Building a more permanent sandcastle in the FMI sandbox

In April 2022, in the response to its consultation on regulatory approach to, among other things, distributed ledger technology (DLT) in financial markets, HM Treasury (HMT) confirmed that it would develop a financial market infrastructure (FMI) sandbox, to allow new technology to be trialled by FMIs. The recently published Financial Services and Markets Bill provides HMT with broad powers to set up one or more FMI sandboxes.

In this post, we summarise some of the key provisions of the proposals. In short, HMT will have fairly broad powers to set up FMI sandboxes and to waive, modify and amend some of the core pieces of FMI legislation on a temporary basis, as well as making permanent changes post-sandbox. There are some indications in the explanatory note of the sort of provision in mind – Article 3(2) of the Central Securities Depositories Regulation (CSDR) (which requires settlement of securities traded on a trading venue to be recorded in book entry form on a central securities depository (CSD)) and the Companies Act (requiring certain formalities in the recording and registration of shares among other things). But we’re sure that HMT is keen to see which other provisions are potentially hindering innovation. We were also heartened to see that there had been some thought given to life after the sandbox and giving HMT the ability to suggest more permanent changes to the regime.

For other thoughts on the Bill, see our post.

What is an FMI sandbox?

The provisions of the Bill allow HMT to make provision for the purposes of testing, for a limited period, the efficiency or effectiveness of carrying on FMI activities in a particular way and for assessing whether or how particular pieces of legislation should apply. In the Bill, such provision is referred to as an FMI sandbox.

The scope of the FMI sandbox powers in the Bill is intended to be sufficiently flexible to enable different FMI sandboxes to be established in future to test different technologies and practices for different entities and activities.

Who will be able to use an FMI sandbox?

Under the proposals set out in the Bill, HMT would be required to describe who can participate in the FMI sandbox arrangements but seems to have broad powers to suggest who could participate. The Bill mentions existing FMIs (broadly, different types of trading venue and recognised CSDs), but also mentions that the regulations could specify other persons, in particular the users of services provided by FMIs.

Temporary modification of FMI legislation

Part of the purpose of the FMI sandbox is to figure out which legislation might need to be amended to accommodate tokenisation and DLT in FMIs. The Bill gives HMT powers to modify legislation temporarily where a particular legislation does not accommodate or is ambiguous in respect to certain technologies or practices envisaged to be used under an FMI sandbox.

One example identified in the explanatory note to the Bill is in relation to operators of multilateral trading facilities (MTFs) which might look to use their own DLT arrangements to settle tokenised securities traded on their market. At present, a key obstacle to this is in Article 3(2) of the CSDR, which requires transferable securities traded on a UK trading venue to be ‘recorded in book entry form in a CSD or third-country CSD’. HMT acknowledges that this means that an operator of an MTF is prevented from being able to use its own settlement arrangements to settle transactions on its market.

Section 17(3) of the Bill lists the legislation that is expected to be in scope of HMT’s powers of amendment. This comprises primary legislation (Companies Act 2006, FSMA 2000), secondary legislation (the Settlement Finality Regulations, the Uncertificated Securities Regulations, the Financial Collateral Arrangements (No. 2) Regulations) and retained EU legislation (the Market Abuse Regulation, the Markets in Financial Instruments Regulation, CSDR). HMT also has the power to make regulations to add to the list of such ‘relevant enactments’, although such regulations must go through the UK’s parliamentary process.

Post-sandbox

For each FMI sandbox, the regulators will provide information and assistance to enable HMT to produce a report assessing whether technology and practices tested in the sandbox had been successful. The performance of an FMI sandbox will be reported to Parliament and, if deemed successful, HMT may make permanent legislative changes, via statutory instrument (subject to the affirmative procedure), to enable FMIs to use that new technology or new practices outside of an FMI sandbox.