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Digital Securities Sandbox can be ‘catalyst of change’: Bank of England exec director

Sasha Mills: the Bank of England’s executive director of financial market infrastructure was speaking at the Guildhall in the City of London | Credit: Ian Hall

A sandbox for financial market infrastructures that is on track to launch in the UK this year has the potential to become a ‘catalyst of change’ towards the adoption of innovative technologies, an executive director of the Bank of England (BoE) said in a speech this week.

The Digital Securities Sandbox (DSS), which will be overseen by the BoE alongside the Financial Conduct Authority (FCA), is being created to enable regulators to curate the take-up of digital asset technology in financial markets – a field seeing surging levels of private-sector investment. It will effectively usher in a ‘test’ regulatory regime for firms to use new technologies that would otherwise not be permitted, such as distributed-ledger technology (DLT), to issue, trade and settle securities in a ‘live’ setting.

In a speech titled ‘The UK’s Digital Securities Sandbox: supporting the next frontier of innovation’, the Bank of England (BoE)’s executive director of financial market infrastructure, Sasha Mills, spoke about how regulators can try to match the private-sector’s pace of innovation and support its beneficial application without compromising financial stability.

“Changing an entire globally connected ecosystem with multiple independent decision-makers within different jurisdictions is likely to take years. The benefits are likely to be felt only when a critical mass of participants have adopted the new ways of doing things. That will not happen overnight, and it may happen in some markets ahead of others,” Mills told the audience at the ‘City Week 2024’ conference.

“We believe the DSS can be the catalyst of that change process – a phase where we collectively test whether this is the direction that the industry will pursue in the long term. We hope that the industry will join us in exploring these new frontiers,” she said.

DSS applications to open in ‘summer’

Mills was speaking (on 21 May) as a 29 May deadline approaches for responses to a 53-page consultation paper – launched by the BoE and FCA on 3 April – that details how the authorities propose to implement and operate the DSS. Final guidance and rules will then be published, with the DSS due to open for applications ‘over the summer’.

The government had set out the next steps towards the launch of the DSS in its response to its own consultation last year.

It described the use of digital assets as having the ‘potential to be genuinely transformative for financial markets’ while seeking feedback on the sandbox’s proposed main features, policy and legal issues, as well as inviting respondents to formally express their interest in actually using it.

‘The fundamental design of the DSS was well received,’ the executive summary of HM Treasury’s ‘Digital Securities Sandbox: Response to consultation’ noted, going on to state that ‘feedback stressed the need for further clarity in various areas, including the application process, […], the interaction of activities in the DSS with activities outside the DSS, and the process for exiting the DSS.’ It states that ‘in most cases these details will be provided by the regulators in due course’.

Nineteen expressions of interest from companies ‘considering participating’ in the DSS – a mix of incumbent financial market infrastructures (FMIs), existing regulated financial services firms and ‘new entrants’ – were received, according to the document. It added that ‘informal engagement with industry suggests that more will be sent’.

RELATED ARTICLE UK government sets out next steps towards ‘Digital Securities Sandbox’ – a news story (28 November 2023) on HMT’s ‘Digital Securities Sandbox: Response to consultation’ 

‘Cultural shift’ required for regulators

Mills was speaking during a one-day strand of discussions focused on ‘digital assets’ at the City Week event, which was held at the Guildhall in the Square Mile and organised by conference company City & Financial Global.

“Rapid advancements in technology and connectivity have made it easier than ever to transact in an increasingly wide range of assets. However, the ‘pipes’ and processes that sit behind those trades have not advanced at a similar pace. That ‘post-trade’ ecosystem – everything that happens after two parties agree to a trade – still relies on institutions holding their own records and reconciling with each other,” Mills – who is one of 22 BoE executive directors – said.

“The introduction of securities on distributed ledgers – digital securities – offers the potential to merge trade and post-trade functions, facilitate more precise settlement times, and introduce more programmability in financial transactions,” she said. “This could streamline processes and introduce more liquidity to a wider range of financial assets. It could also lower the barriers to entry for providers, enhancing the overall resilience of financial markets by moving away from dependency on single firms providing key services.”

Turning to ‘how and when’ regulators should “engage with innovation”, she said that a “cultural shift” was required, describing that the BoE/FCA consultation on the DSS as being “in support of this proactive approach”.

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

RELATED ARTICLE Treasury consultation prepares ground for UK ‘digital securities sandbox’ – a news story (12 July 2023) on the launch of the (previous) DSS-focused consultation

‘Series of supervisory gates’

Mills described the sandbox approach as “hav[ing] the benefit of allowing us to employ a more flexible rulebook” and “allow[ing] regulators to apply a more proportionate approach to regulation and make changes based on observations from activity in the DSS.”

The DSS has, she explained, been designed with a “series of supervisory gates that firms will pass through to progress between these stages”. At each stage the amount of permitted activity increases as companies meet increased standards and regulatory requirements. “This reinforces the Bank’s ability to manage financial stability risks,” she explained.

“This proportionate and gradual approach to rules means they are simpler and less onerous at the outset. They are tailored to new entrants and start-ups that may not have armies of compliance officers nor have much experience of being a regulated entity. As sandbox entrants increase their activity, the rules start to ramp up, proportionate to the scale of their operation,” she said.

On the topic of financial stability, Mills described the use of DLT as “untested at scale in the financial system… mean[ing] the risk of market disruption occurring is likely to be higher compared to established practices and technologies.”

“Therefore, to protect financial stability, firms will have to demonstrate to regulators that their systems can support live activity in the DSS,” she said, adding that “those that pass this test can operate an entity in the sandbox which we are naming a ‘Digital Securities Depository’ (or DSD)”. The DSS is designed, Mills said, to “enable DSDs to graduate to a new regulatory regime if they meet the relevant standards.”


‘Realism’ needed on ‘feeling benefits’

The BoE will impose limits on the value of securities that can be issued in the sandbox. It will be a sandbox-wide limit with firm-specific limits distributed across participating DSDs.

“We are designing the sandbox without certainty over the final number of sandbox entrants,” Mills acknowledged. “Therefore, the calibration of the initial limits for DSDs needs to allow for future growth and provide a level playing-field to incumbents and new entrants. We are proposing that initial limits in each asset class will be the same for all entrants. As with standards, these limits will increase as entrants move through the different stages.”

“We believe this approach to firm-specific limits will act as an accelerator to innovation,” she continued. “While activity is limited, firms will still be able to engage in ‘live’ activity much earlier than they would otherwise have if they were to pursue authorisations through the usual channels.”

The Financial Services and Markets Act 2023 handed the BoE a ‘secondary objective’ to ‘facilitate innovation in the provision of FMI services (including in the infrastructure used for that purpose) with a view to improving the quality, efficiency and economy of the services’.

While Mills described the DSS as a potential change ‘catalyst’, she suggested that people “should be realistic about how long it could take for market participants to feel the benefit of the new technology in post-trade”.

RELATED ARTICLE Sandboxes could ‘amplify problems’: IMF analysis questions many test-spaces’ impact – a news story (11 September 2023) based on an International Monetary Fund (IMF) paper titled ‘Institutional Arrangements for Fintech Regulation: Supervisory Monitoring’

Laying the foundations

The sandbox has been in gestation for more than three years.

HMT ran a call for evidence during the first quarter of 2021 on the ‘UK regulatory approach to cryptoassets and stablecoins’ that included a section on the application of DLT to financial market infrastructures. The document stated that testing ‘could entail making use of existing schemes, such as the FCA[‘s pre-existing] sandbox, or developing new propositions, such as an initiative for testing the operation of a DLT FMI [financial market infrastructure] in the market’.

The government then announced in April 2021 that HMT, in conjunction with the BoE and FCA, would proceed with the launch of a dedicated FMI sandbox. In the government’s response to that consultation, published in April 2022, it stated that the sandbox would be ‘up and running’ during 2023.

The HMT-led DSS consultation noted that one obstacle identified in responses to the 2021 call for evidence was that the UK legislative framework had not been built to support the use of DLT in FMIs. The FSMA 2023 has resolved that hurdle.

Other jurisdictions and nations have been making progress in the same space. In the European Union (EU) – which the UK left in January 2020 – a regulation on a pilot regime for market infrastructures based on DLT began applying on 23 March 2023. HMT’s consultation highlighted that Switzerland – which is also a non-EU member – created a framework for digital assets and for DLT FMIs in 2021 and that Singapore has put in place a DLT framework and completed a number of practical experiments.


Cross-border considerations

The HMT DSS consultation response devoted a section to international considerations.

‘Responses highlighted the need for international co-ordination on various issues relating to the adoption of digital asset technology, in order to avoid frictions cross-border,’ it stated. ‘These include the need to build cross-border interoperability of systems, harmonisation of regulation, taxation and compatibility of legal frameworks.’

Initiatives by supranational organisations – ‘in particular’ from the Financial Stability Board (FSB), Bank for International Settlements (BIS) and International Organisation of Securities Commissions (IOSCO) – were described as ‘helpful’ but ‘will need to be built on further.’

‘Feedback [from the consultation] noted that some digital FMIs may be multi-jurisdictional (or even non-jurisdictional when public blockchains are used), making the determination of any governing law very difficult,’ it added. ‘Digital securities may not be fully recognised under the laws of some jurisdictions.’

‘The government recognises that global co-ordination is essential for facilitating the successful adoption of digital securities worldwide. It recognises that a mixture of regulator and industry-led initiatives is desirable, as now,’ it stated. Among examples of UK authorities’ contributions internationally, it mentioned that the FCA is part of a ‘Project Guardian policymaker group’  announced by the Monetary Authority of Singapore in November 2023. Project Guardian is a public-private initiative exploring the opportunities and risks of asset tokenisation