What is the Digital Securities Sandbox (DSS)?

In summary, the DSS is a regime that will allow firms to use developing technology, such as distributed ledger technology (DLT), in the issuance, trading and settlement of transferable securities such as shares and bonds.

Firms that successfully apply to the DSS will be able to operate under a set of rules and regulations that have been modified to facilitate access. The DSS lasts for five years and will help regulators design a permanent technology friendly regime for the securities market.

It will be possible for firms that successfully apply to the DSS to undertake the activities traditionally associated with central securities depositories, namely the issuance, maintenance and settlement of financial securities. It will also be possible to combine these activities with that of a trading venue, thereby creating new business models.

What does the DSS consultation include?

The BoE and the FCA (together ‘the regulators’) have jointly produced a consultation paper that includes:

1. An outline of the proposed approach to the operation of the DSS, including the BoE’s draft rules and fee regime.
2. A draft guidance document for potential applicants.

The consultation follows HM Treasury’s (HMT) response to its consultation on the DSS published in November 2023 and the Financial Securities and Markets Act 2023 (Digital Securities Sandbox) Regulations 2023 (the DSS Regulations) which entered into force on 8 January 2024 (read more about these developments in our Engage article here).

The BoE and FCA welcome responses to the specific questions posed as part of the consultation paper as well as general feedback on the draft guidance document by 29 May 2024.

The BoE and FCA want to operate the DSS in a way that meets the below overarching aims whilst giving fair consideration to the impact of their policy on key stakeholders:

• Facilitating innovation to promote a safe, sustainable and efficient financial system;
• Protecting financial stability; and
• Protecting market integrity.

In order to protect financial stability, the BoE will impose limits on the value of securities that can be issued in the DSS. This reflects the fact that the new technologies are untested in important financial markets at significant scale.

The DSS is composed of different stages of permitted activity, reflecting the Bank’s approach to managing financial stability risks. There will be a series of gates for ‘sandbox entrants’ (this term is used to refer to a firm which has been approved to enter the DSS, irrespective of that firm’s business model or the stage they have reached in the DSS) to move through to progress from one stage to the next, with the amount of permitted activity increasing with each stage. This glidepath will enable firms eventually to graduate from the DSS to a possible new regime if they meet the relevant standards.  Further detail about the different stages or gates is set out below.

The DSS will allow regulators to determine how the existing regime for the issuance, trading and settlement of securities would need to be permanently amended to support the use of new technologies.

A draft guidance document is included at Appendix A of the consultation paper and should be read alongside it.  The guidance sets out how the DSS will operate and what firms looking to apply to the DSS can expect.  The regulators are also welcoming feedback on the contents of the guidance document including areas where additional guidance would be helpful.

The BoE proposes to use its flexible rulemaking powers to create BoE DSS rules (set out in draft in Appendix B) which are the proposed rules that will apply to DSDs after Gate 2 (further details on the stages are set out below) and the end-state rules which are the BoE’s default of what it anticipates the future requirements on firms may look like.  Appendix C sets out a comparison of the requirements that will apply to firms at Gate 2 and at the end of the DSS. Appendix D sets out the FCA’s proposed amendment of the Decision Procedure and Penalties Manual (DEPP).

Which financial instruments are in scope of the DSS?

The financial instruments in scope of the DSS are specified in Regulation 3(7) of the DSS Regulations and defined as ‘FMI sandbox instruments’. For the purposes of the consultation paper such financial instruments are referred to as ‘digital securities’. The following financial instruments are examples of what is in-scope and could be issued and traded in the DSS:

• equities;
• corporate and government bonds;
• money market instruments such as commercial paper and certificates of deposits;
• units in collective investment undertakings (fund units); and
• emissions allowances.

The trading and settlement of derivative contracts and of ‘unbacked cryptocurrencies’ such as Bitcoin and Ether are not in the scope of the DSS.

The intention of the Bank and the FCA is that financial market participants, such as companies that use capital markets to raise finance, or participants in financial markets who trade securities, should be able to interact with the firms inside the DSS as normal while benefitting from the new technology.

Similarly, unless otherwise specified by the regulators, all financial market participants will be able to use the securities issued in the DSS as they normally would any other security, including in securities financing transactions, or as collateral. They can also write derivative contracts based on those securities. Those activities would still need to comply with the regulations that govern them.

What is the eligibility criteria to apply for the DSS?

The DSS is principally targeted at prospective providers of financial market infrastructure (FMIs) who are established as UK entities.  The DSS Regulations allow for three possible business models: (1) undertaking FMI activities, specifically those traditionally performed by a central securities depository (CSD) (i.e. notary, settlement and maintenance of securities) by being a Digital Securities Depository (DSD); (2) operating a trading venue; or (3) combining both into one FMI to create a hybrid entity.

In acknowledgment that the current framework for the operation of a CSD was not designed with the use of developing technology in mind, a new category of firm was created for the purpose of the DSS. To perform one, or a combination, of the activities of a CSD in the DSS, a firm will apply to be a DSD. A DSD is a sandbox entrant which has been permitted to undertake the activities traditionally performed by a CSD, which results in it being a DSD. References to a DSD include a firm which undertakes other regulated activity alongside its DSD operations, both inside and/or outside the DSS. HMT provided for this through the DSS Regulations by creating a temporarily modified legislative and regulatory framework (modified framework). Since the BoE supervises CSDs, while the FCA supervises the operation of trading venues, the DSS and sandbox entrants will be jointly overseen by both regulators.  The consultation also uses the term ‘hybrid entity’, this is used to refer to a sandbox entrant which combines the roles of a trading venue and the activities traditionally performed by a CSD into one FMI.  Such a firm would be both a DSD and have authorisation to operate a trading venue, it would be supervised by the BoE and the FCA. 

There will be no obligation for firms to participate in the DSS. Firms wishing to undertake the activities of a CSD outside the DSS would need to comply with existing regulatory requirements. However, if firms wish to operate an FMI under the modified framework, they will first need to apply to the regulators to become a sandbox entrant. Firms that do not require the modified framework to operate their business models should do so outside of the DSS.

How might the DSS benefit the wider financial system?

The application of new technology such as DLT could materially improve the efficiency of ‘post-trade’ processes that take place after a trade is executed. By making these processes faster and cheaper, the adoption of these technologies could, if successfully implemented, lead to material savings across financial market participants, such as pension funds, investment firms and banks.

Which stakeholders should respond to the DSS consultation?

The primary audience for the publication is prospective providers of FMI services looking to apply to the DSS and be approved as a sandbox entrant to operate a trading venue and/or settlement services using new technology such as DLT.  It may also be of interest to firms who wish to engage with a sandbox entrant such as the prospective members of a DSD or a firm seeking to offer custody services for the digital securities that are recorded, traded or settled on those FMIs.

How will prospective firms progress through the DSS?

Initially, prospective firms will be eligibility checked and firms that meet the ‘Gate 1’ criteria will be approved as sandbox entrants.  Section 3 of the consultation paper details the Gate 1 criteria.   Stage 2 is the testing stage where sandbox entrants wanting to be a DSD begin testing their systems, engage with BoE supervisors and prepare to meet the expected regulatory and supervisory outcomes at Gate 2 (Stage 2 in Appendix A to the consultation paper). Sandbox entrants that demonstrate to the Bank that they can meet Gate 2 requirements will become DSDs and move into Stage 3.

Sandbox entrants seeking to operate a trading venue should apply to the FCA for permission to operate a Multilateral Trading Facility (MTF) or Organised Trading Facility (OTF). Alternatively, sandbox entrants who already hold a relevant Part 4A permission or exempt persons under FSMA 2000 should engage with their FCA supervisors, who in some circumstances may determine that such persons are already able to undertake their desired activity in the DSS. However, this will ultimately depend on the permissions a firm holds and its proposed business model for the DSS. In some cases, a Variation of Permission (VoP) or further permissions may therefore be required. As stated above, the FCA only anticipates a sandbox entrant operating a trading venue when combined with a DSD to form a hybrid entity.

Stage 3 is where sandbox entrants become DSDs and are given permission by the BoE to undertake the activities of a CSD. Where relevant, they are also appropriately authorised by the FCA. At this stage, firms are permitted to undertake live activity subject to limits outlined by the regulators. At this point, a DSD will not be subject to the full CSDR nor the full end-state BoE rules but to the Gate 2 requirements which reflect the risks posed by firms during this stage, given the limits they are subject to. The FCA proposes to maintain its existing risk-based supervisory approach to the operation of a trading venue.

The BoE will hold two review points in the DSS for DSDs to demonstrate that they meet Gate 3 requirements. These review points are set to ensure that the overall limits in the DSS (in the asset classes for which they have been set) are allocated to firms in a fair and prudent way.  After the second review point, the DSS will be closed to new sandbox entrants.

Stage 4 is the scaling stage and firms that enter this stage will have access to higher limits. At this point, DSDs can increase their activity within the higher limits and begin to consider how they meet end-point requirement after the DSS.

Stage 5 involves operating outside the DSS under a new regime. The regulators and HMT, having learned from the activity in the DSS, intend to create a new permanent regime for settlement if this is considered appropriate. The BoE’s draft DSS rules instrument set out in Appendix B includes the anticipated end-state rules of such a possible new permanent regime to help firms to understand what requirements that is likely to entail.

What are the key milestones for the DSS?

The DSS consultation period will close on 29 May 2024.  In summer 2024, the BoE and the FCA will respond to the feedback received during the consultation period.  The DSS will then be open for applications.  In Autumn 2024, it is expected that the first cohort of DSS applicants will become DSS entrants.

What are the specific timings for the DSS consultation?

The closing date for responses to the consultation paper is 29 May 2024. The eight-week consultation period reflects the fact that the DSS is not a permanent regime and that the DSS rules can be amended during its lifetime as firms and regulators learn about the application of new technology in practice.

Next steps for the DSS

After the consultation period, the BoE and FCA will issue a formal response to the views submitted as part of the consultation process. Following this, the final guidance and rules will be published and the DSS will open for applications over the summer of 2024.  We are following all key developments on the DSS so please get in touch to discuss further.

Authored by Melanie Johnson.