Settlement and Custody of Digital Assets
An Account of the Discussion at the Walbrook Club on 4 March 2020
Settlement and Custody of Digital Assets:
An Account of the Discussion at the Walbrook Club on 4 March 2020
- The advantages security tokens have over securities include lower costs, automation of processes, greater transparency, applicability to novel asset classes and better monitoring and management of post-trade processes
- Settlement of security token transactions needs refinement to counter the lack of on-platform access to fiat currency cash and the need for pre-funding of accounts and to make token-versus-token (TvT) settlement viable and efficient
- Despite a panoply of technical and physical measures, safe custody of securities tokens remains an unresolved problem which badly inhibits the involvement of both global custodians and institutional investors in the security token markets
Other inhibitors to the take-off of security tokens into self-sustaining growth include the regulatory uncertainty of tokens, the absence of standards to facilitate inter-operability between token and non-token platforms and legacy systems and incumbents
The lower costs of tokenized financial markets are nevertheless large enough – one estimate is that the post-trade economies alone could double the value of UK savings in less than 50 years – to warrant the investment necessary to clear the obstacles to a transition
Questions to be addressed
How can the issue of central bank digital currencies (CBDCs) on tokenization platforms be encouraged and accelerated?
Is a convincing solution to the safe custody of security tokens available yet or in prospect soon?
Which existing or future body should take charge of the development of standards to facilitate inter-operability between platforms?
How can security token issuers, investors and service providers best be provided with regulatory certainty?
Will it take a governmental or regulatory intervention to initiate a transition from the current system to a tokenized future?
The Future of Finance view is to hold another meeting to answer the above questions and to continue the conversation. In light of current virus circumstances, we anticipate holding one in July or September. If you would like to sponsor such a meeting please contact Wendy Gallagher. Also view on www.futureoffinance.biz
Tel: 07725 160903
The advantages of security tokens over securities
Security tokens have a number of advantages over traditional securities recorded on digital ledgers. The first is that they are bought and sold on peer-to-peer, blockchain-based networks, in which trusted but expensive centralized intermediaries such as stock exchanges, brokers, custodian banks, central counterparty clearing houses (CCPs) and central securities depositories (CSDs) can be disintermediated. By collapsing trading, settlement and asset servicing into a set of continuous, automated processes, tokenization can eliminate the need for reconciliation of transactions between intermediaries, speeding up settlement timetables and cutting operational costs dramatically.
The second advantage security tokens have over conventional securities is that that controls can be programmed into the settlement process. For example, a transaction that exceeded a counterparty concentration limit could be halted automatically before it settles, reducing the need to rectify problems after they have occurred.
Thirdly, the greater transparency of security token transactions within a blockchain-based network mitigates the risk of style drift or wrongdoing by asset managers, such as investing in illiquid assets or in companies where conflicts of interest exist.
Fourthly, tokenization can be extended to any asset class, including private equity, energy, water, precious metals, fine art and real estate as well as securities, creating the potential to make presently illiquid assets more liquid and revolutionise the way in which they are settled as well as traded. In fact, illiquid private placement markets represent a readier opportunity for tokenization than the established securities markets, precisely because the benefits are greater than they are in the conventional equity and debt markets. Private placements are also larger than the public equity markets. Real estate is another early candidate for tokenization.
Lastly, tokenization makes it easier for all parties to a transaction to monitor its status as it proceeds from initiation to settlement, providing the assurance of full transparency and allowing errors and omissions to be rectified before they cause settlement failure. In fact, one measure of the value promised by the peer-to-peer networks proposed by blockchain-based platforms is the fact that the services developed by SWIFT (via its gpi service for payments) and DTCC (via its DXM service for securities) emulate the benefits of blockchain-based tokenization platforms by showing all parties to a transaction information about its current status contemporaneously.
Neither gpi not DXM makes use of blockchain technology. Indeed, the wider transparency promised by blockchain-based tokenization platforms is evident in some traditional securities markets already (such as the Nordic countries, which operate end-investor accounts). The benefits could be emulated on global scale by shifting the current post-trade value chain on to platforms that allow information to be shared, without any need to use blockchain technology.
Settlement of security tokens is not necessarily superior to securities settlement practices
Likewise, although the post-trade settlement processes in conventional securities markets are often described as complicated, slow and expensive – chiefly because they developed before the advent of digital technology – speed in particular is a relative term in the context of settlement. Provided the asset is a conventional equity or bond, and the settlement instructions are accurate and complete, it never takes a global custodian more than ten minutes to orchestrate the delivery of traditional securities to an account at a CSD and settle the cash leg simultaneously through the Real Time Gross Settlement System (RTGS) at a central bank.
Some parties already think sub-ten-minute settlement is too fast, since it reduces the time available to correct mistakes. It nevertheless contrasts unfavourably with the possibility of instantaneous and immutable settlement of security tokens on a blockchain-based network. But this is to compare the ideal with the actual, in which the actual will always appear less favourably. In reality, instantaneous delivery of security tokens against payment is not established yet even in the crypto-currency markets.
True, the crypto-currency markets – where institutional investors are increasingly active, according to a recent State Street survey – have seen improvements. Exchanging crypto-currency for fiat currency cash, for example, used to take 24 hours, creating counterparty risk and incurring heavy transaction costs, especially in cash and credit. By using application programming interfaces (APIs) to exchange transactional data instantaneously, service providers in the crypto-currency markets have now reduced these costs and risks significantly.
The cash leg of security token transactions remains problematic
Crypto-currency settlement still requires buyers to pre-fund their accounts with cash and sellers to ensure the tokens are available in their account, but the shortening of the settlement timetable has reduced the overall amount of pre-funding required by accelerating the velocity of transactions. A recent report by J.P. Morgan estimated that US$600 trillion is now sufficient to support US$1 trillion of token payments, because blockchain-based networks have facilitated an increase in the velocity of “money.” In principle, this does reduce the need for accounts to be pre-funded. It could ultimately eliminate the need for a central bank to supply members of a blockchain-based network with liquidity.
The crypto-currency markets have also pioneered the so-called instantaneous “atomic” swap, in which one crypto-currency can be exchanged for another directly, on or off a blockchain-based network, without the need to go through centralized intermediaries such as trading platforms or payment systems.
In principle, security token markets could also skip the need for fiat currency cash payment against delivery of the tokens. Instead, one token could be swapped for another. The swappable tokens obviously include payment tokens and especially Stablecoin. In fact, the Utility Settlement Coin (USC) created by the bank-backed Fnality International aims to supersede the stability even of Stablecoins, and eliminate the counterparty risk posed by issuers of Stablecoins by tokenizing holdings of central bank rather than commercial bank money.
But the swappable token does not have to be a cash equivalent. Investors in a security token linked to, say, corporate bonds, could exchange it for another security token linked to, say, gold, instead of exchanging it for a payment token or coming off the tokenization platform to retrieve fiat currency cash through the correspondent banking and RTGS eco-system. This might be called delivery-versus- delivery (DvD) as opposed to delivery-versus-token (DvT) or delivery-versus-payment (DvP).
Central bank digital currencies (CBDCs) could catalyse tokenization
However, a more complete solution to the DvP problem lies in central bank digital currencies (CBDCs) issued on to a blockchain-based network. A recent survey by the Bank for International Settlements (BIS) found 53 central banks engaged in work on CBDCs, seven planning to issue one soon and twice as many in the medium term.1 The People’s Bank of China (PBOC) is reported to have tested a digital renminbi. The Russian and Swedish central banks and the Eastern Caribbean Currency Union (ECCB) central bank are also looking at issuing CBDCs.
But a CBDC can mean different things to different central banks. The Chinese and Russian central banks want primarily to control private sector activity, while the Swedish central bank is reacting to the near-disappearance of demand for physical cash.
Another option is for a central bank to tokenize the settlement of obligations between banks via the Real Time Gross Settlement System (RTGS) but without using blockchain technology (a technology the Bank of England specifically rejected when upgrading its RTGS system). That approach obviously continues to exclude non-banks from access to the CBDC, thereby reducing the risk that private sector banks lose funding as depositors flock to a CBDC at the central bank.
Security token custody is an unresolved problem
One area in which the crypto-currency experience is less encouraging is custody. Exchanges that safekeep assets are hacked repeatedly, and assets stolen, or hard drives containing private keys are lost or destroyed. Although the crypto-currency industry has work in hand – on harder-to-copy seed generation (randomly generated 64-character alphanumeric strings that generate the private keys needed to access digital assets), multi-party computations (MPC) to produce public keys, multiple hardware security modules (HSMs), hot, warm and cold wallets, physical storage, operational resilience, admission to permissioned blockchain networks and authenticated transfers – to improve asset safety, security tokens are still ultimately custodied in vulnerable, centralised databases.
As importantly, the global custodian banks that safekeep traditional securities are not offering a security token custody service because security tokens are not yet an eligible asset class for managers of regulated funds to purchase; existing regulations in most jurisdictions have yet to be adapted to security tokens; it is difficult for custodians to be confident they have full control of digital assets; and it is hard to segregate the safekeeping of private keys sufficiently to keep them off the balance sheet of the bank.
This reluctance of global custodians to commit to support tokenized investments is a major obstacle to the displacement of the existing infrastructure of the conventional securities markets. It is an ironic obstacle, in that one of the factors inhibiting investment in blockchain technologies and the asset classes they support is the poor quality of the settlement and custody infrastructure, and especially the vulnerability of digital assets to hackers. At least one family office that did choose to invest in crypto-currencies was so disappointed by the quality of the custody services available that they built their own in conjunction with IBM, and continue to safekeep private keys in multiple physical locations. They would prefer to purchase a trustworthy service, but have not identified one.
Another obstacle for investors is the prevailing attitude of regulators. Although regulators are keen to learn about tokenization, and recognize they lack expertise in security tokens and blockchain technology, they are scarred by their negative experience of Initial Coin Offerings (ICOs). As a result, regulators lack urgency in adapting existing securities laws and regulations to the new asset class, forcing most issuers and investors to proceed on the basis that existing securities laws and regulations apply to security tokens as well. It has so far proved a safe assumption.
1 BIS Papers 107, Impending arrival – a sequel to the survey on central bank digital currency, January 2020.
Regulatory uncertainty is an inhibitor for investors
In reality, far from encouraging the transformation of the existing structure of post-trade clearing, settlement and custody, regulators have since the crisis reinforced it. They have extended the remit of CCPs, increasing reliance on CSDs, bolstered the capital global custodian banks must allocate to operational risk and increased their liability for losses by investors, introduced trade information repositories (TRs) to increase transparency into derivative and securities financing transactions, and refreshed the legal underpinnings of settlement finality and safe custody.
All of that said, some jurisdictions – including fully developed markets such as France, Germany and Singapore as well as offshore centres such as Malta and Mauritius – have made more progress than others in keeping laws and regulation aligned with technological and market developments. There is also an expectation that technology vendors will provide technology to the established settlement and custody institutions to enable them to offer their clients a service that reassures them they can buy and sell and hold security tokens safely.
Firms that can provide robust security token custody technology of this kind are already attracting the funding to develop their offerings. However, in terms of accelerating the growth of the security token markets, technical progress is no substitute for absolute clarity in their regulatory treatment.
Investors have a lavish financial incentive to support tokenization
Indeed, the reluctance of institutional investors to invest in the asset class is in large part a reflection of the uncertain regulatory status of security tokens. Ironically, no party has a larger financial incentive to support the transformation of post-trade processing through tokenization than institutional investors. Although current settlement and custody services are often described as highly digitised, cheap and efficient, they in fact remain relatively manual and error-prone and as a result relatively expensive.
The servicing costs of the £9 trillion of long-term savings in the United Kingdom, for example, average 2 per cent per annum, or £180 billion a year. Three quarters of this sum (£135 billion) is consumed in post-trade costs, including the back and middle office operations of asset managers as well as the global custodian banks and fund administrators to which they outsource some of the work. If that £135 billion cost was eliminated, the value of £9 trillion of savings would double in 47 years, even without any additional return on investment.
Standards are needed to drive inter-operability during the transition to tokenized markets
A fourth obstacle to change is lack of standards. Even in the conventional securities industry, the take-up of SWIFT standards by banks, brokers, asset managers and financial market infrastructures is incomplete. Proprietary standards, and even faxes, still abound. In fact, a large part of the value added by global custodians is to insulate their clients from the technological backwardness of some of their counterparts by standardizing information they receive in non-standardized formats. This is one reason the custodian banks are reluctant to support radical change: their revenues depend on the maintenance of the status quo.
Yet standards are essential to any meaningful transition to a tokenized future. Since existing infrastructures will not be replaced in a Big Bang by a single tokenized model, blockchain-based tokenization platforms of various kinds will have to interact with each other, and with the traditional platforms that persist. Unfortunately, standards equivalent to SWIFT do not yet exist in the nascent world of blockchain-based tokenization networks.
Without standards, “atomic” swaps between security tokens on different networks are already less efficient than they could be. In the longer term, instantaneous DvT and DvP between networks will be impossible without standards. Although standardisation initiatives do exist – notably the SWIFT gLink concept and LIquidShare– achieving compatibility between blockchain-based networks, let alone tokenization platforms and traditional services remains a remote prospect. Unless this challenge is met, it will be difficult for any security token eco-system to grow through network effects.
The main obstacle to tokenization is the inertia exerted by legacy systems and incumbents
A fifth obstacle is legacy systems and legacy incumbents. One reason emerging markets are among the most enthusiastic about blockchain is that they have less legacy and greater opportunity to attract global capital flows with a cheaper, better and safer technological infrastructure. In developed markets, by contrast, incumbents are making good margins on existing revenues and have no incentive to adopt innovative technologies.
Global custodians, for example, have a vested interest in the persistence of traditional securities markets. They are not enthusiastic about the idea that the greater transparency of blockchain-based networks will enable them to become data managers, supplying their buy-side clients with processed information they can use to generate alpha. Nor do their senior management have any personal incentive to put existing revenues and resources at risk by investing in innovation.
However, the traditional securities markets are demonstrably under threat. The margins of all incumbents – custodian banks, asset managers and financial market infrastructures – are being squeezed. The number and value of initial public offerings (IPOs) is declining. Share buybacks are common pl ace. Corporate issuers are looking to recruit capital by other means (one multinational plan is to distribute dividends to investors that are not even shareholders). It may not take much – greater regulatory certainty about the status of security tokens, for example – to precipitate a major structural shift by investors from securities to security tokens.
Written by Dominic Hobson – Co-Founder at Future of Finance