Digital securities sandbox: HMT publishes consultation response

On Wednesday, HM Treasury published a response to its consultation on the forthcoming Digital Securities Sandbox (the ‘DSS’). Publication of the response coincided with the Government’s Autumn Statement, where the DSS was referenced as one of the measures supporting economic growth. The DSS will be the first financial markets infrastructure sandbox created pursuant to HM Treasury’s new powers under FSMA 2023, enabling participating firms to provide trading and settlement infrastructure for digital securities with the benefit of certain legislative modifications, subject to the close supervision of the UK regulators.

The response gives further insights into how the DSS will be designed and what the statutory instrument that establishes the DSS (the ‘statutory instrument’) will contain. In this briefing, we set out our key takeaways in the response, and highlight how it differs from the proposals set out in HM Treasury’s consultation paper.

The statutory instrument is expected to be published in the coming weeks, to be enacted before the end of the calendar year.

Asset scope and denomination

In the consultation, HM Treasury stated the DSS would be open to debt securities, equity securities and money market instruments. The response confirms that the DSS’ scope will be constructed more broadly, to capture “all relevant assets currently in scope of the regulatory perimeter”, save for derivatives (and unbacked cryptoassets). This will likely mean that all types of transferable securities will be eligible in the DSS, as well as funds in UCITS form.

Similarly, the response confirms that the Bank of England will be able to allow, in the DSS, instruments that are denominated in a currency other than sterling (although HM Treasury expects early DSS activity to be focused on sterling-denominated assets). This will be comforting to the industry, given its concerns that the DSS would be restricted to sterling denominated assets only.

Activities, designations and authorisations

The response confirms the DSS’ activity scope remains unchanged, so will target notary, settlement and maintenance functions plus the operation of a trading venue (meaning calls for payments, custody and other services to be brought within the DSS’ scope were rejected). However, HM Treasury have also indicated that the DSS will be designed to accommodate proposals that combine or distribute functions traditionally performed by CSDs or MTF/OTFs in a novel way. The Bank of England will be given flexibility to facilitate any new FMI calibrations through its management of the rules applicable to digital securities depositories (i.e. UK CSDR), many of which will be moved into regulator rulebooks.

In a trading venue context, the response confirms that the existing authorisation process will continue to be relied upon. That means applicants seeking to operate a trading venue in the DSS must hold an existing Part 4A FSMA permission (or be exempt), or apply for authorisation as an investment firm operating an MTF/OTF in the normal way, albeit potentially requiring a variation of permission.

Non-DSS activities

The term ‘non-DSS activities’ refers to activities conducted outside of the DSS that relate to assets issued or traded on DSS infrastructures. HM Treasury have confirmed that it will carry-forward its earlier proposals in relation to non-DSS activities. As such, firms outside of the DSS will be able to deal in digital securities without being approved as a sandbox entrant, subject to complying with the same rules and regulations as applicable to traditional instruments. There is no clear indication as to how the Government intends to address any technical ambiguity that might arise in relation to non-DSS activity, although there is reference to the Government potentially bringing further legislation into the scope of the DSS (meaning it can be modified) at a later stage.

Limits

A key differentiating factor of the DSS is its approach to limits, which will be set by regulators on an ongoing basis rather than being ‘hard-wired’ into the legislation implementing the DSS. The response does not set out greater detail in relation to how the overall limits will be set or apportioned between sandbox entrants. Instead, the response states that these sorts of issues will be set in regulatory guidance in due course.

Eligibility to participate

In spite of industry requests, the response confirms that firms seeking to participate in the DSS as sandbox entrants must be established in the UK. This will exclude firms that would have liked to participate through a UK branch of an entity established in an overseas country. HM Treasury have confirmed that firms will be permitted to apply as a group or consortium, however, which may serve as an option for non-UK established entities. Non-UK established entities may also interact with DSS infrastructures as participants and/or by providing ancillary services.

Applications to the DSS

In a similar vein to limits, the response does not set out further details regarding applications to the DSS, and instead states that the approach to applications (and related matters) will be set through regulatory guidance, which will be subject to industry consultation. The response indicates a wind-down plan will not be needed at the time of the application, but will need to be agreed with regulators before live activity can commence.

Legislative modifications

The response gives more insight into how certain legislation will be modified through the DSS. It explains that:

• Many of the existing CSDR requirements will be disapplied via the statutory instrument, with some rules being replaced by regulator rules. This will enable to Bank of England to manage the CSDR requirements more flexibly than would otherwise be the case if modifications were ‘hard-wired’ in the statutory instrument (which can only be modified by a further statutory instrument, or act of Parliament).
• By contrast, modifications to the Companies Act 2006 and the Uncertificated Securities Regulations will be set out in the statutory instrument (as opposed to being disapplied and replaced through regulator rulebooks).
• The Bank of England will be given powers to offer an exemption from the rules requiring designation under the Settlement Finality Regulations (the ‘SFRs’) while sandbox entrants are in the DSS. The exemption is optional, and firms will be able to seek SFR designation while participating in the DSS. That said, sandbox entrants must obtain SFR designation when exiting the DSS if operating a securities settlement system, although the Government will consider whether this is necessary for non-systemic operators.
• The Government will consider whether and how to modify certain additional legislation outside of the DSS framework, including the SFRs and the FCARs.
• No modifications will be made to MiFIR, and no exemptions to the transaction reporting requirements in Article 26 will be granted (on the basis HM Treasury considers those requirements to be compatible with digital securities).
• The Government may bring further legislation into the scope of the DSS by way of further statutory instruments, although we would expect any further statutory instruments to take time to develop and enact. An additional statutory instrument may not also be realistic if the relevant issue is not sufficiently material to the objectives of the DSS, given the constraints on Parliamentary time.

Duration

As expected, the response confirms the DSS will initially last five years (but may be extended). Sandbox entrants may also exit the DSS before the end of the scheme.

Exiting the DSS

One area of uncertainty in the consultation concerned the process for exiting the DSS, which will require legislative modifications made during the DSS to be made permanent. The response gives few additional details, and reiterates that the Government believes it has the tools in needs to put permanent amendments in place reasonably quickly. However, those permanent amendments will be made via statutory instrument after a report to Parliament in relation to the DSS is submitted, so will (as the response states) be subject to Parliamentary time constraints. It remains to be seen whether this will serve as a block to transitioning out of the DSS or not.

Digital cash and the payment leg

The DSS will enable flexibility around the digital cash solutions that can be used for settlement. Payments-related legislation will not be modified through the DSS, however, meaning cash solutions will need to comply with all existing payments legislation. The exception is the requirements relating to cash settlement in UK CSDR, which will be disapplied and converted into regulator rulebooks. This will allow the Bank of England to determine what sorts of digital cash solutions will be permissible in relation the payment leg of transactions in digital securities.

Custody

In its consultation, the HM Treasury made clear that it expects any custody functions relating to digital securities to continue to be subject to the existing CASS framework. The response confirms that this will remain the case, notwithstanding concerns surrounding how the CASS rules should be applied in a digital context. The response indicates that the DSS will defer to the FCA’s ongoing work on adapting the CASS framework for digital assets, most recently expanded upon in the FCA’s DP23/4 (which was issued in the context of stablecoins, but with the custody elements stated as being relevant to cryptoassets that meet the definition of a specified investment (e.g. security tokens)).

Sovereign debt issuance

There have been several industry calls for the Government to issue a sovereign debt instrument within the DSS, to galvanise support to the digitalisation of securities more broadly. The response appears to dampen those expectations, by stating that although the DSS’ design will not precluding the issuance of sovereign debt, the expectation is that the focus of the DSS will be on the issuance of private sector debt instruments, at least in the short term. It thus makes no reference to amending the Government Stock Regulations and Treasury Bill Act, as would be necessary for a digital gilt issuance.

Permissionless systems

In its consultation, HM Treasury hinted that it was considering whether the use of permissionless DLT systems was appropriate in a financial markets context, owing to potential integrity and stability concerns. The response confirms that HM Treasury will remain technology neutral, and consider applications involving the use of permissionless DLT. That said, HM Treasury suggest that regulatory compliance may be more difficult for permissionless systems, and reiterated that the PFMIs would continue to form the basis for regulating financial markets infrastructure activity, both inside and outside the DSS.

Retail

The response makes clear that no changes will be made to facilitate the involvement of retail investors in the DSS. As such, the existing requirements on intermediation and investor protection will not be modified.

Jurisdiction and choice of law

The response confirms HM Treasury will not carry forward proposals to require DSS infrastructures to commit to being governed by English and Welsh law as a condition of participating in the DSS. As previously noted, however, applicants must have a UK established entity.

Expressions of interest

As a point of market colour, it is worth noting that the response disclosed that HM Treasury has received 19 expressions of interest, across a mix of incumbent FMIs, existing regulated financial services firms and new entrants (with informal engagement suggesting further expressions of interest will emerge in due course). It is too early to say whether the DSS will be more popular than competitor pilot regimes, but the initial response appears encouraging.

Next steps

As mentioned above, we understand the statutory instrument implementing the DSS will be published in the coming weeks, and will be enacted before the end of the calendar year. We also expect HM Treasury, the FCA and/or the Bank of England to consult on various matters concerning the DSS’ implementation (as referenced in the consultation and response). Of particular importance will be the rules and templates relating to applications and participant eligibility.