Institutions see everything to play for in UK’s DLT sandbox

Some of the UK’s largest financial institutions have welcomed the government’s consultation on establishing a financial market infrastructure “sandbox” for firms experimenting with blockchain technology.

Duncan Moir, senior investment manager in the alternatives team at asset manager abrdn, says the Digital Securities Sandbox (DSS) could be something that “fuels further digital innovation in UK financial services, and the approach to eligibility and risk-based supervision encourages new entrants to the UK market.”

Others say the sandbox—a regime analogous to a play space, in which regulators could temporarily modify and disapply legislation, and thereby remove barriers to firms wishing to experiment with distributed ledger technology—compares favorably with the European Union’s own DLT pilot scheme. This was launched in March by the European Securities and Markets Authority (Esma) and has faced criticism for imposing strict volume caps on the issuance of digital securities and tokens.

In the EU regime, individual issue limits are set at €500 million ($548 million) in terms of market capitalization for shares, €500 million in terms of assets under management for funds and €1 billion ($1.1 billion) in terms of issue size for debt. Over the regime’s intended six-year lifespan, any financial market infrastructure (FMI) listing more than €6 billion ($6.6 billion) on DLT would become subject to the Markets in Financial Instruments Directive and Central Securities Depositories Regulation. If the total reaches €9 billion ($9.9 billion), the FMI must transition out of DLT into conventional infrastructure.

The UK regime could potentially be more favorable [than the EU’s] in terms of flexibility because, for instance, they don’t have limits in the legislation. However, it is important to note that there will be limits and we currently don’t know what those limits are going to be

Nicole Sandler, Barclays

Under the UK’s proposed regime, each DLT use case would be assessed at the authorization stage and no limits would be imposed on securities issuance.

The UK Treasury last month published a consultation on its approach to delivering a DSS lasting up to five years. Bonds, equities, funds and money market instruments—though not crypto or derivatives—are in scope in what would be the first FMI sandbox delivered through the Financial Services and Markets Act 2023. The consultation closes on August 22.

Simon Helm, counsel in law firm Ashurst’s digital assets practice, believes the UK is benefiting from “second-mover advantage.”

“It’s had the opportunity to listen to criticism of the EU DLT pilot and to try to address the concerns of participants,” he says. “One of them is around the limitations on the size of shares, bonds or funds—the units of which can take part in the project.”

The head of technology at a large bank says one positive aspect of the proposed sandbox is “it hasn’t compressed the opportunity into a specific number. There are some limits in the EU that the UK has successfully navigated around. It’s a more flexible model. The UK has listened to feedback from the market on some of the strengths and weaknesses around the EU pilot regime.”

Etay Katz, partner in Ashurst’s digital assets practice, says the lack of volume limits or notional limits is “very encouraging” and could be a “game-changer” for the UK’s proposed scheme.

Some institutions, however, remain cautious. Nicole Sandler, Barclays’ head of digital policy, says, “I agree that the UK regime could potentially be more favorable in terms of flexibility because, for instance, they don’t have limits in the legislation. However, it is important to note that there will be limits and we currently don’t know what those limits are going to be. The Financial Conduct Authority [FCA] and Bank of England will be able to decide what that limit is for each test. That said, we welcome both the collaborative initiatives from the UK and EU.

“If Barclays were to participate in the DSS or EU pilot scheme, it would likely be in a third-party initiative, led by an FMI or vendor, and alongside a group of financial institution participants.”

No limits

Under the UK regime, the Bank of England and FCA would review applications from digital securities depositories (DSDs), multilateral trading facilities (MTFs) and organized trading facilities (OTFs) for sandbox approval notices, also known as ‘visas’.

Ashurst’s Katz points out that the sandbox would allow participants to perform certain central securities depository (CSD) functions without full authorization—a more flexible set of arrangements than those available under the EU pilot. Sandbox participants would not need to be currently authorized CSDs or trading venues, so start-ups could potentially take part.

Gonçalo Lima, capital markets ecosystem lead at blockchain firm R3—which is working with FMIs to develop DLT platforms—says the UK has learned from Esma’s mistakes, that its proposal amounts to a “more competitive and well thought alternative” to the EU pilot scheme, and that it might enable the country “to gain a lot more traction on DLT adoption.”

He adds that UK regulators will be able to approve projects faster than Esma’s national competent authorities and that this will be a “game-changer” in terms of return on investment.

Kevin Gaffney, director for secondary markets policy at UK Finance, which represents the country’s banking and financial services industry, believes the strategy avoids a “cliff edge” at the end of the experimentation period. Gaffney, who is also a former FCA adviser, says this will ensure a “smooth glide path out of the sandbox.”

[Derivatives] would be natural hedges for instruments in scope and therefore allow for a much more comprehensive testing, and maintain the UK’s competitiveness in this space

Gonçalo Lima, R3

Yvonne Deane Harte, principal, capital markets and wholesale policy at UK Finance, says limits will be adjusted “depending on how regulators are satisfied that risk is being managed and that participants are ready to scale.”

An entity designated as a DSD would be subject to a temporarily modified legislative and regulatory framework, with requirements that are proportionate to the risks it is taking. It would also be subject to the remaining unmodified CSD legislation, as either a CSD, DSD or a new category of entity, when it left the sandbox. The UK is not currently intending to create a new category of trading venue, given that the framework for MTFs and OTFs does not need significant amendment to accommodate digital securities.

The head of technology at the large bank believes DLT could create a more distributed and competitive landscape for the safekeeping, transfer, servicing and recording of assets, but that non-FMI banks will need greater certainty around the liabilities and indemnities of the DSD role in comparison with their regular custody function.

Call to action

Market observers say the UK’s proactive approach compares favorably with those of jurisdictions farther afield.

David Easthope, head of fintech, market structure and technology at analytics firm Coalition Greenwich, believes the sandbox “stands in fairly stark contrast with the current climate in the US.”

Greg Schvey, CEO of market infrastructure technology company Axoni, agrees that the DLT regulatory framework has not been as explicitly outlined in the US as it has been in the UK, “though we have seen no-action letters from the Securities and Exchange Commission that function similarly, allowing initial live-testing of DLT securities settlement within limited timeframes and volumes.”

Ben Reeve, partner at Oliver Wyman, which co-wrote UK Finance’s recent report on the potential for securities tokenization, says the evolution of the country’s regulatory framework has the potential to allow tokenized securities to carry out all the functions of traditional securities for the entire lifecycle—including repurchase transactions, posting as collateral and securities lending activity.

UK Finance’s Gaffney believes there are also opportunities in unlocking the fractionalization of illiquid assets through tokenization, “For example, an investor could own a fraction of a private fund.”

R3’s Lima thinks the UK is prepared to be much clearer than the EU when it comes to cash on ledger—something that will be needed for delivery-versus-payment atomic settlement, which involves the instant exchange of two assets such that the transfer of one occurs only upon the transfer of the other. He believes the UK consultation “goes deeper in asking what features participants need for digital cash”.

Yet Lima is also among those who believe the UK’s approach could be improved further. He highlights the fact that the proposed sandbox will not include derivatives, which he believes “would be natural hedges for instruments in scope and therefore allow for a much more comprehensive testing, and maintain the UK’s competitiveness in this space.”

Ashurst’s Helm agrees it would be helpful if hedging arrangements undertaken at the same time as the purchase or sale of a security could be accommodated on the blockchain.

Katz also echoes suggestions by primary market dealers that there may be merit in expanding the scope of instruments under the sandbox to include derivatives used to hedge the currency or interest rate risks faced by issuers, “Upfront hedges can be used to ensure that the issuer receives a more certain rate of return. I think that is probably what the big dealers are gunning for when they say that they wish for derivatives to be entered on DLT, and that is worth considering.”

Editing by Daniel Blackburn