New regulatory powers Financial market infrastructure: regulatory sandboxes
The Act enables HM Treasury to set up one or more Financial Market Infrastructure (FMI) sandboxes, which will enable participating firms to test and adopt new technologies and practices. An FMI sandbox will do this by enabling participating firms to be subject to temporary modifications to legislation, where that legislation does not currently accommodate such activities or is ambiguous as to whether or not it can be accommodated. HM Treasury will also be able to make permanent changes to legislation, via statutory instrument (subject to the affirmative procedure where primary legislation is being changed), on the basis of what is learned in each FMI sandbox, having first reported back to Parliament.
	FMI play a crucial role at the center of financial markets, providing the platforms, networks and processes that facilitate the trading, clearing, settling, reporting and administration of securities transactions. A number of FMI are considered systemically important, meaning their failure could lead to financial instability and/or disrupt the effective functioning of the market, with subsequent negative impacts on the real economy (for example, if a transaction fails to settle in time, this can add cost and inconvenience to both financial and real economy participants). It is therefore crucial that there is a robust, regulatory framework that ensures risks are properly managed, but that is also able to be flexible in the face of technological change.
	At the same time, it is important that FMI can innovate and adopt new technologies or practices, which could enable both FMI and the firms which use them to reduce their operating costs and perform in new and more efficient ways. It could also improve the resilience of FMI, to the benefit of financial stability. Effective competition and innovation can enable more agile companies to better meet customer needs and challenge incumbents by providing improved services.
	A particular example of a new technology is Distributed Ledger Technology (DLT), which is a form of database technology that digitally records transactions across multipleledgers at the same time. The data on these ledgers is replicated simultaneously or in rapid succession, shared and synchronised to achieve a form of decentralised consensus across the network. The ledger is an immutable record of all the transactions that have taken place within the network previously and is therefore capable of providing a high degree of certainty in transactional data, which is a key legal requirement of FMI.
	Technology, such as DLT, could potentially provide greater efficiency, transparency and overall resilience in the performance of FMI. It could fundamentally change the role of intermediaries operating within the securities trading, clearing, and settlement cycle, for instance, particularly if activities currently performed by separate FMI can all be performed on the same ledger.
	This may not always have desirable policy outcomes, given that intermediaries provide useful checks and balances that protect investors, maintain regulatory compliance and preserve the resilience of FMI. The benefits and suitability of DLT in financial markets has not yet been proven, particularly when compared to more conventional IT systems. The role of FMI will need to evolve with new technology, like DLT, to safeguard the benefits of the current system, while also ensuring that the potential benefits of innovation are captured.
	It is not always clear what legislative changes will most effectively support FMI in their safe use of new and developing technologies or practices. In 2021, HM Treasury conducted a Call for Evidence to examine the application of DLT to FMI. A key issue identified in responses to the Call for Evidence was that the UK legislative framework is not designed to support the use of DLT in FMI, and that an-evaluation of the legislative framework would be needed to enable the use of DLT and to realise its potential benefits while ensuring regulatory objectives around their safety and robustness are met. While responses identified many areas of legislation that may need changing in future, it is not fully clear what legislative and regulatory changes are needed and how these should be made. Responses to the Call for Evidence identified a need to experiment with the use of DLT in markets, so that HM Treasury, regulators, and industry can better understand the impacts of emerging technologies, like DLT, to ensure that regulatory objectives are met, and in particular to understand what changes should be made to the FMI legislative framework to support the effective and safe adoption of DLT.
	The use of sandboxes was highlighted as a key method of doing this. The term "sandbox" has been applied in different ways, both in and outside of financial services. Broadly, it is a term used to refer to a safe space in which to experiment and learn, and in some circumstances test new technology. In 2016, the FCA launched its "Regulatory sandbox", which allows businesses to test new technologies and products in financial markets, in a controlled manner and with close regulatory oversight, within existing legislative frameworks. In addition to helping firms navigate the authorisations process, the FCA provides firms in the sandbox with informal steers to help them understand the potential regulatory implications of their business model.
	After the Call for Evidence, the government committed in April 2021 that HM Treasury in conjunction with the Bank of England (the Bank) and the FCA would develop an FMI sandbox to allow technology to be trialed by FMI. These measures are intended to allow FMI to test whether and how they can use new technology or new practices to perform specific activities and to test its compatibility within the existing legislative framework in an effective, efficient, and safe way.
	The Act provides HM Treasury with powers to set up an FMI sandbox for the purposes of testing the carrying on of FMI activities with new technology or practices. FMI entities (i.e., the type of entity allowed to participate in an FMI sandbox) include, for example, existing recognised CSDs, and operators of multilateral trading facilities (MTFs), though it could include other categories of FMI in future. The scope of the FMI sandbox powers 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.
	HM Treasury will be able to temporarily disapply or modify relevant legislation relating to the regulation of FMI (defined as ‘relevant enactments’ in the Act) and to allow FMI entities to innovate, within the scope of the activities they have been authorised to carry out, in an FMI sandbox. The full list of legislation in scope, which can be amended, is included on the face of the Act in section 17(3), and includes retained EU law before it is revoked. This includes:
elements of retained EU law, such as the UK Central Securities Depositories Regulation 2014 (CSDR), the Markets Abuse Regulation 2016 (MAR) and the UK Markets in Financial Instruments Regulation 2014 (UK MiFIR);
legislation implementing UK law, such as the Settlement Finality Regulations 1999 (SFRs); and
other UK legislation, such as the FSMA 2000 and the Uncertificated Securities Regulations 2001 (USRs).
	HM Treasury will have the ability to add to the legislation in scope of the FMI sandbox using secondary legislation. HM Treasury intends to consult industry on the proposed temporary modifications to legislation which would be tested in the FMI sandbox. FMI entities will be required to apply to the regulators in order to participate in the FMI sandbox, and a limited number of FMI entities would be selected to participate. An FMI sandbox will be created by a statutory instrument, and a full impact assessment will be provided as and when that occurs. It is intended that each statutory instrument will set out:
The relevant legislation to be modified or disapplied.
The activities that FMI are permitted to undertake in an individual FMI sandbox. For example, HM Treasury may choose to include securities issuance, settlement and maintenance in scope of an FMI sandbox, activities currently performed by CSDs. Temporary modifications to legislation could enable participants of an FMI sandbox to perform these activities using DLT. HM Treasury could also allow certain activities that are currently performed by separate FMI to be combined into one entity within an FMI sandbox. For instance, an FMI sandbox could potentially allow a trading venue to perform securities issuance, settlement and maintenance (in addition to trading), while under current legislation these activities may only be performed by a CSD.
Requirements and restrictions for participants in an FMI sandbox. This could include the types of securities that FMI participants will be allowed to issue/trade/settle, and in what quantities.
The role of the regulators in running an FMI sandbox and what enforcement powers they will have.
The duration of an FMI sandbox. The powers enable HM Treasury to set the desired timeline in secondary legislation. HM Treasury will have the power to terminate an FMI sandbox sooner at its discretion and ensure there is a smooth transition for participating firms between being subject to the temporary modifications to relevant enactments within an FMI sandbox and provisions adopted permanently outside an FMI sandbox in general legislation.
What processes participants in an FMI sandbox will have to put in place to either wind-down its activities by the end of a sandbox or what process they will need to put in place to continue their activities outside an FMI sandbox on a permanent basis, to the extent that they are authorised to do so.
	Aside from where legislation has been modified or disapplied to accommodate new technology and new practices, participants in an FMI sandbox would otherwise be required to comply with all other existing, relevant legislation and regulator rules that apply to the activity they are undertaking.
	For each FMI sandbox, the regulators will provide information and assistance to enable HM Treasury 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, HM Treasury may make permanent legislative changes in general law, via statutory instrument subject to the affirmative procedure, to enable FMI to use that new technology or new practices outside of an FMI sandbox. HM Treasury may consider whether further consultation is needed with industry when making legislation permanent. It is possible that permanent legislative changes may be broader or vary from the modified legislation within an FMI sandbox, subject to the technology or practices being tested and assessed as intended.
	HM Treasury will be able to ensure that transitional arrangements are in place which would allow successful FMI participants, with appropriate authorisation, to transition from an FMI sandbox to providing the same or similar authorised services outside of the FMI sandbox as part of the permanent FMI regulatory framework under general law. This will provide continuity and will prevent the risk that FMI participants would need to stop providing services until permanent legislative changes are made. HM Treasury and the regulators will be able to put in place arrangements to ensure the successful wind-down of a participant, where that participant does not intend to or will not be permitted to operate outside an FMI sandbox.
	The success of any FMI sandbox will be contingent on a high level of cooperation between the regulators, in large part because an FMI sandbox could entail FMI entities regulated by one regulator engaging in activities that are regulated by another regulator. For example, operators of MTFs proposing to use DLT for settlement, are currently supervised by the FCA but the performance of CSD-type settlement activities within an FMI sandbox are currently supervised by the Bank. Critical to the success of the FMI Sandbox will be ensuring that there is neither duplication nor gaps in the legal and regulatory oversight of FMI entities.
	The government’s approach to establishing FMI sandboxes is intended to strike a balance between providing a sufficiently flexible, yet secure, environment to identify how emerging technologies (such as DLT) and new practices can operate within a particular framework of legislation. It will enable permanent changes to legislation to be made where appropriate. This measure will also ensure an appropriate level of Parliamentary scrutiny is maintained.