The UK has just opened its long-awaited digital securities sandbox – a carefully supervised experiment where participants are able to operate new technical systems under more relaxed regulations. The sandbox is designed to test the potential of distributed ledger technology to underpin the next generation of financial market infrastructure.
If the UK is able to move swiftly, providing a regulated infrastructure for tokenised assets, the advantages for the City of London could be enormous. If the benefits of tokenisation – improved collateral mobility, removed or minimised counterparty risk, settlement on demand, enhanced functionality via smart contracts – are crystallised in the UK, then financial business will migrate here to take advantage of that. The UK does not have long to innovate before the US ploughs ahead and entrenches its advantage. The sandbox is a vital opportunity to promote this development.
The sandbox is also the UK’s answer to the European Union’s blockchain pilot regime, which launched 18 months ago. The pilot regime, though it shared the UK’s aim of evaluating DLT as the basis for settlement systems, has not been taken up to any meaningful degree. This is largely because of the €6bn cap, which many market participants felt was too low to warrant the substantial investments required to develop new infrastructure.
The Financial Conduct Authority and Bank of England hope to have learned from the EU’s experience. As second movers, they can correct some of the mistakes made across the channel and design an experiment that will prove more useful.
The idea of entirely removing the cap on activity within the sandbox is untenable. Experimenting both with new technologies and new regulations is an inherently risky process and allowing assets to migrate to new infrastructure at their own pace is something few regulators would countenance.
Instead, the DSS has a system of gates. As participants satisfy the supervisors on the robustness of their systems, limits on the volume of assets allowed in the sandbox will be raised and then removed altogether. Providing a clear roadmap to scaling sandbox activity should give potential participants more confidence that their efforts and investments will not be wasted.
Higher expectations require full buy-in
In the 18 months since the blockchain pilot regime was launched, activity in the digital assets ecosystem has been advancing at a feverish pace, with new digital bonds being issued at a steadily increasing clip.
The result is that many market participants have already put in much of the time and money required to get their digital asset market infrastructure well past the proof-of-concept stage. They are looking for regulatory approval to go to market and conduct real business.
That opportunity will come as soon as they are able to satisfy the supervisors that they have the capacity to do so safely. But, for the sandbox to deliver on its potential, the official sector must be prepared to get involved.
There are two things missing from the sandbox, at present, which will inarguably form foundational parts of the digital asset ecosystem.
Digital gilts
The first is digital gilts. Government bonds are important, not just as tools for funding government expenditure, but as structural components of financial markets. One of the key value propositions for a token-based digital asset ecosystem is that assets used as collateral could be moved more quickly and efficiently. Government bonds are frequently used as collateral so any real test of a tokenised market infrastructure should include them.
Digital gilts do not necessarily have to come directly from the UK Debt Management Office. It is possible for market participants to buy gilts, immobilise them, then issue tokens against them for their clients. This would effectively bring government bonds into the digital asset ecosystem, albeit via a potentially more complex and less transparent method.
If the government were to issue digital bonds, it would mark an indication that it believes in the aims of the sandbox and its participation might encourage commitment from the private sector.
Central bank money
The other key component of a tokenised digital asset ecosystem is a means of settling the cash leg of securities transactions. Certainly stablecoins and commercial bank money tokens for doing just this already exist, but the Bank for International Settlements’ principles for Financial Market Infrastructure state that central bank money should be used for settlement wherever possible and the Bank is unlikely to want to see settlement migrate away from central bank money.
There are a number of forms that a solution for central bank money settlement versus tokenised assets could take. The Bank of England could follow the lead of the Swiss National Bank and issue a wholesale central bank digital currency. That would create a tokenised form of central bank money that could be freely exchanged with digital assets on chain and within the same platform.
This approach is also being explored by the Banque de France as part of the European Central Bank’s central bank money trials. The Banca d’Italia and Bundesbank are exploring alternative solutions to ensure that central bank money can operate in a digital asset ecosystem. The Bank of England will certainly be keeping a close eye on these experiments and hoping to learn as much as it can before embarking on its own programme. The upgrade to the real-time gross settlement system might also provide a solution.
But the Bank may consider that its Omnibus accounts provide an opportunity for market participants to provide a synthetic wholesale CBDC. Omnibus accounts enable a payment system operator to pool funds, hold them with the central bank and then provide a payments architecture for their clients, giving them the ability to settle in an instrument wholly backed by central bank money.
Lewis McLellan is Editor of the Digital Monetary Institute, OMFIF.
These topics were explored in OMFIF’s Digital assets 2024 report.
