In this opinion piece, Marcus van Abbé, Head of Digital Market Infrastructures at enterprise blockchain firm R3, compares the EU’s DLT Pilot Regime to the UK’s Digital Securities Sandbox.
Both the UK and the EU have emerged as fintech powerhouses over the past few years. London, Paris and Berlin all frequently appear on lists of the world’s top ten fintech hubs, each contributing several billion dollars to their respective economies and sitting right at the forefront of innovation.
This has stoked competition, with governments and regulatory bodies in both regions looking to inch ahead in the race to a financial services revamp. To this end, the EU’s digital finance package and the UK’s Financial Services and Markets Act (FSMA), their respective landmark digital finance guidelines, both set out proposals to utilise distributed ledger technology sandboxes to enable enduring financial services innovation.
The EU made the first move, with the EU DLT Pilot Regime, launched on 23rd March 2023. The UK then followed suit, launching its very own Digital Securities Sandbox (DSS) on 8th January 2024. Both sandboxes are instrumental in the development of their guidelines, allowing Financial Market Institutions (FMIs) and other financial institutions to explore DLT in a regulated framework by temporarily modifying legislation.
For the industry to truly realise why DLT is a critical piece of the puzzle when looking to unlock the full potential of tokenization and digital assets, we must invest time into understanding the potential impacts and advantages of the EU DLT Pilot Regime and the DSS in their respective markets.
Who can participate?
First, it’s important to take note of the set rules regarding participation, as these can potentially limit the use cases being explored in each sandbox. The FSMA enables far broader institutional participation in the DSS than the DLT Pilot Regime allows. The EU DLT Pilot Regime is open to use by multilateral trading facilities (MTFs) and central securities depositories (CSDs). The DSS is available for UK-based MTFs and CSDs but is also open to technology companies – allowing for a wider range of use cases and collaboration between incumbents and cutting-edge new entrants.
The Pilot Regime does, however, allow direct access for retail investors. Generally, regulated exchanges don’t allow access to retail participants, however if ESMA grants permission, the pilot regime waives this, on the condition that the exchange or settlement system offers compensation if something goes wrong.
There are some limitations. Retail investors are expected to have a sufficient level of trading ability, competence and experience – including a working knowledge of DLT. Users also cannot act as a market maker or engage in algorithmic trading.
The HM Treasury currently does not permit retail access to the DSS, however in its consultation response back in November, it stated that retail participation is not ruled out and that future sandboxes may look at more novel retail focused solutions.
In terms of participation, the DSS has the edge on the DLT Regime. Whilst the Pilot Regime allows for retail access, it actually accounts for a very small number of users. Instead, the DSS’s inclusion of technology companies allows for greater collaboration between FMIs and new cutting-edge firms, fostering a more innovative environment.
What use cases are being explored?
The use cases for each sandbox differ significantly. The EU Pilot addresses barriers to adoption within MiFID II and Central Securities Depositories Regulation (CSDR). This is done by offering some exemptions to these regulations, enabling firms to test and experiment with DLT specific to use cases that fall under these legislations.
This is where the DSS has another edge. Unlike the EU DLT Pilot Regime, the DSS goes further than just disapplication, by allowing for the modification of legislation or even the application of specific legislation in certain scenarios.
Crucially, the DSS enables the modification, amendment and creation of rules by the Bank of England and FCA, creating the opportunity for the design and implementation of a bespoke regulatory framework. As a result, the conclusion of the DSS may result in a more targeted regulatory framework for a wider range of use cases.
Which technologies are being used?
A key point where the DSS and EU DLT Pilot Regime differ is hinted at in their names. The EU DLT Pilot Regime solely focuses on promoting the use of DLT, whereas the DSS promotes the use of ‘developing technologies’ which includes, but is not limited to, DLT.
The Pilot Regime allows market infrastructures to use either permissioned or permissionless blockchains for the issuance and trading of tokenized bonds, stocks and funds – including money market funds.
Similarly, the DSS allows for digital representations of debt and equity securities, and money market instruments. Derivatives are deliberately excluded, as no derivatives-specific legislation is modified under the regulations. The DSS however does not currently allow the use of permissionless blockchains, as it is difficult for permissionless systems to comply with current legislation. This makes private and permissioned blockchains more important in the exploration of innovative use cases, that will further the UK’s position as a leader in the tokenization and digital asset space.
The DSS once again trumps the Pilot Regime in this respect, as it promotes the use of more than just DLT.
Staying ahead of the curve
It is clear an increasing number of banks and financial institutions will turn to pilot programmes and regulatory sandboxes as this technology matures and industry adoption grows. Both the DSS and the Pilot Regime are hugely promising first steps in the introduction of industry wide DLT applications for the trading and settlement of securities.
The DSS may offer a more sophisticated framework in the enablement of innovation, providing a broader scope of technologies and regulatory flexibility. It seems it may also allow the participation of a wider range of infrastructures and companies than its European counterpart.
The DSS may benefit from a ‘fast follower’ approach, learning from ESMA’s market implementation however the consultations have proven to be invaluable. Allowing European NCAs to find a best path forward for their market participants and build on ESMA’s work.
Through continued dedication to smart frameworks and consistent collaboration, the industry can leverage tokenization and DLT to reach the ultimate end goal for financial markets – participants building innovative products to progress markets via the secure, seamless and streamlined management of their assets across different networks.
