Comment on Digital Securities Sandbox Joint Bank of England and Financial Conduct Authority Consultation Paper

Re: Digital Securities Sandbox joint Bank of England and Financial Conduct Authority consultation paper[1]

To Whom It May Concern:

This joint proposal from the Bank of England and the Financial Conduct Authority (together, “the UK regulators”) for a digital securities sandbox (“DSS”) reflects a commendable commitment to incorporating innovation into the financial system. The sandbox is designed to generate real-world insights about whether distributed ledger technology (“DLT”) could streamline the issuance, trading, and settlement of securities without undermining investor protection, market integrity, or financial stability. As the consultation aptly notes, “use of developing technology, such as DLT, has the potential to change settlement by offering increased speed and efficiency, while potentially removing the need for intermediaries,” but opportunities for testing the technology have been limited.[2] I write to make the case for a cross-border sandbox between our respective jurisdictions, which would build on the promise of the DSS and serve our investors, market participants, and regulators. This letter outlines one simple approach that our jurisdictions could take to implementing a cross-border sandbox. It reflects my sole views as a Commissioner of the United States Securities and Exchange Commission (“Commission”) and does not necessarily reflect the views of my fellow Commissioners, the Commission, or any other department of the United States government.

The proposed cross-border sandbox would allow firms to conduct the same sandbox activities under the same regulatory requirements in both the United Kingdom and the United States. I suggest that, contrary to the proposal, the DSS be open to US-domiciled firms. Together with a Commission-enacted micro-innovation sandbox[3] and an information sharing agreement between our two jurisdictions, the expanded eligibility would foster cross-border innovation. The SEC’s micro-innovation sandbox would allow firms to experiment in the marketplace with specified technologies – such as using DLT to issue, trade, and settle securities – under their choice of regulatory requirements.[4] Thus, firms participating in the DSS could choose to operate in the US under the same regulatory conditions as those they follow in the UK.[5] The firms’ US activities would have to stay below predetermined monetary and customer ceilings and would be subject to the general anti-fraud provisions of the securities laws.[6] The information-sharing agreement between the SEC and UK regulators covering joint sandbox activity would enable both regulators to learn from activity undertaken in both jurisdictions.[7] An information-sharing agreement also would address the concerns about lack of supervision over non-UK firms that led to the proposed exclusion of non-UK firms from the DSS.[8]

Even though I tend to be more of a beach than a sandbox type of regulator,[9] sandboxes have proven effective in facilitating innovation in highly regulated sectors. Experience in the UK and elsewhere has shown that sandboxes can help innovators “try out their innovations under real-world conditions.”[10] A sandbox can provide a viable path for smaller, disruptive firms to enter highly regulated markets to compete with larger incumbent firms. According to one report, firms that entered the FCA’s sandbox raised 15% more capital, are 50% more likely to raise capital, and are 25% more likely to survive years later.[11] This capital raising effect is most pronounced for “smaller and younger firms.”[12] One report found that firms have used the FCA’s sandbox to “understand how regulatory requirements would apply to their innovative services or products,” perform testing that could “speed up the creation of a minimum viable product,” or use their experience with real customers to “refine their business model.”[13]

Sandboxes also can benefit regulators by creating an environment that helps produce effective and efficient regulations. A 2019 survey of sandbox regulators found that 73 percent believed “that implementing a sandbox contributed to building their capacity around fintech, and about 85 percent reported that it helped them to assess the appropriateness of their legal or regulatory frameworks.”[14] Regulators can “acquire insight into the development process for innovations” and “better understand how emerging products and services might operate in the real world.”[15] Sandboxes can provide regulators with “empirical evidence . . . to support policy development” and “can be beneficial where regulatory requirements are unclear or missing or create barriers to entry disproportionate to the risks.”[16]

Most important, sandboxes can benefit the public. Allowing firms to access markets without having to comply immediately with the full panoply of regulations provides a manageable entry point into highly regulated markets. As a consequence, consumers and investors have access to products and services that might not otherwise be available to them.

A cross-border sandbox could be even more transformative than a solely domestic one. The US and UK are well paired for such an experiment due to our shared commitment to capital markets as a vital building block of a growing and dynamic economy. Additionally, we have well-integrated financial markets,[17] a shared role as global financial service providers,[18] and a reputation for being financial technology hubs.[19] A cross-border sandbox would allow US and UK innovators to benefit from simultaneously serving markets in two jurisdictions. It also would benefit regulators by producing more data on how complex emerging technologies operate in different contexts than would be possible with a single jurisdiction sandbox.[20] A cross-border sandbox also could benefit the British and American public as it could prompt firms domiciled in one jurisdiction to expand their product and service offerings to the other.

A cross-border sandbox covering the issuance, trading, and clearing of securities using DLT is particularly ripe for exploration. Experiments might look, for example, at how tokenization could enable further market transparency,[21] fractionalization of assets,[22] and “operational efficiencies” to reduce costs, including shortening settlement time.[23] Other participation candidates might be solutions to tokenization hurdles, including the lack of interoperability across different blockchains and tokens,[24] cybersecurity risk,[25] privacy concerns,[26] the fragmentation of asset ownership, and any unique challenges arising from the cross-border nature of blockchains.[27] Of course, as a regulator my focus is less on positing ideas of how innovation might improve the financial markets than it is on ensuring that innovators can try to operationalize their ideas.

My proposal may not be as immediately actionable as other responses to your consultation request. However, this consultation request from the FCA and Bank of England offers a timely opportunity to discuss greater cross-border collaboration in facilitating innovation. I look forward to discussing with you, my colleagues in the US, and interested members of the public in the US and the UK about how we might bring a cross-border sandbox to life.

Commissioner Hester M. Peirce
United States Securities and Exchange Commission

APPENDIX: Proposed Micro-Innovation Sandbox

The proposed micro-innovation sandbox would allow firms to perform certain activities in the US under a self-selected set of regulatory conditions and consistent with statutory fraud prohibitions and pre-specified activity ceilings. The activity ceilings, which the Commission would set after notice-and-comment, would be high enough to encourage firms to participate and to generate useful data for regulators.[28] Firms could use the opportunity to build the market case for their product and to address any design or implementation flaws. While allowing firms to select their own regulatory conditions may cause anxiety in some regulatory quarters, to maximize their chances for permanent exemptive or no-action relief, firms would have to adhere to reasonable conditions. Firms would select a regulatory system that they believe protects investors and markets to maximize their longer-term success with the Commission.

An overview of the elements of the proposed micro-innovation sandbox follows. I emphasize that this micro-innovation sandbox is not a Commission proposal, but rather a response to numerous conversations that I and my staff have had with people who would like to experiment in the US with new technologies, products, and services. It is a work-in-progress. I welcome public comment on the viability and design of a micro-innovation sandbox at CommissionerPeirce@sec.gov.

• Eligible firms. Any firm that wishes to operate in the US, unless it is subject to a bad actor disqualification.
• Eligible activities. The Commission would publish an initial list of eligible activities, based on public input.[29]
• Ceilings. The Commission would set domestic activity-specific customer and monetary ceilings based on public input. The goal in setting such ceilings would be to enable participants to achieve sufficient scale to gauge market reaction to their product or service and to identify areas for improvement without compromising investor protection or market integrity.
• Duration and exit. Firms could participate in the micro-innovation sandbox for two years, provided they do not exceed the customer limitations or monetary ceiling. Firms could amend their conditions during this period in response to market experience, but doing so would not restart the two-year clock. During this two-year period, firms would work with the Commission and its staff to secure a no-action letter or exemptive order covering their activities. The Commission staff could extend for a year sandbox eligibility for firms that are actively working on a no-action letter or an exemptive order, but the objective of the micro-innovation sandbox would be to move to more permanent relief within two years.
• Conditions. Participants would choose their regulatory conditions. The conditions could be modeled on the conditions for participation in a foreign sandbox. Alternatively, the participant could design its own set of conditions. The Commission would enforce compliance with the self-selected regulatory conditions within the US, provided that such conditions are consistent with constitutional and statutory authority.
• Notice of participation. Firm sandbox participants would submit a notice of participation. This notice would disclose to the Commission their expected activities, the desired outcomes, and their self-selected regulatory conditions. Firms would explain why current regulations pose a significant barrier to their proposed activities, the known material risks of their activities, and how they would mitigate such risks. The Commission would review the notice only to ensure that it is substantially complete. Such review would occur within ten business days, after which point the sandbox participant could commence its activities.
• Public disclosure. Firms would make their notice submission available in a prominent place on their public website.
• Preventing fraud. The Commission’s existing antifraud authorities would apply to all sandbox activities.
• Commission monitoring. The Commission would monitor sandbox activities for compliance with the participant’s stated conditions and for investor protection and market integrity reasons. In addition, the Commission would gather insights for a more permanent and broadly applicable Commission regulatory regime.
• FinHub. The Commission’s Strategic Hub for Innovation and Financial Technology (“FinHub”) would work with firms to help them navigate the sandbox notice submission and the no-action letter or exemptive order process. An explicit metric of success for FinHub would be firm participation in the sandbox and successful exits to no-action or exemptive relief.