Last month, the UK Government opened consultations into the introduction of a Digital Securities Sandbox (DSS), a means to test and explore the potential offered by digital securities in financial markets.
The
DSS will encourage industry players to test financial market infrastructures (FMIs) that leverage digital asset technology, by enabling firms to model the operations of a securities depository and trading venue using distributed ledger technology (DLT)
to accommodate digital assets.
The three general objectives of the DSS include:
- Testing how existing UK legislation needs to change to accommodate digital asset technology and new practices associated with it
- Enabling the financial sector to test and adopt digital asset technology in FMIs
- Testing the use of FMI sandboxes as a policymaking concept
The sandbox will consider new technology to understand how innovations can benefit financial markets and the wider ecosystem. It will also consider whether the legislative environment is fit for purpose or needs to be modified in order to accommodate this
sort of innovation.
HM Treasury’s paper on the consultation launch explains that the DSS will be a regulatory
construct, not a technology system, and will operate on a ‘same risk, same regulatory outcome’ basis.
It will allow participating entities operating an FMI that uses digital asset technology to have access to a modified regulatory framework that will enable them to test and scale their activities, while also giving regulators the ability to set requirements
in a flexible way, evolving as the participating entity’s experience and business model matures, and as appropriate risk management becomes embedded.
Sophia Le Vesconte, counsel in the fintech team at Linklaters LLP spoke to Finextra on the DSS consultation, stating: “We are currently witnessing a new wave of financial market innovation, as financial market infrastructure providers explore the potential
of emerging technologies like blockchain and distributed ledger technologies.”
Le Vesconte furthers that redesigning how market infrastructure operates could potentially garner significant efficiency gains and open up new revenue streams in financial markets. While some types of innovation can be realised within existing legal and
regulatory frameworks, others cannot.
The DSS was legislated for in the recent Financial Services and Markets Act (FSMA), which received Royal Assent in July 2023. FSMA provides HM Treasury with powers to establish FMI sandboxes, a key aspect of these powers also includes the ability to make
permanent changes to legislation on the basis of what is learnt from the sandbox. To change legislation, HM Treasury will report to Parliament on the operation of a particular sandbox, setting out why and how it intends to change UK legislation on a permanent
basis. The permanent changes themselves would be enabled by HM Treasury laying a further statutory instrument before Parliament.
Speaking to Finextra on the DSS, a source familiar with the matter explains that the industry’s reception to the premise of the consultation has been very welcoming. “The industry across Europe is looking at opportunities to experiment with this technology
and has seen a lots of positives in the UK’s approach.”
The EU’s DLT Pilot Regime launched in March this year is led by the European Securities and Markets Authority (ESMA), and while it is not entirely dissimilar in concept to the DSS, it has shown some strictures which have chafed against some players. It is
expected that the UK will take a more pragmatic approach with the DSS.
The EU’s pilot regime has already attracted a number of applications, as well as some critiques, and has seemingly fuelled interest from firms looking to build out their own solutions to capitalise on the regulatory momentum. In March this year it was
reported that Brussels-based Euroclear may launch a DLT platform for the issuance and settlement of digital bonds within the year.
Euroclear, which operates the UK Central Securities Depository (CSD) and the CREST electronic settlement system, plays a key role in supporting the financial markets in the UK and internationally by enabling investors to hold international securities. Given
Euroclear’s previous involvement and experience in innovating in the space, it will not only be interesting to view its response to the UK’s DSS consultation, but any of its DLT-related announcements in the coming months.
Euroclear supported the
Banque de France and a consortium of banks in the issuance of a digital sovereign fixed income security that was settled with an experimental central bank digital currency (CBDC) – a wholesale CBDC. The Banque de France pilot found that there are costs
and frictions that exist in the current system that could be done away with, on a more automated, distributed ledger ecosystem.
In a paper on the DLT experiment in France,
Euroclear stated that the experiment indicated that the “value of blockchain technology does not lie in replicating ‘as is’ the management of securities settlement operations. Rather it lies in the opportunity for the market to change the way it organised
so as to reduce trade to settlement cycles, increased direct market participation and reduce reconciliation efforts.
Additionally, the paper reads that the experiment also showed the capacity of blockchain platforms to coexist and interoperate with existing settlement infrastructures. “By attracting more direct market participants on a common ledger for post trade operations,
blockchain could also reduce the overall cost and increase the efficiency of the capital markets.”
The UK Digital Securities Sandbox clearly seeks to address some of the challenges identified in relation to the EU’s DLT Pilot Regime, by providing participants with a clear path to exiting the DSS on a permanent legislative footing, for example.
Any uptake of solutions which emerge from the DSS or other similar projects is likely to be at an organic, generational pace of adoption. It’s possible that this would mean the emergence of hybrid systems that operate in parallel for years before full scale
adoption.
The challenges of moving away from legacy technologies that plague that financial are well documented, and the conversation around the significant expense, complexity and regulatory challenges of migrating to new systems is unlikely to change in the context
of DLT adoption.
Given these challenges, it is perhaps more likely that we will see adoption of DLT in new and novel asset classes rather than in full-blown FMI frameworks. Finextra’s source states: “This will likely be in more marginal asset classes where there is already
a lot of friction, cost and manual processing, such as private assets or funds.”
Observations about balancing risk with opportunity are also raised by Le Vesconte: “In recent years, we have seen regulators and policymakers across the globe grappling with the issue of whether any changes to existing frameworks are desirable to support
and attract innovation while at the same time continuing to mitigate all relevant risks. The implications of any fundamental changes to law are not always easy to assess in the abstract. Sandboxes like the DSS have been seen as a promising solution to allow
for new models and potential changes to law to be tested within a controlled framework.”
It is important to recognise that capital markets already operate in a highly sophisticated and, in many ways, efficient, manner with extremely high resilience. Central banks across the globe will need to be beyond confident that efficiency, resilience and
stability thresholds are met before considering an innovative approach.