope of the DSS include digital representations of certain financial instruments set out in paragraphs 1-3 and 11 of Part 1 of Schedule 2 to the Financial Services and Markets Act 2000 (Regulated Activities Order) 2001 (RAO), which include, for example, debt and equity transferable securities, money market instruments, units in collective investment undertakings, and emission allowances (FMI sandbox instruments). Derivative instruments (as defined by paragraphs 4-10 of Part 1 of Schedule 2 to the RAO) are specifically out of scope.
The regulators may put in place limits on the overall activity conducted in the DSS, and on activity conducted by individual Sandbox Entrants. These limits will be set to minimise any impact on wider financial stability from the failure of a Sandbox Entrant. Firm-specific limits will be managed via the Sandbox Approval Notice (SAN) issued to each Sandbox Entrant, which will set out the conditions under which DSS activities can take place. The Explanatory Memorandum notes that the “SAN will act as a “visa” detailing the permitted activities being performed and the restrictions in place, including what limits have been allocated to that entity.” In addition, HM Treasury may direct regulators to put in place further restrictions within the DSS overall.
A key principle of the DSS will be that digital securities issued/traded/settled via a Sandbox Entrant are the same as their traditional equivalents, such as bonds, equities, and fund units. This means that, aside from where particular modifications to legislation are made as part of the DSS, they should accordingly be treated in the same way as their traditional equivalents from a legal and regulatory perspective. This facilitates the principle that these instruments are capable of being utilised across markets, for example as collateral or as part of repo transactions, where this can be done in compliance with existing laws and regulations.
In-scope FMI participants of the Digital Securities Sandbox
Certain FMI entities established in the UK will be eligible to apply to participate in the DSS as Sandbox Entrants. These entities are:
an RIE that is not an overseas investment exchange;
a recognised CSD;
an investment firm with Part 4A permission to operate an MTF under Article 25D of the RAO;
an investment firm or an investment exchange with Part 4A permission to operate an OTF under Article 25DA of the RAO; and
other firms established in the UK which are permitted to participate by the regulators.
The DSS framework will apply to Sandbox Entrants in the DSS, and to entities which conduct activities in connection with the activities of the Sandbox Entrant. For example, a person outside of the DSS who decides to transact in securities traded on a platform operated by a Sandbox Entrant as a “user” of that platform would also fall within the scope of the DSS framework. Other in-scope entities include entities that provide services to, or receive services from, a Sandbox Entrant, or in relation to an FMI sandbox instrument.
It is a specific requirement that Sandbox Entrants must be established in the UK. This means that an overseas investment firm which operates a trading venue would not be eligible to apply to become a Sandbox Entrant, unless it establishes a UK legal entity to do the same. However, the Regulations do not contain any specific limitation on an overseas firm from engaging with a Sandbox Entrant, thus an overseas firm could still use a platform operated by a Sandbox Entrant, or provide to, or receive services from, a Sandbox Entrant.
Firms will be able to carry out DSS activities in line with disapplied or modified legislation specified in the Regulations, and will be able to continue to perform non-DSS activities in relation to entities and assets covered under the DSS framework, provided that they comply with existing legislative and regulatory obligations. Additionally, firms will be required to comply with all existing legislation which is not disapplied or modified by the Regulations, and will be given equal treatment as their traditional equivalents under such legislation.
How to apply to the Digital Securities Sandbox
A firm which is eligible to participate in the DSS as a Sandbox Entrant or one which is permitted to participate in the DSS by the relevant regulator may apply to the FCA or the BoE for approval to participate. If the application is successful, the firm will then be designated as a Sandbox Entrant. However, in order to carry out CSD activities in the DSS, the firm will need to be designated as a “Digital Securities Depository” (DSD). It will also be a precondition for a Sandbox Entrant which seeks to operate a trading venue in the DSS to have full authorisation to operate an MTF or an OTF, or to be exempt as an RIE.
The relevant regulator will specify the manner in which applications to participate in the DSS must be made. It is anticipated that firms will need to provide information including the activities proposed to be carried out in the DSS, FMI sandbox instruments to be used on the applicant’s platform when carrying out these activities, and details of existing legislative barriers to using developing technology if the activities proposed to be carried out inside the DSS are carried out in accordance with existing legislation. The relevant regulator will then either (i) approve the application; (ii) approve the application subject to variations or conditions; or (iii) reject the application.
Next steps for the Digital Securities Sandbox
The DSS will last up to five years from the date the Regulations are made and will expire on 8 January 2029, subject to any extensions by HM Treasury who are empowered to extend the DSS if required. HM Treasury must report to Parliament on the operation of the DSS and determine how UK legislation should be permanently amended to accommodate developing technology. Participants will then be able to exit the DSS either by continuing to operate under a permanently amended legislative framework, or by winding down their activities in the DSS. Sandbox Entrants which demonstrate their ability to carry out DSS activities in a manner which is consistent with regulatory outcomes will be eligible to apply to continue carrying out these activities under a new regime created from the amended DSS framework.
The government’s aim is to permanently adopt into legislation any application, disapplication or modification which was implemented in the DSS. The overall objective is to achieve an end result which addresses the concerns raised in the response to HM Treasury’s 2021 Call for Evidence, that is, to avoid and remedy any existing legislative gaps which would otherwise be disruptive and costly for DSS participants to comply with when using developing technology.
The operation of the DSS will be managed primarily by the FCA and the BoE, with HM Treasury maintaining close involvement. The FCA and the BoE will issue guidance in due course on the operation of the DSS, and on the exact application timeline. In the meantime, firms which are interested in applying to become Sandbox Entrants should contact the relevant regulators, ahead of the application window opening later in 2024.
Looking further ahead – The UK Digitisation Taskforce
Separately from the DSS, there are other initiatives underway with the ultimate goal of removing or reducing frictions in the current legislative framework that inhibit the adoption of new technologies in the capital markets. The UK’s Digitisation Taskforce was established in 2022 with the aim of driving forward the full digitisation of the UK shareholding framework by eliminating the use of paper share certificates. In July 2023, the Digitisation Taskforce published an Interim Report, which sets out a number of recommendations, including:
the bringing forward of legislation to stop the issuance of new paper share certificates;
the introduction of legislation to require the dematerialisation of all share certificates at a future date;
a requirement for intermediaries participating in clearance and settlement systems and offering shareholder services to use common technology for responding to ultimate beneficial owner requests; and
following the digitisation of shareholdings, the discontinuance of cheque payments and a requirement for dividend payments to be made directly to the bank accounts of ultimate beneficial owners.
The final report of the Digitisation Taskforce (including practical steps for implementing proposals and timescales for implementation) is expected early this year.