No-one playing in the sandbox

May 2024 

The EU's DLT pilot regime (DTLR) went live in March 2023, and the UK's equivalent Digital Securities Sandbox (DSS) is set to open for applications this summer. Both regimes seek to facilitate safe and legal experimentation — in particular, by amending the Central Securities Depositories Regulation (CSDR) to allow firms to combine functions currently performed separately by trading venues and CSDs. However, interest from market participants remains low, with firms seeming to opt for independent testing outside of the regulatory initiatives. This article recaps the latest regulatory developments and sets outs considerations for firms. 

The EU's pilot regime for market infrastructures based on DLT (now dubbed 'DLTR') was agreed in May 2022 — and it applied a year later, in May 2023.

The DLTR sets out a legal framework for the trading and settlement of transactions in cryptoassets that qualify as financial instruments (under MiFID II) — seeking to facilitate an environment for safe experimentation.

Under the pilot:

• Authorised financial institutions must be granted a specific permission to participate.
• This permission is limited to six-years — but is valid throughout the EU. 
• Operators are subject to various organisational requirements — with competent authorities able to request additional prudential safeguards. 
• Only certain financial instruments can be admitted — i.e. bonds, shares and fund units — with market capitalisation below specified thresholds. 
• Once permission is granted, operators can request exemptions from certain regulations. Most significantly, operators can request permission to combine the activities normally performed by both Multilateral Trading Facilities (MTFs) and CSDs. (See more information in our previous article here).

Under the DLTR, ESMA is required to publish annual interim reports — the first of which was due in March 2024. However, since going live, no DLT market infrastructures have been authorised under the regime.

And so, in lieu of this report, Verena Ross (Executive Director of ESMA) wrote a letter (PDF 150 KB) to the EU institutions highlighting the main challenges considered to be hindering uptake. These include:

• The novelty of the regime.
• Difficulty in finding providers for the cash settlement leg. 
  • In particular, given the timing mismatch with MiCA authorisations (that will only begin later in 2024), it has been difficult for applicants to find cash leg providers. Pending further clarification by the Commission, the pilot regime specifies that payments can only be settled using e-money tokens issued by credit institutions, and not by e-money institutions.
  • There is currently also a lack of viable CBDC alternatives. 
• Lack of clarity on the regulatory expectations for custody services, particularly for self-hosted wallets. 
  • In particular, there is uncertainty regarding to what extent there may be an overlap with custody services under MiCA or MiFID II. 
• Interoperability challenges between DLT and traditional infrastructures (and among DLT infrastructures themselves). 
  • In particular, it is difficult for DLT MTF operators to find a DLT trading and settlement system or DLT settlement system (since none have been authorised yet) or to have access to a traditional CSD (given technological and operational complexities). 
• Investor protection concerns. 
  • The regime allows NCAs to authorise access for retail investors under certain conditions, including additional “compensatory measures”. However, in light of the complex interaction between MiFID II and the pilot regime, and the investor protection implications of direct access, the identification of convergent compensatory measures may be challenging. 
  • Moreover, the direct access of retail investors warranted the limitation of financial instruments admitted to trading to non-complex financial instruments. Requests for further clarity have been made to avoid inconsistency in the implementation of this across the EU.
• Low thresholds for financial instruments admitted to trading. 
• Uncertainty about duration of pilot. 
  • Participants want to ensure they have sufficient time to implement and operate projects before investing.

In response, Mairead McGuiness (European Commissioner for Financial Services) has re-emphasised (PDF 152 KB) the importance of the regime and of “exploring quality solutions based on DLT to create new markets, improve efficiency of existing ones, reduce costs and mitigate certain risks”. She noted that despite the current lack of authorisations, there has been an observed increase in engagement from the financial industry. As such, the Commission will be fully dedicated to mitigating each of the challenges flagged. In fact, with regards to the pilot's duration, she clarified that there is no expiration date. 

For the most part, the UK has followed the EU's lead, although with a slightly slower timeline.

In 2021, HM Treasury (HMT) conducted a Call for Evidence to examine the application of DLT to FMIs. A key issue identified in responses was that the UK legislative framework is not sufficiently “fit for purpose” in this context. And so, in April 2021, the government announced that HMT (in conjunction with the Bank of England (BoE) and FCA) would develop FMI sandboxes to allow participants to “test and adopt new technologies”.

In July 2023, HMT published a consultation (PDF 506 KB) setting out its proposed approach to delivering a Digital Securities Sandbox (DSS), which would be the first sandbox delivered under the Financial Services and Markets Act 2023. (PDF 2.41 MB)

In April 2024, the BoE and FCA laid out further detail on how the DSS would be delivered:

• It will modify regulation (most notably, the UK CSDR) to enable experimentation in the trading and settlement of digital securities such as shares and bonds. Successful applicants will be able to provide securities depository and settlement services and operate a trading venue including, for the first time, from the same legal entity. 
• It will last five years and may lead to a new permanent regime — with the government having the tools in place to achieve this “reasonably quickly”.
• It is open to firms that are “established” in the UK — i.e. have a registered office or head office in the UK for the duration of the sandbox. 
• Participating firms must be able to identify regulatory barriers preventing the proposed activity being carried out under existing regulations. 
• It is composed of different stages of permitted activity, in order to manage financial stability risks. 

The consultation closes at the end of May, with regulators planning to issue final guidance and open the sandbox by Summer 2024.

However, as in the EU, it's possible that firm engagement could prove low due to many of the same concerns noted in Ms Ross' letter. Additional concerns might also include:

• The initial scope being limited to sterling-denominated assets. 
• The fact that most e-money and / or stablecoins are unlikely to be permitted for initial use as settlement assets. 
• A lack of clarity on whether projects with retail participation are permitted.
• Managing potential interactions between BoE, FCA and PRA requirements — especially where an entrant is separately authorised. 
• A general hesitancy regarding innovating in full-view of competitors and regulators.
• A belief that more meaningful and efficient testing can be done independently — where firms can focus on their own functionality.

DLT represents the possibility for vast efficiency gains within financial services — through cryptographically-secure record keeping and smart contract automation. However, traditional financial market infrastructure and regulation has evolved to require separate entities to perform different operational functions. This means that the full advantages of operating on a shared ledger cannot be met.

The DLTR and DSS represent an opportunity to begin unlocking those advantages. In particular, the regimes could lead to faster and cheaper ways for securities to trade, settle, and be utilised among financial market participants. Moreover, this work could also ultimately fold into wider initiatives such as the Regulated Liabilities Network or the BIS' unified ledger — which aim to combine tokenised central bank money, tokenised deposits and other tokenised assets on one platform. (Read more in our article here) (PDF 1.89 MB).

However, it seems regulators may have further to go in order to entice firms to innovate in these sandboxes rather than in their own walled gardens. And, regardless of where experimentation takes place, certain challenges persist, including:

• Benefits cannot be achieved in a silo and rely on all stakeholders in the ecosystem operating together 'on chain'. 
• Transitioning from complex and embedded legacy systems onto DLT infrastructure is a delicate and complex process, involving effort and expense. 
• Interoperability (between DLT and non-DLT solutions, and between different types of DLT solutions) must be ensured, so as to avoid fragmentation of the trade-settlement process.  

KPMG in the UK can support firms with all forms of experimentation — in particular, through the KPMG global network, KPMG professionals have access to German firm's experience supporting the first German DLT pilot regime application. Our services include:

• Strategy and business case development, assessing the feasibility of pilot regime/sandbox applications.
• Development of technical requirements for priority use cases, process design and mapping. 
• Documentation refinement and updates to pilot regime/sandbox applications in line with regulatory requirements
• If you have any questions or would like to discuss further, please get in touch.