April 15, 2024

The Financial Services and Markets Act 2023 (Digital Securities Sandbox) Regulations 2023 came into force on 8 January, creating the UK’s first digital securities sandbox, within which firms will be able to test new technologies under the revised legislative framework.

The development follows a consultation ending in August 2023, which set out HM Treasury’s proposed approach to delivering the sandbox. At the heart of the rules is the UK’s desire to modernize its financial market infrastructure through digital asset technology.

In fact, in an explanatory memorandum to the rules, HM Treasury specifically mentioned distributed ledger technology or DLT as a potential innovation that could be incorporated into central securities depositories and trading venue activities.

Nevertheless, the memorandum expressed caution on the grounds that new technology could compromise overall market efficiency and stability.

In our view, the sandbox is an important way forward. The UK legal framework was not designed with new technologies like DLT in mind. Nevertheless, it is important that existing legal or regulatory gaps do not create inertia in the development of the UK technology landscape.

Accordingly, in this article we will take a look at the application of sandbox in DLT as well as further considerations regarding its implementation.

DLT in financial market infrastructure

Overview of DLT

At its core, DLT uses a digital ledger that is collectively updated and maintained by a network of computers. Proposed entries on the ledger are checked and verified collectively by the network.

If the proposed entry is accepted, a network update is pushed, such that every copy of the digital ledger is updated simultaneously.

DLT is unique because there is no central authority to oversee or administer the process. Given their decentralized design, distributed ledgers can provide greater security, immutability, and efficiency than traditional ledgers.


Incorporating DLT into the operation of a central securities depository or trading venue would be transformative. A trading and settlement platform built on DLT could deal with the issues associated with intermediate shareholding structure.[1]

In this regard, the technology can enable investors to become direct owners of their investments bypassing intermediaries, thereby improving transparency and the ability for shareholders to exercise their rights without the need for CREST, which That is the central securities depository for the markets. For UK and Irish stock subscriptions.

More broadly, DLT could bring new functionality, including round-the-clock operations and instantaneous, or “T+0,” settlements.[2]

The technology can also be used to generate fundamentally different configurations in the provision of shareholding, trading and settlement services that have not yet been imagined. DLT will also enable platforms to streamline and automate regulatory reporting.

This stems from the fact that data is taken directly from the ledger rather than through a series of separate reporting systems, meaning greater data consistency, less reconciliation, and lower compliance costs overall.

Opening the door to DLT

Despite the advantages of using DLT, the UK legal and regulatory framework presents a number of issues that may need to be addressed.

Companies Act 2006

Various provisions of the Companies Act 2006 will need to be updated to accommodate trading, settlement and maintenance of shares using DLT:

  • Registration of transfers – Section 770: The concept of an instrument of transfer may need to be clarified to ensure that transfers using DLT can be treated as a proper instrument of transfer;
  • Securities – Section 783: Reference to securities should be expanded to include issuance, trading, settlement or maintenance using DLT; And
  • Company Records – Section 1134: The provisions relating to company records will also need to be amended so that records kept by a company include records stored in a distributed ledger.

Central Securities Depository Regulation

Brought into UK law by the European Union (Withdrawals) Act 2018, the Central Securities Depository Regulation regulates the operation of central securities depositories as well as the settlement of financial instruments in the UK.[3]

However, several modifications would need to be made to allow the use of DLT:

  • Recording of transactions – Article 3: Provisions need to be updated to accommodate the recording of transactions using DLT;
  • Integrity and reconciliation – Article 37: The text refers to the use of reconciliation measures to ensure that the number of securities issued at the central securities depository aligns with the number of securities held by recipients. However, the resolution measures referred to only include traditional records of issuance, not collective records created using DLTs; And
  • Settlement – ​​Article 40: Processes involving digital or tokenized forms of payment using DLT are not explicitly recognized.

Uncertified Securities Regulations 2001

Uncertified securities regulations allow ownership in securities to be validly certified and transferred without written documentation. As a result, the rules omit some of the formalities under the Property Act 1925 that are normally required in the disposal or assignment of property.

The various issues include:

  • Objective – Regulation 2(1): There is no express language enabling transfer of securities from the distributed ledger; And
  • Rectification – Regulation 25: The process of rectifying the issuer’s securities register does not explicitly cover securities issued using DLT.

sandbox modification

In light of the existing framework, HM Treasury intends the sandbox to facilitate the testing of new technologies, including DLT, by creating an environment subject to applicable, unfettered and amended law.

For example, the recording of transactions in book-entry form under Article 3 of the Central Securities Depository Regulations has now been amended to include any type of recording using developing technology. The full set of amendments is set out in a Schedule to the Regulations and includes some of the provisions previously identified.

Firms must apply as a so-called sandbox entrant and be accepted into the sandbox in order to execute activities within the scope. Only UK-established entities that meet the eligibility criteria in paragraph 3 of the Rules may participate.

activities in the workplace

HM Treasury said in the memorandum that any legislative amendments would focus primarily on the following activities:

  • Notarization: Recording of the security in the settlement system;
  • Settlement: Delivery of securities from one party to another;
  • Maintenance: operation of securities accounts; And
  • Trade: Operation of multilateral trading facilities or organized trading facilities.

The first three activities are the activities of central securities depositories, while the fourth activity relates to the operation of a trading venue.

We consider amendments to these activities important to facilitate the use of DLT in financial markets. For example, the sandbox will allow participants to do all four activities within a single unit.

Existing law requires trading venues to separately engage a central securities depository to notarize, settle and maintain transactions on their platforms. Allowing a single entity to conduct all four activities with the help of DLT will certainly help realize the full potential of the technology.

Nevertheless, the sandbox allows non-sandbox activities to take place, subject to current legal and regulatory requirements. Again, we see that this enables firms inside the sandbox to integrate with the broader financial market by allowing them to perform different activities across the value chain.

property in scope

The sandbox allows digital representation of select financial instruments, including debt and equity securities, money market instruments and collective investment undertakings in transferable securities.

Derivatives are excluded in the sense that no derivatives-specific laws are modified under the regulations. Clearly, the drafting of the regulations is broad and aims to cover a wide variety of devices.

A key principle of the sandbox is that digital securities issued, traded or settled within the sandbox, including DLTs, will be treated the same as their traditional counterparts from a legal and regulatory perspective.

Similar to allowing both sandbox and nonsandbox activities, this principle enables companies inside the sandbox to integrate with the broader financial market, as digital securities can be dealt in all markets.

further thoughts

Despite the flexibility of the sandbox, there are several considerations in its operation.

Governance of DLT

The memorandum did not clarify whether the use of DLT in sandboxes would need to operate on a permission basis, where access is limited to authorized entities.

Certainly, permissioned ledgers that retain the ability to monitor or override transactions will be easier to regulate than a traditional approach. This, of course, addresses the problem of permissionless ledgers, adding opportunities for arbitrage, self-custody, and new models of governance.

The drafting of the sandbox is technology-neutral, presumably in keeping with the government’s broader objective of advancing the UK technology landscape. However, further guidance or amendments may be needed to ensure that different permutations of DLTs can legitimately exist under current law.

international adoption

The technologies inside the sandbox will ideally be developed in line with international standards. This ensures a high level of compatibility and, in turn, ensures the adoption and integration of DLT into the financial market infrastructure.

Accordingly, international cooperation, perhaps secured through industry and government initiatives, will be needed to develop cross-border systems and harmonize legal or regulatory approaches, given that some jurisdictions restrict transactions conducted using DLTs. Cannot even be recognized.

Selection of governing law

Establishing a governing law for assets on a distributed ledger is challenging, because DLT allows cross-border operations by design.

As mentioned, entries and transactions on the distributed ledger are collectively determined by nodes, some of which may be located overseas, such that the need for a sandbox could make it possible for a UK-based entity to control the system. Can’t happen.

Currently, there is no specific requirement to designate English law as the governing law in the sandbox, although it will be interesting to see how participating companies operate in practice.

next steps

Sandboxes will be a key driver of implementing DLT into financial market infrastructure. As part of its mandate, HM Treasury will have the authority to report the results of the sandbox to Parliament and explain whether any permanent changes to the law are needed.

HM Treasury is also permitted to create additional sandboxes under the rules, each with different configurations.

Accordingly, we see these strengths as opening the door to further innovations, for example, using DLT to achieve the share dematerialization recommendations presented by the Digitization Taskforce in its interim report.

Ultimately, the sandbox allows firms and regulators to test new technologies in a controlled manner and is an acknowledgment that changing the UK legal framework is an ongoing process. We welcome this latest development.

The sandbox will be open for a period of five years until January 8, 2029 and will be operated by the Financial Conduct Authority and the Bank of England.

[View source.]

Source: www.jdsupra.com

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