NOVEMBER 2024
At the end of September, the Bank of England (BoE) and Financial Conduct Authority (FCA) opened the Digital Securities Sandbox (DSS) — the UK equivalent of the EU DLT Pilot regime. The DSS will facilitate the use of developing technology, such as DLT, in the issuance, trading and settlement of securities by allowing firms to operate under a temporarily modified legal and regulatory framework. Specifically, the sandbox will allow entrants to undertake the notary, maintenance and settlement activities traditionally associated with central securities depositories (CSDs) and combine these activities with the operation of a trading venue. The sandbox's opening comes after consultation with industry closed in May 2024.
Some changes have been made to the original proposal - including allowing non-GBP denominated assets and reducing the minimum capital requirement. However, stablecoins and e-money are still unable to be used as settlement assets, due to financial stability concerns. The application form itself is supplemented by a full policy statement (PS24/12) and final guidance.
The DSS is expected to eventually feed into wider ongoing DLT initiatives — e.g. unified ledgers or the regulated liabilities network — that seek to combine tokenised central bank money, tokenised deposits and other tokenised assets on one platform. Such initiatives integrate developments in both the public and private sector to experiment with bringing more of the financial services ecosystem `on chain'.
Background
The DSS is the first Financial Market Infrastructure (FMI) sandbox created under powers conferred on HM Treasury (HMT) by the Financial Services and Markets Act (FSMA) 2023. FMI sandboxes allow firms to experiment with new or different practices and developing technology in the execution of their key functions. As the first FMI sandbox, the DSS will also become a test-case for this new form of policymaking, where regulators can observe activity in a controlled environment and consider whether changes to rules or legislation are required to enable it.
The DSS will allow sandbox entrants to undertake the notary, maintenance and settlement activities traditionally associated with CSDs and combine these activities with the operation of a trading venue. DSS activity will be `live' and the regulators' intention is that the wider financial ecosystem should be able to interact with a sandbox entrant in broadly the same way they would with a traditional FMI.
To protect financial stability however, limits will be placed on the value of securities issued into the DSS.
The DSS is, by its nature, a temporary regime. However, the powers in FSMA 2023 allow the government to legislate using secondary legislation to put in place a permanent regime, after reporting to Parliament. A smooth transition should be available for successful sandbox entrants into any new permanent regime introduced when the DSS closes.
The opening of the DSS (which has been accompanied by a full policy statement (PS24/12), additional DSS guidance and the application form) follows the earlier consultation paper that was published in April 2024. Respondents generally welcomed the regulators' initial proposals.
The DSS' twin initiative in the EU - known as the DLT pilot regime opened for applications in March 2023. However, so far, this regime has struggled to stimulate interest - see more in our previous article here.
Stages for a sandbox entrant
The DSS is divided into a series of gates for entrants to move through, providing a path to progress from one stage to the next. The level of permitted activity increases with each stage.
- Purpose: Identify firms eligible to join the sandbox.
- Legal designation: None.
- Criteria / applicable rules: Eligibility criteria for Gate 1 (assessed via application form): (i) UK established entity (not branches), (ii) Activities and assets in scope of the DSS, and (iii) There are potential regulatory barriers or obstacles to activity outside the DSS.
- Purpose: Testing stage and engagement with regulators to operate a trading venue or to be a Digital Securities Depository (DSD).
- Legal designation: Sandbox entrant.
- Criteria / applicable rules: Continue to meet eligibility criteria.
- Purpose: Firms carry out live business under initial limits.
- Legal designation: DSD/authorised operator of a trading venue
- Criteria / applicable rules: Gate 2 Bank rules for DSDs (assessed via Gate 2 application form). FCA requirements for operators of trading venues.
- Purpose: Firms grow the business with a path to full authorisation for DSDs.
- Legal designation: DSD/authorised operator of a trading venue.
- Criteria / applicable rules: Gate 3 Bank rules for DSDs. FCA requirements for operators of trading venues apply.
- Purpose: Firms gain full authorisation to operate outside the DSS for DSDs.
- Legal designation: To be decided/new category of FMI.
- Criteria / applicable rules: Revised CSD regime reflecting sandbox learnings or alternative regime. BoE end-state rules to provide the `default' of what the revised regime could look like to provide a glidepath.
Digital security eligibility
Examples of what 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)
- emissions allowances
NB: before HMT's initial consultation made clear that cryptoassets which do not qualify as financial instruments under the RAO (i.e., unbacked cryptoassets or stablecoins) are out of the scope of the DSS and on this basis they do not qualify as FMI sandbox instruments. Moreover, such cryptoassets would also not be appropriate as a settlement asset on financial stability grounds.
Application eligibility
The DSS is open to firms of all sizes and at all stages of development as long as they are legally established in the UK. This could be an existing financial institution that is already authorised or recognised under current regulation or a new entrant to the market.
Fees
The BoE/FCA has proposed a `pay as you go' fee regime. This includes a £10,000 fee payable on application, a £40,000 fee payable on successfully passing through Gate 2 and regular fees to be paid annually during participation in the DSS, estimated at £85,000. The BoE/FCA has also proposed that fees should be additive for hybrid firms that will also require FCA authorisation in the normal way as outside the DSS.
What does this mean for firms?
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 UK's DSS (as well as the EU's DLTR) 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).
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 - see more in our previous article here. 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'. Currently, market interest in the DSS seems hindered by the lack of `on chain' settlement options. UK regulators have acknowledged that wholesale central bank digital currency is under development but could be several years before deployment.
- 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.
Next steps and how KPMG in the UK can help
The DSS will now be operational until December 2028 but can be extended by the government. The window for applying to join the DSS is expected to close around March 2027, so that the regulators and firms inside the DSS can prepare for a transition to a possible new permanent regime, provided the new technologies are implemented successfully. In the short term, UK regulators plan to arrange roundtables to discuss significant legal and policy issues within the DSS.
KPMG in the UK can support firms with various forms of experimentation — in particular, through the KPMG global network, KPMG professionals have access to KPMG in Germany'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.
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