UK Digital Securities Sandbox Opens its Doors

Applications are now being accepted for the UK's Digital Securities Sandbox (DSS). Firms established in the UK can leverage the DSS to create new financial market infrastructures (FMIs) for digital securities.

The DSS is a regulatory space for firms to develop and implement new business models leveraging distributed ledger technology (DLT). It confers powers on HM Treasury, the Bank of England and the Financial Conduct Authority (FCA) to disapply or amend certain rules that conflict with the use of DLT and similar technology.

At the core of the project is the possibility to use DLT for the trading and settlement of securities, including shares and bonds; potentially, within a single FMI. DLT systems are networked databases with functionality that is not found in traditional environments. Each system is different, but common features include peer-to-peer hosting, the use of cryptographic techniques to record transactions, and the ability to execute short computer programs known as "smart contracts." The application of these to the holding of, and transactions in, digital securities can simplify procedures, enhance security, and deliver greater transparency, compared to existing arrangements.

Digital Securities Depository

In traditional finance, central securities depositories (CSDs) perform three main functions:

• They keep the master records of securities issuances.
• They keep books to reflect the allocations of those securities in and between the accounts of different investors (directly or through intermediaries).
• When investors agree to transfer parts of their holdings to each other, CSDs amend their books to show the changed positions and transfer cash from any sale.

In the language of the EU Central Securities Depositories Regulation, which is the basis of the corresponding UK legislation, these are called:

• The notary function.
• The maintenance function.
• The settlement function.

The DSS invites firms to perform any of these three functions, using DLT or similar technology, as a Digital Securities Depository (DSD). Applicants to the DSS must specify at least one of them as part of their business plan. Approval to operate as a DSD must be obtained from the Bank of England, as the regulator of CSDs in the UK.

Recognising that settlement in central bank money will not always be practical, the Bank intends to permit the use of commercial bank money with little or no credit or liquidity risk, as well as "equivalent, regulated, private forms of money." That may include tokenised commercial bank money, but it is not expected that stablecoins or e-money will be allowed. Participants with permissions to accept deposits under Part 4A of FSMA will be able to use their own account arrangements. The Bank has signalled that it will expect central bank money to be used in due course, as its Real Time Gross Settlement facility evolves to deal with new structures.

Multilateral Trading Facility

It is also possible to operate a venue for the trading of digital securities under the DSS. The multilateral trading facility (MTF) is an existing form of organised trading with nondiscretionary execution. The DSS permits the combination of DSD and MTF functionality as a "hybrid entity," making use of DLT to facilitate trading and settlement in the same FMI.

Authorisation to operate an MTF must be obtained from the FCA. The conditions for operating an MTF under the DSS are consistent with the existing requirement; but, in practice, "hybrid entities" will need to segregate MTFs in the DSS from other trading venues.

Eligibility

The DSS is open to firms already regulated as UK-established recognised investment exchanges (but not overseas investment exchanges), recognised CSDs, and investment firms holding a Part 4A permission to operate an MTF or an organised trading facility (OTF). New entrants may also apply, provided that they are established in the UK. The latter will need to obtain authorisation from the Bank of England to operate as a DSD and, where they intended to operate an MTF, from the FCA before proceeding through the DSS.

The DSS is open to a range of business models, provided that the following conditions are met:

1. There is a DSD component. Stand-alone MTFs are not expected to be approved as part of the DSD.
2. The financial instruments involved are transferable securities (eg, shares and bonds), money-market instruments, or units in collective investment undertakings as defined in the Regulated Activities Order. Derivatives will only be considered when they meet the definition of a transferable security.
3. There are identifiable legislative or regulatory barriers to be addressed. Business that can operate outside of the DSS would be expected to do so.

Although the DSS was originally considered for Sterling-denominated instruments, its scope has been extended to include other currencies. The current position is set out by the Bank as follows:

Instruments can be denominated in any currency, except those for which there are sanctions in place. For domestic government debt, regulators will confirm consent with the relevant home regulator and/or issuer before activity can take place. Settlement for the asset can be in any currency for which the sandbox entrant is able to support physical settlement, subject to approval by regulators […].

Stages

The DSS is structured on the basis of four distinct stages:

Stage 1 (Testing)

Applicants are designated as "sandbox entrants" and given a "Sandbox Approval Notice" (SAN) that reflects the activities to be undertaken. A SAN is not an authorisation, and regulated activities need to be undertaken only when authorisations have been obtained.

Stage 2 (Go-Live)

Applicants who have the appropriate authorisations and have demonstrated their ability to go-live will be allowed to undertake live operations subject to firm-specific limits.

Stage (Scaling)

The scale of authorised business will be allowed to increase, subject to overall DSS limits.

Stage 4 (Operation Outside the DSS)

Participants will leave the DSS to operate as CSDs or new FMIs under rules designed in the light of the DSS.

Conclusion

The DSS provides an opportunity for the testing of new business models leveraging DLT and similar innovations. Firms will be able to create DSDs, together with or separately from MTF functionality; potentially, changing the landscape for FMIs in the UK.