On 21 May 2024, the Bank of England (BoE) published a speech on the UK’s Digital Securities Sandbox, which was delivered by Sasha Mills, Executive Director of Financial Market Infrastructure, at City Week 2024. In the speech, Ms Mills discusses how support for innovation interacts with clear rules and a commitment to financial stability, as well as opening ‘the next frontier for innovation’.

Key points to note from the speech include:

  • Approach to innovation: The regulators’ approach to innovation is a ‘cultural shift’ which requires them to think differently, including looking at the aspects of existing regulation that are inadvertent barriers to the use of new technologies; weighing up in their decision making the incentives for both existing financial market infrastructures (FMIs) and new entrants to invest in the technology; and engaging in constant dialogue with industry to ensure their approach is meeting the objectives of regulators and the industry.
  • Digital Securities Sandbox: The BoE and the Financial Conduct Authority (FCA) are currently consulting on the operation of the Digital Securities Sandbox (DSS) – a new ‘test’ regulatory regime that allows firms to use developing technologies that would otherwise not be permitted (e.g. distributed ledger technology (DLT)) to issue trade and settle securities in a live environment – in order to support that proactive approach. The DSS seeks to support innovation in both digitally native securities and ‘digital twin’ tokenised securities, in a range of regulated asset classes – unregulated assets (e.g. Bitcoin) are not permitted in the DSS. The Sandbox is open to UK-registered firms and lasts for 5 years, and the BoE and FCA’s consultation closes on 29 May 2024 – see our blog for more details.
  • Flexible rules: The DSS has been designed with several stages of permitted activity, and there will be a series of supervisory gates that firms will pass through to progress between stages. Sandbox entrants will follow a ‘glidepath’, where at each stage the amount of permitted activity increases as they meet increased standards and regulatory requirements. This proportionate and gradual approach is intended to mean rules are simpler and less onerous at the outset, tailored to new entrants and start-ups, and the rules will start to ramp up as Sandbox entrants increase their activity. The BoE and FCA will have the flexibility to modify the rules as they learn from the Sandbox, and to react to feedback from innovators.
  • Financial stability: As the use of DLT is untested at scale in the financial system, the risk of market disruption occurring is likely to be higher compared to established practices and technologies. Firms will therefore need to show regulators that their systems can support live activity in the DSS, and if they can pass this test they will be able to operate a ‘Digital Securities Depository’ (DSD) within the DSS. There will be firm-specific limits on activity within the DSS, which will increase as entrants move through the different stages.
  • Other initiatives: The DSS is only one pillar in the BoE’s approach to innovation. For example, it now has a secondary innovation objective which applies to some of its regulatory powers, including ensuring its rules facilitate innovation with a ‘view to improving the quality, efficiency and economy’ of FMIs’ functions. The BoE is also continuing innovative work in other areas, such as its research on the digital pound, continuing formulation of the systemic stablecoin regime, and increased focus on modernising the BoE’s wholesale payments infrastructure (including to support innovation by commercial banks in tokenised deposits).
  • Timeframe: Ms Mills warns that it is likely to take years for market participants to feel the benefits of the new technology in post-trade, as those benefits are likely to be felt only when a critical mass of participants have adopted the new ways of doing things. She also notes that it may happen in some markets ahead of others. However, the BoE believes the DSS can be the catalyst of that change process, allowing the industry and regulators to collectively test whether this is the direction that the industry will pursue in the long term.