On 30 September 2024, the Bank of England (the “Bank”) and Financial Conduct Authority (the “FCA”) (together, the “Regulators”) issued a joint policy statement (the “Policy Statement”) addressing responses to the Digital Securities Sandbox (“DSS”) consultation paper (the “Consultation Paper”), which was released in early April 2024. Our full analysis on the original Consultation Paper proposals has been discussed here. We have set out a summary of the fees, assessments, and supervisory approach at each of the five stages of the DSS (i.e. the four “Gates” and the “End State”) in this table.
The Policy Statement sets out both (i) substantive changes made to the draft DSS rules published in April (the “Draft Rules”); and (ii) updates to and explanations of proposals previously set out in the Consultation Paper, in response to industry feedback and requests for clarification. We have set out our summary of both below.
Currently, the Regulators have only appended the final version of the Gate 2 rules, along with the updated guidance (collectively the “DSS Rules”) to the Policy Statement, but have not published the final draft of, or any amendments to, the End State rules, which will be “periodically updated as the DSS progresses and matures”. While no exact timeline was given for the publication of the final End State rules, the Regulators did respond to related feedback within the Policy Statement.
With the release of this Policy Statement, the DSS is now open to applications for trading venues, digital security depositories (“DSDs”), and hybrid entities.
1. Fees and Timelines
(a) Fees
Despite industry concerns that the initially proposed fees were prohibitively high, the Bank has confirmed that it will not vary the fees previously set out in the Consultation Paper, although it notes that “fees after Gate 2 are estimates and will be applied on a cost recovery basis, reflecting the actual amount of effort spent on DSS activity that is chargeable back to firms”. The Bank also confirmed that it will review fees payable after Gate 2, as well as where there is overlap with the FCA’s fees (yet unconfirmed) for hybrid entities.
(b) Timelines
For trading venue applicants, although the statutory timeframe under the Financial Services and Markets Act 2000 (“FSMA”) to determine an application in twelve months remains unchanged for the DSS, if complete, the FCA will usually assess the application within six months. Firms that seek to operate a trading venue in the DSS, but do not have permission to do so, are encouraged to book a pre-application meeting with the FCA ahead of submitting a Gate 1 application.
For DSD applicants, the Bank has now provided indicative timelines for each stage of the application process, which are set out below. For hybrid entities, whilst the Regulators will attempt to coordinate the process where possible, two distinct assessments will still be carried out.
2. Substantive Changes
Substantive changes from the approach and guidance set out in the Consultation Paper are summarised below.
Substantive Changes |
Scope |
Non-GBP denominated assets and settlement | The Regulators originally intended to limit the scope of assets in the DSS to GBP-denominated assets and to settlement taking place in GBP, with the intention to review this over the course of the DSS. However, following industry feedback, the Regulators have amended the rules to enable DSDs to settle securities denominated both in GBP and non-GBP currencies within the DSS. Money settlement of securities will also be able to take place in such other currencies where available. Limits will be set for activity in non-GBP assets that hold an important position for the functioning and financial stability of the financial system, which will be in addition to those published in the Consultation Paper for selected GBP asset classes. The Bank expects limits to be required for asset classes including (but not limited to) corporate bonds in EUR and USD, which serve as an important form of funding for some UK firms. When setting firm-specific limits for non-sterling assets, the Bank may take into account a firm’s overall limits across currencies and asset classes. These limits will be published as soon as practicable. |
Flexibility |
In response to industry feedback that the draft Go-live limits were too low in practicality and that the long wait until the Gate 3 review points for an uplift in limits made the Go-live limit particularly inflexible, the Policy Statement has introduced the following changes: |
Gate 2 limits | Subject to various conditions, firms may be granted an uplift to their Gate 2 Go-live limits, allowing them to have a range (with the lower bound being the previously communicated Go-live limit): - Gilts will have a range of £0.6 billion - £1.25 billion;
- Sterling corporate bonds will have a range of £0.9 billion - £1.5 billion.
Other asset classes such as commercial paper and certificates of deposit will also have the possibility of benefiting from an uplift to the Go-live limit. However, ranges for these have not been provided as multiple median-sized issuances are already possible within the initial limit. One consequence of granting uplifts to certain sandbox entrants means that firms within the Go-live stage may face different firm-specific limits at any given time in practice, despite meeting the same set of requirements. These limits will be set out in each firm’s Sandbox Approval Notice (“SAN”). |
Gate 3 review windows | Consultation respondents requested as much flexibility as possible for application timings to move to Gate 3, alongside access to increased limits, as this would facilitate efficient scaling. In response, the Regulators have introduced a third optional review point (subject to demand and the Regulator’s capacity to assess firms). This will ensure that firms do not face elongated waiting periods if they miss the first Gate 3 assessments as the optional review point will take place between the two previously proposed dates. |
Proportionality |
Minimum capital requirements | Following feedback from several consultation respondents that the capital requirements in the DSS proposed in the Consultation Paper were too high and may present a barrier preventing small entities or new market entrants from participating, the Regulators have reduced the minimum capital requirement for a DSD from at least 9 months of operating expenses to only 6 months. The Regulators may also consider reducing this minimum further in specific cases where a firm can evidence that: (i) they can wind down in quicker than six months; and (ii) key risks are being addressed in line with the DSS requirements. Wind down plans will be reviewed by the Bank to ensure they can be executed in practice with the capital held by DSDs. |
DSD links (bank guarantees and letters of credit) | The Regulators have removed the detailed provisions on the use of bank guarantees and letters of credit to secure DSD links as previously set out in the Draft Rules (based on provisions in Commission Delegated Regulation (EU) 2017/390). Instead, only the high-level provisions in Article 48 of Chapter 2 of the DSS Rules will apply, which in our view is in line with allowing for greater flexibility and a technology-neutral approach. The Regulators consider that this will make the DSS Rules easier to understand for firms. The Bank will maintain the option to use the SAN on a bespoke basis to address any issues. |
3. Other Clarifications
Apart from the substantive changes set out above, most of the Regulators’ responses were merely explanatory, providing updates on points that were left outstanding when the Consultation Paper was published, or implementing non-material changes to the Draft Rules to allow for easier understanding or to remove drafting oversights.
Other clarifications set out in the Policy Statement are summarised below.
Other Clarifications |
General |
Retail activity | For trading venue applicants, the DSS Rules allow for direct retail participation, provided that operators comply with the existing FCA regulatory frameworks (including all applicable provisions of the FCA Handbook). For DSD applicants, the Bank has confirmed that it will consider changing the DSS Rules or individual firm SANs to allow for direct retail access to that DSD on a case by case basis, subject to additional scrutiny and the firm’s ability to demonstrate that incremental risks to non-professional clients and AML/KYC standards have been appropriately addressed in the proposed business model. |
Gate 2 Rules |
Fund tokenisation | Following the Bank’s commitment outlined in the Consultation Paper to further evaluate the appropriate limits on fund tokenisation activities and their potential applications, firms have generally expressed support for the tokenisation of units in money market funds. In the Policy Statement, the Regulators have confirmed that where fund tokenisation activity takes place within the DSS, aggregate limits on such activity in the DSS will not be imposed, in contrast to the other asset classes set out in the Consultation Paper. However, the Regulators will impose firm-specific limits, such that DSDs will only be able to record units of funds up to a certain size (i.e. total assets under management, or “AUM”). These firm-specific limits will apply from Gate 2 and the AUM cap will increase over subsequent stages of the DSS. The firm-specific limits will be published on the Bank’s website alongside each DSD’s SAN, following a consultation by the Bank with the fund management industry in the coming months. |
Supervisory Approach at Gate 2 |
Applications | Firms seeking to become DSDs will be required to self-attest and explain how they expect to comply with and implement the DSS Rules. The Bank has confirmed that its assessments will focus on breaches to firm-specific DSS limits; cyber contagion; and significant asset losses. Any proposal that has retail clients directly participating in a DSD will attract substantive additional scrutiny. |
Roundtables | Upon entering the DSS, the Regulators will hold both periodic and ad-hoc roundtable meetings with firms to discuss legal and policy issues within the DSS. This will include workshop-type discussions on specific parts of the application and assessment process, and clarity on the evolution of DSS Rules. |
Transparency | Each DSD’s SAN will be published on the Bank’s website, and periodic reports will be published detailing the utilisation of capacity within the DSS for different asset classes. The Regulators are open to dialogue with prospective applicants to clarify aspects of DSS regulations or the assessment process where this will support a wide range of applicant types, but firm-specific engagement will focus on assessment, not general application support. |
Ancillary activities | The Regulators clarified that FSMA will be amended to exempt DSDs from FSMA authorisation requirements in respect of any regulated Financial Market Infrastructure (“FMI”) activities (those being the activities traditionally performed by a CSD) or ancillary FMI activities (as defined in the DSS Rules) for which it has approval in its SAN. For clarity, the DSS Rules have been amended to state that firms must apply to vary their SAN where they intend to carry on ancillary FMI activity but do not have the correct permissions in their existing SAN. |
Reporting |
Downstream reporting | The Bank clarified that its role is not to provide market-wide communications in the event of a firm incident in the DSS – instead, platforms will be responsible for informing downstream participants of such. |
Reporting of infringements | The Bank confirmed that the disapplication of various UK Central Securities Depositories Regulations (“UK CSDR”) provisions has not created a regulatory vacuum for reporting mechanisms. However, the Bank agrees that Article 65 (whistleblowing provisions) of the UK CSDR should be reapplied. |
Settlement |
Payments leg settlement assets | In the Consultation Paper, the Bank stated that it will allow for the “use of commercial bank money with little or no credit or liquidity risk, or equivalent private forms of money, to be used as a payment asset within the DSS”. In the Policy Statement, the Bank has clarified the following: - A wholesale central bank digital currency (“CBDC”) may be considered for the settlement of certain transactions once the Bank has finalised its approach and implementation of a GBP CBDC, and extensive consultation will be held before any such transition. No timeline has been given at this stage.
- Apart from a GBP CBDC, wholesale stablecoins and e-money cannot be used for money settlement in the DSS for any currency.
- Despite concerns from respondents, the Bank has confirmed that where a DSD needs to access commercial bank money solutions as a settlement asset, the DSD will need to partner with or use a commercial bank with the appropriate FSMA Part 4A permissions to hold its members’ cash balances and effect payments.
- Additionally, the DSS Rules have been amended to require that where a DSD intends to provide the core settlement service in relation to the payments leg and any other ancillary banking services, it must be authorised under FSMA as a credit institution and have the appropriate permissions to do so.
- To facilitate this, the DSS Rules have been amended such that authorised credit institutions may enter the DSS to carry out ancillary banking activity (either for the DSS section of its own business, or for a third-party DSS) without having to separate their DSD activity from their existing operations.
|
DSD links | Rules on DSD links (Article 48 Chapter 2 of the DSS Rules) are applicable to linking of securities settlement systems rather than trading systems, notwithstanding situations where trading and settlement may be interchangeable. |
Requirements under Chapter 3 of the DSS Rules will now be part of the Gate 2 rules rather than amendments to a technical standard. This will allow the Regulators to amend them as necessary over the course of the DSS. |
Settlement finality | It has been confirmed that adequate protection to participants in any securities settlement system that a DSD operates can include protection by contractual arrangements. |
Interaction With Other Regulatory Frameworks |
FCA rules | The FCA will consult separately on the application of the custody framework to cryptoassets (which could include digital securities). Firms are expected to safeguard and administer digital securities in the DSS in line with the current CASS framework. Questions on bid/ask frameworks, smart contracts, and tokenised proxy voting have also been briefly addressed. |
USRs rules | DSS provisions relating to the Uncertificated Securities Regulations 2001 (“USRs”) interact with the UK CSDR in the same way as outside of the DSS. |
Government Stock Regulations | Consultation comments have been passed on to HM Treasury. |
Sterling Monetary Framework (“SMF”) | Digitally native assets are not currently eligible as collateral within the SMF, but the Bank will continue to monitor market developments. |
Interoperability | The Regulators are currently considering how to deliver interoperability between new and existing ledgers. |
Future Updates |
Prudential treatment of digital assets | Implementation of the Basel standard for the prudential treatment of cryptoasset exposures is to be taken forward by the Prudential Regulation Authority separately from the DSS. |
Digital asset taxonomy | The Regulators are currently considering providing a digital assets taxonomy, but note that it would need to be developed “through building international consensus”. |
Article co-authored by Marelize Abercrombie, Trainee Solicitor at CMS
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