Future of Finance Webinar on 25 November 2021
Both ACSDA and the Future of Finance are grateful to Percival Software for making today’s discussion possible.
Finally, it destroyed the product itself: the journalism.
25 years ago I was working in an industry that was about to be disrupted by a new technology.
The industry was publishing.
The technology was the Internet.
Our business consisted of writing journalism to fill the space between display advertisements in print magazines which were then snail-mailed to people the advertisers wanted to reach.
The Internet first destroyed the distribution: the snail-mailing.
Then it destroyed the revenues: the advertising.
It is now impossible to make a decent living in trade publishing.
It is a familiar story in technological capitalism, but it has a savage twist.
We have all laughed at the Western Union executive who dismissed the telephone as having “too many shortcomings to be seriously considered as a means of communication.”
And the founder of IBM predicting a world market for “maybe five computers.”
Or, worst of all, we have shuddered at the Board of Kodak telling the in-house inventor of the digital camera to “take that box and go away; we don’t ever want to see you again” in case he ruined the market for photograph albums.
But I know from personal experience that it is entirely possible to know that your business faces an existential threat.
To understand the nature of the threat.
And yet to be virtually powerless to do anything about it.
This is the sobering reality that faces the central securities depositories of the world today.
Blockchain technology – or, to be more specific, the tokenisation technique derived from blockchain technology – is an existential threat to everything that CSDs do.
Today, CSDs play a vital role at multiple points in the securities services value chain.
And it really is a chain: a sequential process in which data is passed between each link in an extended order of intermediation.
Each link in the chain depends for its progress on the data received from the previous link in the chain.
And each link in the chain must reconcile its data bi-laterally, and sequentially, with the data kept by the other links in the chain.
Even simplified like this it is a complicated, highly intermediated process in which the CSDs are densely involved at five crucial points:
- Issuance: safeguarding the integrity of the issue
- Settlement: delivering securities against payment in central or commercial bank money
- Registration: keeping a record of who owns what
- Custody: keeping securities in electronic omnibus or beneficial owner accounts
- Asset servicing: providing news of corporate actions and delivering their value to investors
Tokenisation replaces the chain with a network in which data is either shared simultaneously or so instantaneously that it might as well as be simultaneously.
Tokenisation threatens every basic function of a CSD:
- Issuance: Instead of issuing securities into a CSD, companies issue tokens into the digital wallets of investors
- Trading: Instead of being listed and traded on a stock exchange through brokers, tokens are exchanged directly between the wallets of investors on a blockchain-based network
- Settlement: Instead of being settled by delivery of securities against payment in central bank money, purchases are settled by delivery of security tokens against payment tokens between digital wallets
- Registration: Instead of the CSD keeping a register of investors, and updating it every time a trade is settled, every transaction is recorded on the blockchain-based ledger
- Custody: Instead of securities being held in accounts at the CSD owned by investors or their custodian banking agents, tokens are held in digital wallets controlled by investors that are either on or off the blockchain-based network
- Asset servicing: Instead of corporate actions notifications being issued by CSDs to custodian banks and investors issuing instructions to custodian banks to pass on to issuers, smart contracts built into the security tokens pay entitlements automatically to owners recorded on the ledger of the blockchain-based network as soon as the conditions for payment (such as the dividend payable per share and the payment date) are settled.
If this is what happens, it means:
- The stock exchange that owns many of you must undergo a metamorphosis into a tokenisation platform, or die.
It also means:
- Your role in issuance is gone
- Your role in registration is gone
- Your role in settlement is gone
- Your role in custody is gone
- Your role in asset servicing is gone
Those things are gone because tokenisation is not a merely disruptive technology.
It’s not one of those modest changes that allows you to cut your costs or reduce your risks.
It is a potentially comprehensive shift in the foundations on which the entire securities industry is built.
That is why the wrong question to ask is: What does this mean for our business?
And why the right question to ask is: What is the most efficient end-state for the securities industry as a whole – and where will we fit within it?
The good news is that a change in the underlying technology paradigm of an entire industry cannot happen overnight.
The bad news is that you have absolutely no control over how fast that change will eventually occur.
The rate at which tokenisation is adopted will be driven by hundreds of minor advances in technology, thousands of decisions about cost, investment and competition, and by millions of changes in buyer perceptions and behaviour.
These are things over which you have no influence whatsoever.
All you can know is this.
That these changes are going to upset the existing structure of the industry.
That they are going to overturn established competitive positions.
And that somewhere in the turmoil created by these vast, exogenous changes lie opportunities for CSDs, as well as threats.
While those uncontrollable changes do their work, all you can hope to do is three things, each of which is much simpler to state than to execute.
First, understand what is going on.
Secondly, predict the likely evolution of the structure of the industry and the competitive landscape.
Thirdly, throw as much resource as you can – people and money – at innovations you judge likely to endure and to create new, stable and defensible sources of revenue for the future.
So our first problem is to understand what is going on.
This is hard.
Because there is a lot going on – and it is happening very fast.
Frankly, it is impossible to keep up and still do your day job.
You will not find it difficult to find people offering to do it for you.
But as leaders of the CSD industry you must not let others dictate what you think.
You must get into the details yourselves, not rise above them.
You must shed your ingrained mental maps.
And ditch your routine corporate responses.
Above all, look for data that can illuminate the terrain.
Unfortunately, the data in this field is not of the best.
There are multiple sources, which capture different sets of information.
They contradict each other.
Double counting is rife.
Definitional problems abound.
Like is not always compared with like.
And some data that would be useful does not yet exist at all.
However, there is one thing we can see very clearly indeed: token markets can grow rapidly.
Coinbase, the leading centralized crypto-currency exchange, was valued at US$100 billion at its initial public offering (IPO) in April this year.
The amount of crypto-currency held in Decentralized Finance (DeFi) protocols has risen from zero in 2015 to nearly US$90 billion today – and the market cap is put far higher, at US$175 billion or even US$260 billion.
Uniswap, the leading DeFi token exchange, has a market value of US$13.3 billion.
The value of Non-fungible Tokens (NFTs) – unique digital assets – has increased from zero in 2015 to nearly US$17 billion today.
The main NFT marketplace, OpenSea, was valued in its most recent fund-raising at US$1.5 billion.
These markets do not operate to an eight-hour trading day.
In fact, they never shut; they are open 24/7/365.
And they have grown astonishingly quickly.
Almost without institutional support.
And despite a string of thefts, frauds and insider dealing scams.
The main reason they have grown quickly is that they have cleared the major engineering hurdle by being 100% digital.
Unlike most forms of engineering, software can be written, tested, fixed and upgraded very fast at low cost.
The time from concept to market is vanishingly small.
There is also intense competition to exploit not just opportunities, but vulnerabilities in the code.
So the infrastructures, as well as the products, evolve rapidly.
The safe custody of private keys, for example – a topic of intense interest to CSDs – has passed from Hot Storage through Cold Storage to Hardware Wallets, and from Multi-Sig to Multi-Party Computation – three if not four technological eras, if you like – in just a couple of years.
In short, this wave of technology is driven by young people writing code.
Coding is the critical skill.
Which is why Glassdoor reports a 300% annual increase in blockchain-related jobs.
And why DevOps experts – the people who know how to deliver, evolve and improve digital services at extremely high velocity – are the hardest employees to recruit.
CSDs are not well-placed to attract DevOps engineers.
But CSDS are well-placed to understand what is going on: a lot of the output of the software being written will be extremely familiar to anyone working at a CSD.
For all the jargon surrounding Decentralised Finance (or DeFi) – staking, yield-farming, pooling – what is going on in DeFi is what has been going on since the Sumerians invented finance 6,000 years ago as a means of transferring value through time.
It’s market-based finance, that’s all.
As CSDs, you can be at home in this world, if you make the effort to understand it, engage with it, and work out where you fit into it.
Which brings us to the second problem you face.
How will the industry and the competition evolve?
At the moment, the securities services industry is focused on custody not of security tokens, but of crypto-currencies.
A number of custodian banks – especially in the United States where the Office of the Comptroller of the Currency (OCC) in July last year allowed regulated banks to safekeep crypto-currency – now offer or plan to offer a service.
There are also plenty of independent suppliers of custody services, and of hardware and software to safekeep crypto-currency – more than 50 in fact.
Crypto-currency custody is also where private equity money is being invested.
More money has been invested in crypto-currency custody so far this year than in all the previous six years.
Custody accounts for a quarter of all private equity investment in all blockchain companies this year.
Crypto-currency exchanges offering custody and independent crypto-currency custodians make up nearly half the blockchain unicorns to have been born in financial services so far (a unicorn being a company valued at its latest funding at more than US$1 billion).
Why, you might ask, is crypto-custody so hot?
The answer is simple: institutional investors are buying crypto-currencies.
A survey conducted by ISSA this year, of asset managers and asset owners, found one in seven was investing in asset-backed or “native” security tokens already, and up to two in five expected to do so within two years.
But crypto-currency is not the real opportunity.
The combined value of eight tokenizable asset classes – equities, bonds, real estate, mutual funds, privately managed assets including privately placed equity and debt and just one precious metal (gold) – is US$416 trillion – 166 times the value of the entire crypto-currency universe.
If just three quarters of 1 per cent of global real estate, or 2 per cent of the global bond markets, were tokenised, they would be as big as the entire global crypto-currency market today.
And this is starting to happen.
Commercial real estate is being tokenised.
Bonds are being tokenised.
Equity is being issued in tokenised form.
So are precious metals, fine art, private equity, mutual funds and collectibles.
Some of the largest asset managers in the world are funding the development of platforms to tokenise mutual funds in both London and Luxembourg.
At a time when the core source of revenue of the CSDs – namely, publicly listed companies – is shrinking, tokenisation is an opportunity which is hard to ignore.
And organisations like yours are NOT ignoring it.
The ISSA survey of custodian banks and exchanges and their sell-side and buy-side clients found the numbers exploring blockchain had tripled in a year; the number with live services had doubled; and that the value of the investments was up by a third.
The biggest areas of interest?
Bonds, ETFs, OTC equities and mutual funds.
The capabilities most affected?
Issuance, asset-servicing, execution and settlement, collateral management.
This is happening.
It’s happening to the things that you do.
And there are real reasons why it is happening.
Tokenisation cuts the cost of capital for issuers.
It cuts the cost of transactions for investors.
It broadens the range of asset classes that investors can buy.
And it extends the number of investors that can take part in the market.
For now, it remains almost laughably small – though the data available, again, is less than ideal.
After sifting through three lists of tokenised offerings I identified a total of 134 unique security token offerings in the last four years, raising a total of $10.3 billion.
Which is less than one thousandth of the current size of the global equity markets alone.
But one thing we have learned from the crypto-currency markets is that they can grow fast.
And two of the major obstacles to the growth of security tokens are being cleared.
First, Stablecoins have put the cash leg of token transactions on to blockchain networks.
Very soon, central bank digital currencies will put central bank money on to blockchain networks.
Secondly, regulatory uncertainty is dissipating.
Generally speaking, security tokens are securities, and existing securities laws apply: law and regulation is no barrier to tokenisation.
However, questions of speed and scalability do remain unanswered.
The solutions advanced so far – closed or permissioned networks, Proof of Stake rather than Proof of Work and “sharding,” nested blockchains, sidechains, and so on – are not adequate to realise the full potential of tokenisation.
Another problem to be solved is inter-operability.
Blockchain protocols are diverging and need tools to allow assets to move between them.
Just such tools (like FinP2P) are being developed now.
Inter-operability with traditional securities markets will be needed too, and for a long time – because tokens are not going to replace existing securities markets overnight either.
Ways for buy-side firms to trade seamlessly across tokenised and traditional markets must be found.
And they will be.
Because already we see the new world converging with the old.
Blockchain networks with securities markets.
Closed, permissioned blockchains with open, un-permissioned blockchains.
Unregulated firms with regulated firms.
Across the world, on average, 76 per cent of blockchain companies already have a regulatory licence of some sort.
This is not the Wild West any more.
Fanatical, libertarian blockchain enthusiasts may still despise regulation.
But blockchain-based companies are actively seeking regulatory licences.
In other words, being regulated already provides no defence against disintermediation.
You cannot hide behind your regulator – your regulator is out there ushering your future competitors within the same regulatory perimeter as you.
In the future, what will eat the revenues of regulated incumbents is not unregulated challengers but regulated challengers.
Which brings us to the third and final challenge tokenisation sets for CSDs
What innovations can CSDs adopt that will create new sources of revenue?
As far as I can tell, most CSDs have yet to engage seriously with this question at all.
A Nasdaq survey of market infrastructure CIOs in June this year found blockchain ranked, in their list of priorities, way behind AI, robotic process automation and the Cloud.
Two thirds to three quarters were doing nothing at all about blockchain.
Of course, some CSDs have done and are doing some things.
Though most of the moves depicted here are tightly focused on narrow problems, such as managing shorter settlement timetables.
The bolder moves are driven not by CSDs, but by the exchanges that own CSDs.
Which is not unhelpful: a substantial majority of the CSDs of Latin America are owned or part-owned by exchanges.
There is a long and growing list of things CSDs could do with blockchain.
Tokenise issuance services.
Building a blockchain.
Taking on new asset classes.
But some reticence is understandable.
The experience of ASX (a blockchain project three times delayed) and ID2S (a CSD start-up now in liquidation) is discouraging.
Most CSDs are small.
They do not have the people or the money to throw at speculative blockchain projects.
Most CSDs are incumbents too.
The instinct, to resist threats to skills acquired over a long period and valuable positions occupied for many years, is natural.
Inertia, or an unwillingness or inability to adapt to changed circumstances, is the default position of incumbents everywhere.
To which monopoly adds the special difficulty of having customers that are also inert.
If customers are not defecting, that is only because they have nowhere else to go.
It does not mean the threat does not exist.
Or that you are not vulnerable to competitors who know their costs and can price accordingly.
Or, above all, that your customers are actually satisfied with the service that they are getting.
On this point, I leave you with a short quote from a webinar I moderated recently.
So there you have it from Nadine Chakar, head of digital at one of the biggest global custodian banks in the world.
Articulate your position.
Or risk being left behind.
I hope these remarks have been helpful.
It is time now for our discussion.
To help facilitate our discussion, we are joined by two independent experts in the field of blockchain and securities.
Andrea Tranquillini is an independent consultant and adviser to financial market infrastructures planning their course towards digitisation of the securities industry. He is an expert on CSDs, having only recently stepped down as CEO of ID2S, the Paris-based CSD for money market instruments, but also having worked at four other CSDs: Clearstream, Monte Titoli, globeSettle and VP Lux.
Jack McDonald is CEO at Standard Custody and Trust Company, a Polysign subsidiary that provides institutional grade custody for digital assets. Jack is a former president and CEO of the Conifer Group, the fund administration business acquired by the Carlyle Group in 2015, which he joined after a career in asset management with Schroders and UBS.
But this conversation should not be between the three of us only.
This is your event rather than ours, organized by ACSDA for you, and all three of us would welcome your questions and comments, starting immediately.
So, do please start asking questions and making comments right away.
We won’t save them up to the end but answer them as we go along.
To get us under way, I’d like to ask the $50,000 dollar question: Is tokenisation an existential threat to CSDs? In other words, am I right to worry that their issuance, settlement, registration, custody and asset servicing roles are redundant in tokenised markets?