UK Regulators Consult on Digital Securities Sandbox

On April 3, 2024, the Bank of England and U.K. Financial Conduct Authority published a joint consultation paper on proposed rules for the incoming digital securities sandbox. The Financial Services and Markets Act 2023 (discussed in our client note, A Boost for UK Financial Services) empowered HM Treasury to establish sandboxes to facilitate the use of digital assets in financial markets. HM Treasury confirmed its approach to the DSS, which is the first such sandbox, in December 2023. The DSS will offer eligible firms a modified set of rules and regulations for a period of five years, enabling them to test out services using technology such as distributed ledger technology and give the regulators time to finesse a regulatory regime. It is hoped that digital securities could bring advantages, such as streamlining processes and reducing settlement risk and settlement times.
 
The Financial Services and Markets Act 2023 (Digital Securities Sandbox) Regulations 2023 were published in January 2024, and provide that those eligible to participate in the sandbox are U.K. recognized investment exchanges, recognized central securities depositories and investment firms that are licensed to operate a multilateral trading facility or organised trading facility, as well as any other firms identified by the FCA or PRA. Securities that may be traded within the sandbox include equities, corporate and government bonds, money market instruments, units in collective investment undertakings and emissions allowances. Derivatives contracts and ‘unbacked cryptocurrencies, such as Bitcoin, will be out of scope.
 
Responses to the regulators' consultation on their proposed rules for the DSS may be submitted until May 29, 2024. Final guidance and rules for the DSS will be published following feedback and the DSS will open for applications in summer 2024. Key aspects of the proposed BoE/FCA rules include:
 
Eligibility
 
Under the proposed rules, firms will need to demonstrate clear regulatory barriers that otherwise prevent their activity outside the DSS. There will be three possible business models for participation: (i) conducting the activities of a central securities depository in relation to digital securities (known as a digital securities depository); (ii) operating a trading venue; and (iii) combining both activities into one financial market infrastructure.
 
Stages
 
There will be five stages in the DSS, and firms must pass through a series of four gates consisting of compliance with increased regulatory standards, before moving to the next stage.
 
DSS rules
 
The regulators are empowered to make rules applicable to both sandbox entrants and other persons who engage in DSS activity but are not themselves sandbox entrants. The BoE has published proposed rules for digital securities depositories as part of the consultation paper, given these entities have been found to have the highest legal and regulatory barriers to using developing technology. The FCA has not published proposed rules for a new regime, as there do not appear to be particular legal or regulatory challenges for trading venues to operate with digital assets. As a result, the FCA views it as unlikely that firms intending to operate only a trading venue will be accepted into the DSS, given they are not facing regulatory barriers, but decisions will be made on a case-by-case basis.
 
Management of financial stability and market integrity risks
 
The BoE will place limits on digital securities depository activity in the DSS to manage financial stability risks. The FCA will require trading venues within the DSS to meet the same standards as those outside it.