Promising tool: the UK’s new DSS

December 2023 | FEATURE | CAPITAL MARKETS

Financier Worldwide Magazine

December 2023 Issue

Technological innovation is reshaping the way financial markets operate. Multiple new forms of digital securities – which are digital representations of ownership of an underlying asset supported by blockchain and distributed ledger technology (DLT) – create opportunities and challenges for participants.

In terms of challenges, the digital assets space has experienced significant turmoil over the past few years. With their safekeeping more important than ever, hacks, thefts and lost passwords have become commonplace and an increasing threat.

So, what is being done to help companies protect their digital assets? One initiative, proposed by His Majesty’s Treasury (HMT) in July 2023, is to establish a financial markets infrastructure (FMI) sandbox, or Digital Securities Sandbox (DSS).

The DSS is to be delivered under the powers granted as part of the Financial Services and Markets Act 2023, empowering HMT to set up individual FMI sandboxes that are designed to enhance understanding of the use cases for emerging digital asset technologies, including DLT.

According to HMT, the DSS will facilitate the testing and adoption of digital securities across financial markets. Through the DSS, industry will be able to set up financial market infrastructures that utilise digital asset technology, which can perform a number of activities in relation to digital securities under a temporarily modified legislative and regulatory framework.

“In our July 2023 ‘Unlocking the power of securities tokenisation’ report, written in conjunction with Oliver Wyman, we set out a roadmap for industry and government on how the UK could have a leading digital market,” states Yvonne Deane Harte, principal for capital markets policy at UK Finance. “We called for the urgent roll out of the first FMI sandbox for the use cases identified as most pressing, to be ambitious in the design of the sandbox so that it could be used as a tool to help coalesce industry standards, and to ensure that there were no cliff-edges for participants when the sandbox ends.”

Building digital markets

As a means of testing and exploring the potential offered by digital securities in financial markets, the DSS is considered by many to be the missing piece of the puzzle – a promising tool toward accelerating innovation and showcasing the UK’s strengths as a leader in the transformation of the digital assets space.

“As a means of testing and exploring the potential offered by digital securities in financial markets, the DSS is considered by many to be the missing piece of the puzzle.”

In summary, the DSS has been designed to allow the industry to: (i) establish and operate FMIs using digital asset technology; and (ii) perform the activities of central securities depositories and trading venues in relation to existing security classes, which are expected to include a subset of regulated financial instruments that may be digitally native issuances such as digital bonds and equities or digital representations of existing securities, including digital versions of money market instruments.

“The DSS will enable participating firms to test and adopt new technologies and practices,” affirms Ms Harte. “Regulatory sandboxes are a tool within regulation that allow businesses to test and experiment with new and innovative products, services or businesses under supervision of a regulator for a limited period of time.”

To run in parallel with the DSS, HMT has also announced that a cross-industry body will be created to maximise the opportunities presented by the sandbox, enable wider market coordination on the adoption of digital technology, and ensure that HMT benefits from the views of stakeholders across the market, including investors, wholesale banks, FMIs, issuers, the legal community and custodians.

“Run well, the DSS will be a great tool for partnership between government and industry to identify how laws and regulations need to evolve, and what other digital market infrastructure is required, as the trading of digital securities becomes the norm in our capital markets,” adds Ms Harte. “We also praise the work HMT has undertaken to ensure that this DSS distinguishes itself from the European DLT pilot scheme.”

Digital gilt

With the deadline for consultation feedback having passed on 22 August 2023 (HMT acknowledges that proposals and expressions of interest will still be welcome after that date), the DSS statutory instrument is expected to be laid before the UK parliament late in 2023.

Concurrently, the Bank of England and the Financial Conduct Authority (FCA) are working to publish further guidance, consult on rule changes and set out the application process.

“We firmly support the principle expressed by HMT in its consultation paper that digital securities should be treated in the same way as conventional securities as far as possible,” notes Ms Harte. “We agree that flexibility in relation to the payment leg of digital securities is imperative, as some of the key benefits of DLT-based systems may only be realised through on-chain payment solutions.”

Moreover, the association wants to see sufficient resources devoted to the DSS to ensure its continued success. “We call on HMT, the FCA and the Bank of England to support the DSS by issuing a digital gilt,” she concludes. “This would raise the profile of the DSS, demonstrate HMT’s confidence in the technology involved, and encourage wider adoption and experimentation.”

Fraser Tennant