The UK government is preparing to introduce a new regulatory framework for testing and adopting digital securities in financial markets. The Digital Securities Sandbox (DSS) will allow firms to use digital asset technology for trading and settlement infrastructure under a modified legislative and regulatory regime. The DSS is expected to launch in early 2024, following the passage of the Financial Services and Markets Act in June 2023.
The DSS is the first financial market infrastructure sandbox to be created under the powers granted by the Financial Services and Markets Act 2023. The act enables the Treasury to establish sandboxes by way of statutory instrument, with the aim of facilitating innovation and competition in financial services.
The DSS will enable firms to experiment with digital securities, which are traditional financial instruments that are represented and transferred using digital asset technology, such as distributed ledger technology (DLT). Digital securities have the potential to improve the efficiency, transparency and resilience of financial markets, as well as to enable new business models and products.
However, the existing regulatory framework for financial market infrastructures (FMIs), such as central securities depositories (CSDs) and trading venues, may not be suitable or optimal for digital securities. For example, some FMIs may face legal or operational barriers to using DLT, or may not be able to comply with certain requirements, such as settlement finality or record-keeping. Therefore, the DSS will provide a temporary and flexible environment for FMIs to test and adopt digital securities, while preserving the existing regulatory outcomes and protecting consumers and market integrity.
How will the DSS work and who can participate?
The DSS will allow firms to apply to set up and operate digital securities depositories and/or trading venues under a temporarily modified legislative and regulatory framework. The Treasury will determine the scope and duration of the modifications, as well as the eligibility and application criteria for the participants. The Bank of England and the Financial Conduct Authority will be responsible for supervising and enforcing the DSS activities, as well as providing guidance and feedback to the participants.
The DSS will be open to both authorised and unauthorised firms, provided they are established in the UK and use digital asset technology for their FMI activities. The Treasury is also considering whether to allow collective applications by groups of entities acting on a distributed basis. However, the DSS will not be available to firms that can achieve their proposed model in compliance with the existing regulatory framework, or to firms that intend to use digital assets for non-FMI activities, such as issuing or investing in digital securities.
The Treasury has invited firms to express their interest in using the DSS, as well as to provide feedback on the proposed approach and some further policy and legal issues. The consultation will close on 22 August 2023, and the Treasury will publish its response and finalise the DSS framework later this year. The legislation implementing the DSS will be laid before Parliament in due course, and the DSS is expected to launch in the first quarter of 2024.
What are the benefits and challenges of the DSS?
The DSS is a promising tool for financial market innovation, as it will enable firms to explore the possibilities and benefits of digital securities, while reducing the regulatory uncertainty and risk. The DSS will also provide valuable insights and evidence for the Treasury and the regulators to inform future changes to the law and regulation, as well as to foster cross-industry and international collaboration on digital asset standards and best practices.
However, the DSS also poses some challenges and limitations, such as:
- Technology considerations: The DSS will require firms to use robust and secure digital asset technology, as well as to address the operational resilience and outsourcing risks associated with it. The Treasury and the regulators will also need to ensure that the DSS is compatible and interoperable with other FMIs and payment systems, especially in relation to the digital cash or payment leg of digital securities transactions.
- Prudential treatment of digital assets: The DSS will require firms to consider the prudential implications of using digital assets, such as the capital, liquidity and risk management requirements. The Treasury and the regulators will also need to clarify the accounting and valuation methods for digital assets, as well as the tax implications for the participants and the users of the DSS.
- Reporting and custody of digital assets: The DSS will require firms to comply with the reporting obligations for digital securities transactions, such as the transaction reporting and trade transparency rules. The Treasury and the regulators will also need to define the roles and responsibilities of the custodians and the users of digital assets, as well as the legal status and ownership rights of digital securities.
- Retail users of digital assets: The DSS will require firms to protect the interests and rights of the retail users of digital securities, such as the investors and the issuers. The Treasury and the regulators will also need to ensure that the retail users have access to adequate information, advice and redress mechanisms, as well as to prevent fraud, market abuse and money laundering involving digital assets.
The Treasury and the regulators will seek to address these challenges and limitations through the consultation process, as well as through ongoing dialogue and engagement with the industry and other stakeholders. The DSS will also be subject to periodic review and evaluation, and the Treasury and the regulators will have the power to modify, suspend or terminate the DSS activities if necessary.
The DSS is a significant step towards enabling the UK to become a global leader in digital asset innovation and adoption. The DSS will provide a conducive and flexible environment for firms to test and adopt digital securities, while ensuring the safety and soundness of the financial markets. The DSS will also generate valuable learnings and feedback for the Treasury and the regulators to inform future policy and regulatory developments, as well as to foster cross-industry and international cooperation on digital asset standards and best practices.
