Background

On 30 September 2024, the Bank and the FCA announced that the DSS is now open for application, and the link to the online application process can be found on the FCA’s website.

What is the DSS?

The DSS provides a regulated environment for firms, in particular financial market infrastructures (“FMIs”), to use developing technology, such as distributed ledger technology (DLT), in the issuance, trading and settlement of transferable securities such as shares and bonds. It is the first FMI sandbox created under the powers conferred on HM Treasury by the Financial Services and Markets Act (FSMA) 2023. Please see our previous Engage article covering the Financial Services and Markets Act 2023 (Digital Securities Sandbox) Regulations 2023 (the “DSS Regulations”), which established the DSS and entered into force on 8 January 2024.

The Bank and the FCA have also issued a Policy Statement (PS24/12) regarding their approach to adopting new technologies in the operation of financial market infrastructures. The Policy Statement is published in response to the Consultation on the implementation and operation of the DSS, which ran from 3 April to 29 May 2024. The Consultation set out the “Glidepath” design of the DSS, whereby the structure of the DSS consists of a series of “gates” allowing sandbox entrants to progress through the various stages of the DSS, and to eventually graduate from the DSS under a new permanent regime—please see our previous Engage article for a more detailed overview.

Alongside the Policy Statement, the Bank and the FCA have further published:

• guidance (“DSS Guidance”) for firms intending to operate, or who are currently operating, in the DSS – a draft of the guidance documentation was previously included as Appendix A of the Consultation;
• the joint FCA and Bank application form for Gate 1 (i.e. for entry into the DSS);
• the Bank’s draft Gate 2 application form for firms seeking to be approved as Digital Securities Depositories (“DSDs”); and
• the set of rules that will apply to DSDs after passing Gate 2 at the “Go-live” stage of the DSS (“Bank DSS Rules Instrument 2024”)—a draft version of the Gate 2 rules were previously included in Appendix B of the Consultation.

Key Takeaways

Following feedback received to the consultation earlier this year,  the Bank and the FCA  have made some targeted changes to the DSS, although the final approach is largely consistent with the proposed approach.

In summary, key changes to the proposed policy and points of note include the following:

• Scope of the DSS extended to include non-GBP denominated assets: It was originally proposed in the Consultation that the DSS would be limited to GBP-denominated assets and settlement would take place in GBP. Noting that, among other reasons, such an approach is at odds with the current supervisory framework for traditional CSDs where FMIs in the UK and the EU are permitted to settle the cash leg of their securities transactions in multiple currencies and that imposing currency restrictions is inconsistent with how UK companies operate in practice, the scope of the DSS has now been extended to include non-GBP denominated assets.
• End-state rules: The Policy Statement notes that it is the intention of the Bank, the FCA and HM Treasury to create a new permanent regime (if appropriate) for settlement based on learnings derived from the DSS. To that end, the Consultation included draft “end-state rules”, to help firms anticipate what the requirements are likely to be under a possible new permanent regime. The Policy Statement notes that the decision was made not to publish a revised version of the draft end-state rules at this stage, given that one of the main aims of the DSS is to test how existing legislation may need to change to accommodate digital asset technology.  Instead, the Bank is committed to reviewing the draft end-state rules over the course of the DSS and to engage with industry participants accordingly. The Bank anticipates that it will publish revised end-state rules once the DSS has been running for at least 15 months.
• Settlement and approach to innovation in money and payments: Although the Bank recognises that it has not yet finalised its future vision for the provision of central bank money settlement in GBP, it notes that frameworks are still developing and the Policy Statement and refers to the Bank’s recent discussion paper on its approach to innovation in money and payments—see our previous Engage article for more information on this discussion paper—and reiterates the Bank’s view that there are significant financial stability risks around wholesale use of new private forms of money. Accordingly it confirms that, currently, the Bank will not allow stablecoins or e-money to be used for money settlement in the DSS.
• Limits in the DSS: The Consultation proposed overall capacity limits for established key sterling asset classes (e.g. gilts, corporate bonds, asset-backed securities, money market instruments and FTSE 350 equities). The Bank will have the ability to allocate and manage individual, firm-specific limits within the overall capacity limit. Respondents to the Consultation expressed concern that that limits for the Go-live stage lack flexibility or are too low.  Accordingly, the Policy Statement notes that the Bank will introduce a mechanism to allow the Bank to grant uplifts to limits for those that have passed Gate 2 into the Go-live stage, should a DSD reach their initial Gate 2 limit before application windows for Gate 3 have opened.
• Gate 3 progress review: The Consultation proposed two review points in the DSS for DSDs at the Go-live stage, whereby firms may demonstrate that they meet Gate 3 requirements in order to progress to the Scaling stage (at which point they would be allocated an uplift in the relevant limits). In response to feedback that having two fixed review points may slow the progress of firms through the DSS (i.e. the first available Gate 3 review window would be 12–15 months after the first Gate 2 assessments, approximately 15–18 months after the DSS launch), the Bank has introduced a third optional review point which will take place approximately midway between the two proposed dates. The Bank further noted that the timings of the review points should only be seen as indicative at this stage, as such timings will be guided in part by firm readiness and the speed at which firms scale in the DSS.
• Gate 2 rules – DSD links: A sandbox entrant is approved by the Bank as a DSD after passing Gate 2, at which point a DSD be subject to the Gate 2 requirements, and not the full set of requirements in the unmodified UK Central Securities Depositories Regulation (“UK CSDR”), nor the full end-state Bank rules. The Gate 2 rules include provisions around DSD links (as defined in detail in the Bank DSS Rules Instrument 2024—broadly, these refer to arrangements between DSDs or DSDs and CSDs, such as arrangements for facilitating the transfer of securities between the entities where a DSD is a participant in the securities settlement system of another DSD, or arrangements where a DSD accesses another DSD indirectly via an intermediary). In response to feedback to the Consultation, the final draft of the Gate 2 rules replaces detailed provisions on the use of bank guarantees and letters of credit used to secure DSD links that were based on provisions in Commission Delegated Regulation (EU) 2017/390 with more high level provisions based on article 48 of UK CSDR.
• Gate 2 rules—settlement finality: Under the proposed approach in the Consultation, DSDs would not be required to obtain designation under the Settlement Finality Regulations (SFRs) during the course of the DSS. While respondents agreed with this in principle, clarity was needed regarding what protection to participants in Article 39 of Chapter 2 of the Bank DSS Rules Instrument 2024 meant in this context, on the basis that without a settlement finality designation, DSDs would have to rely on contractual provisions. The Policy Statement confirms that ‘protection to participants’ refers to contractual protections and/or rulebook provisions or similar that determine when a transaction is final, and Article 39.1 has been updated accordingly to state that “a DSD must ensure that any Securities Settlement System it operates offers adequate protection to participants, including by contractual arrangements”.
• Interaction with the Critical Third Parties regime (the “CTP Regime”): In response to a query on whether a DSD may be considered a CTP—see our previous overview of the CTP Regime—the Policy Statement confirms that it is unlikely a DSD would be designated a CTP. This is on the basis that DSDs would already be regulated under a regime intended to deliver similar outcomes to the CTP regime.
• Minimum capital requirements: In the Consultation, the Bank proposed that firms at the Gate 2 stage may use their own approaches to calculating the minimum level of capital to cover going concern risks and the cost of winding down, and the minimum capital level floor is set at the equivalent to nine (9) months of operating expenses. In response to Consultation feedback, the Bank has reduced the minimum capital requirement for a DSD to six (6) months of operating expenses. Accordingly, the Bank will also be reviewing wind down plans to ensure that wind down plans can be executed in practice with the capital held by DSDs, such that the lower capital requirement does not materially increase risks.
• Whistleblowing provisions: In response to feedback around the absence of whistleblowing provisions in the Bank DSS Rules Instrument 2024 and the DSS Regulations (more specifically, by disapplying and not replicating article 65 of the UK CSDR), the Policy Statement confirms that the Bank agrees with such comments and that the matter has been referred on to HM Treasury.
• Scope of instruments: Whilst the Bank has confirmed that derivatives are out of scope of the DSS, it notes that exchange traded derivatives and warrants could be in scope if they are transferable securities.

Next steps and timings for the DSS

The DSS is currently expected to be operational until December 2028, with the application window for new participants closing around March 2027—although this timing may be extended by HM Treasury—to allow regulators and firms participating in the DSS to prepare for a potential new permanent regime. Additional resources such as operational information, the DSS Rules and firm Sandbox Approval Notices (SANs) will be made available via the DSS Dashboard on the Bank’s website. We will continue to follow key developments on the DSS such as the further draft rules (i.e. draft Gate 3 rules, and a revised draft version of the end-state rules) which, as mentioned above, are expected to be published after the DSS has been operational for at least 15 months.

For more information, feel free to get in touch with a member of the team and visit our Hogan Lovells Digital Assets and Blockchain Hub.

This article is for guidance only and is a non-exhaustive summary only of certain aspects of the points discussed and should not be relied on as legal advice in relation to a particular transaction or situation. 

Please contact your normal contact at Hogan Lovells if you require assistance or advice in connection with any of the above. 

Authored by Christina Wu and Isobel Wright.