21 December 2023

Taken from the published LinkedIn pulse article.

This week, on Monday 18th of December, His Majesty’s Treasury of the UK government cleared the last legislative hurdle for implementing the Digital Securities Sandbox (DSS). The statutory instrument titled The Financial Services and Markets Act 2023 (Digital Securities Sandbox) Regulations 2023 is now set to come into force on the 8th of January 2024.

Once in operation, the DSS will facilitate the testing of digital securities within financial markets to support the long-term integration and adoption of digital assets in the UK. As the digital asset industry in the UK has evolved, the government has sought to understand the impact of emerging technologies, such as distributed ledger technology, on financial market infrastructures (FMIs) to ensure that the adoption of these technologies is effective, secure and sustainable.

In 2021, the government issued a Call for Evidence to assess the application of digital asset technologies within FMIs. In the government's response, published in April 2022, it was noted that the existing legislative framework in the UK does not adequately support the use of digital asset technologies within FMIs. Further, the dynamic and evolving nature of the digital assets industry presents challenges in predicting the necessary regulatory and legislative changes for future-proofing digital asset technology adoption in FMIs.

To address these challenges, the government acknowledged the importance of experimenting with digital asset technologies within financial markets. When the Call for Evidence closed in 2021, the government announced the development of FMI sandboxes in conjunction with the Bank of England and the Financial Conduct Authority, which will have operational and supervisory responsibility. Sandboxes allow for the temporary alteration and suspension of existing regulations and legislation, eliminating regulatory barriers and providing flexibility for limited test cases - therefore enabling informed decision-making regarding the legislative framework required for digital assets in the future.

The passage into law of the Financial Services and Markets Act 2023 (FSMA 2023) on the 29th of June provided HM Treasury with the powers to set up FMI sandboxes - such as the DSS - via statutory instruments. For each sandbox, a statutory instrument must be laid before Parliament to provide the legal basis for temporarily disapplying or modifying relevant legislation. The DSS, the first sandbox to be established through FSMA 2023 with the passage of its statutory instrument this week, is designed to specifically allow participants to operate and manage FMIs utilising digital asset technology within a structured environment and adjusted legal and regulatory context.

The DSS mandate was initially outlined in the government’s consultation, published on the 10th of July and reaffirmed as the basis for its approach in the consultation response on the 22nd of November. HM Treasury has been clear that participation in the DSS is reserved for companies with clear regulatory barriers to their proposed business model and operating relevant FMI activities to the sandbox, with firms applying to join the DSS and be designated a ‘Sandbox Entrant’ to be assessed based on criteria set by the Bank of England and FCA. To perform the activities of a central securities depository, an additional designation from the Bank of England as a ‘Digital Securities Depository’ is also required.

The main activities under the remit of the DSS include the functions of a CSD, including notary, settlement, and maintenance, as well as operating a trading platform, with the legislative and regulatory environment being altered to support digital asset technologies in these use cases.

Activities within the DSS pertain to current security types (either digital-native issuances or digital renditions of traditional securities). Whilst firm-specific limits on participating entities within the sandbox will be implemented by regulators to ensure financial stability, limits are subject to change as progress is made and will reflect each participant's capacity for fulfilling obligations and managing risks effectively.

Assets that fall within the DSS include digital representations of financial instruments defined in the Regulated Activities Order (RAO) including debt, equity, and money market instruments, and units in collective investment undertakings. Derivatives are excluded from DSS activities unless they refer to assets held by a Digital Securities Depository and settled under existing, unmodified regulations.

DSS operations will also involve tangible market activities and assets. Digital securities that are issued, traded, settled, and maintained through the DSS are expected to integrate seamlessly with broader financial market operations and will be treated the same as their traditional equivalents, such as collateral posting or repurchase agreements, provided they align with established legislative and regulatory frameworks.

HM Treasury plans to run the DSS for 5 years, with the possibility of extension. However, to look to the future, the evidence gathered from the DSS will be used by HM Treasury in reporting to Parliament on the operation of the sandbox, and the setting out of why and how it intends to change UK legislation permanently based on information gathered. The permanent changes would then be enabled by HM Treasury laying a further statutory instrument before Parliament.

The DSS aligns with the UK government's goal to position the UK as a global leader in the digital assets sector, a commitment echoed by the Chancellor of the Exchequer, Jeremy Hunt, most recently on December 19th in the House of Commons. Establishing the DSS provides a proportionate evidence-based approach to identifying the risks associated with emerging technology integration, whilst also recognising the constraints of existing regulations to business operations. In doing so, the DSS will facilitate the secure and efficient integration of digital asset technologies into FMIs and provide a definitive pathway for firms operating digital asset technologies in financial markets to establish their projects within a legal framework.

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