Settlement and custody of digital assets Part II

A SUMMARY AND FULL REVIEW OF THE DISCUSSION AT THE WEBINAR ON 20 OCTOBER 2020

Summary

Stablecoins are pioneering the token issuance and trading markets, where they are likely to be used for hedging and synthetic trading purposes.

Central bank digital currencies (CBDCs) might displace stablecoins, or CBDCs and stablecoins might establish a stable form of co-existence.

In the long run, security tokens might replace securities. Tokenised securities have already been issued successfully on to both public and private blockchains and been settled using both a CBDC and traditional fiat currency.

Major financial institutions around the world are working closely with national regulators to work out how security tokens can be issued, traded, settled and safekept on a regulated basis.

Tokenisation will force some traditional intermediaries in the securities markets – notably central securities depositories (CSDs) – to adapt or risk being disintermediated.

Regulators in France and Singapore have taken the lead in accommodating security tokens, notably by encouraging issuance and trading through legal changes and grants of licences.

The current boom in DeFi tokens will interrupt regulatory progress towards accommodating security tokens if investors are seen to suffer unwarranted losses.

However, the DeFi boom is also pioneering instruments and institutions which will help the security token markets to grow.

DeFi and other parts of the token markets have discovered the importance of liquidity and are rediscovering roles and techniques the traditional securities markets use to provide it.

Safe custody of private keys remains essential to the growth of security token markets. Technical methods of custody have improved, but custodians must develop value-added services too.

Digital identities could reduce the cost of on-boarding and monitoring issuers and investors and enhance regulatory confidence in the integrity of security token markets.

A difference in the approach to tokenisation by DeFi enthusiasts and traditional financial institutions interested in security tokens is now discernible.

Regulators are more likely to encourage convergence than further divergence.

Full Review

Regulated stablecoins are pioneering the nascent token issuance and trading industry. GMO Internet, the Internet infrastructure company headquartered in Tokyo, has become the first publicly listed company to apply for a trust company charter from the New York State Department of Financial Services (NYSDFS) to issue a regulated Japanese Yen stablecoin.

Stablecoins are useful to currency traders and hedgers

It is a significant development because the Japanese Yen is the third most liquid currency behind the US dollar and the euro, accounting for a quarter of activity in a foreign exchange (FX) market that, according to the latest Bank for International Settlements (BIS) survey, turned over US$6.6 trillion a day in April 2019.

It follows that the Japanese Yen stablecoin will be used by traders and buy-side users of FX in conjunction with other stablecoins for hedging and synthetic trading purposes. If the Bank of Japan elects to issue Japanese Yen as a central bank digital currency (CBDC) this could further encourage trading activity, or it might make a Japanese Yen stablecoin redundant – twin possibilities that confront stablecoins issued in other currencies too.

Only the passage of time will decide whether CBDCs ultimately displace stablecoins. However, it is reasonable to predict that the payments instrument which delivers the most efficient settlement of the cash leg of a security token transaction will eventually dominate.

CBDCs and stablecoins may achieve a stable co-existence

A CBDC fungible with fiat currency and available on a blockchain clearly has an edge over any payment tokens used on a blockchain, where access to fiat currency requires going off the chain and into the traditional payments systems run by correspondent and central banks.

However, it is also possible to envisage a mutually rewarding relationship between CBDCs and stablecoins, in which central banks issue CBDCs to FinTechs as well as banks, as a way of distributing currency to consumers. CBDCs could remain an inter-bank currency only, with stablecoins pegged to CBDCs used by consumers and industrial and commercial companies in their day-to-day payment activities.

Theoretically, CBDCs also create the possibility of programmable money. However, if issuers of CBDCs attempt to place restrictions on how CBDCs can be used – for example, insisting it is spent by the beneficiary rather than saved, or forbidding its use to purchase alcohol or tobacco – they risk creating more than one price for the same currency, so restrictions of that kind are likely to prove impossible in practice.

Security tokens might eventually supplant securities

If CBDCs threaten to supplant stablecoins, security tokens pose the same threat to traditional securities – and tokens based on traditional debt and equity instruments are now being tokenised successfully on both private and public blockchains.

In twin experiments conducted in April 2019 and May 2020 FORGE, the Société Générale subsidiary that experiments with blockchain technology with the ambition of designing a new digital market infrastructure for the capital markets, has already issued security tokens representing covered bonds on a public blockchain (albeit to itself) and proved the transactions can settle in either classical fiat currency or an experimental CBDC issued by the Banque de France.

The bank, which expects to open its platform to third parties next year, worked closely with the French regulator in running the experiment. Clearly, regulated status encourages investors to buy, hold and trade assets, and Société Générale is not alone in understanding this. Investment banks around the world are working with regulators to establish how security tokens backed by both liquid and illiquid assets can be brought to market in regulated form.

Banks are working with regulators to provide a sound basis for security tokens

These engagements are proving fruitful in educating both market participants and regulators in how existing regulatory frameworks can be adapted to security tokens and vice-versa. Regulators in Austria, France, Germany, Spain, the United Kingdom, Australia, Canada, India, Singapore, Thailand and other jurisdictions are now positively encouraging regulated firms to innovate in security token markets.

The NYSDFS, for example, has been regulating stablecoins since it granted Gemini Trust Company – issuer of the Gemini dollar, the first regulated stablecoin – in May 2018. This has given the regulator a high degree of familiarity with crypto-currencies, issuers and service providers. That in turn means licence applicants know what capital reserve, cyber-security requirements, compliance and Know Your Client (KYC), Anti Money Laundering (AML), Countering the Financing of Terrorism (CFT) and sanctions screening requirements they must meet.

In France, a change in the law published as early as October 2017 (the Pacte law) enabled the Autorité des marchés financiers (AMF) to regulate issues of crypto-currency tokens from April 2019. A Blockchain Order of December 2017 allowed unlisted assets to be issued not into a central securities depository (CSD) – as required by the Central Securities Depositories Regulation (CSDR) – but on to a blockchain.

Central securities depositories must respond to the threat-cum-opportunity of tokenisation

This was an important innovation by the AMF, because in the long run tokens do threaten to make CSDs redundant. Tokens can be issued into digital wallets on a blockchain directly instead of into a CSD, or even into accounts at a CSD.

Smart contracts can be written into the tokens themselves to safeguard the integrity of the issue, relieving CSDs of responsibility for ensuring the number of tokens in custody does not exceed the number in issue, and settlement can take place on the chain between digital wallets.

True, until all securities are tokenised, CSDs will still be needed to hold traditional securities, settle and collateralise transactions and safeguard the integrity of issues of securities. But the threat is postponed rather than eliminated. Indeed, in the long run traditional exchanges which own CSDs that fail to accommodate tokens will be putting their entire business franchise – listing, trading and data fees as well as settlement and custody fees – at risk if they do not adapt.

French and Singaporean regulators are driving how tokens are regulated

In March this year the AMF scored another European first, with the launch of an examination of the legal obstacles to the issuance of security tokens on to blockchain networks, which are liable to regulation not only under CSDR but under the Settlement Finality Directive and as multilateral trading facilities (MTFs) or organised trading facilities (OTFs) under the second iteration of the Markets in Financial Instruments Directive (MIFID II) and the Markets in Financial Instruments Regulation (MIFIR).

The review by the AMF is expected to end with adjustments favourable to security tokens in early 2021. In fact, the French regulator has already declared blockchain platforms exempt (as “bulletin boards”) under MiFIR and is sponsoring an exemption for security tokens from CSDR and the Settlement Finality Directive.

Likewise, Singapore has claimed leadership of security token regulation in Asia. The Monetary Authority in Singapore (MAS) issued a licence to a security token exchange for SMEs (1X, backed by Singapore Exchange (SGX)) as early as November 2019. And EQUOS.io, a crypto-currency exchange run by Diginex – which listed on Nasdaq via a SPAC transaction on 1 October – was granted a regulatory exemption from regulation under payments law by the MAS. This was what drew Diginex to Singapore from Hong Kong.

The DeFi token boom is both a threat to regulatory progress and valuable R&D

However, regulated institutions working on security token projects are concerned about the risk of regulatory regression. The likeliest prompt is the current boom in DeFi tokens, where 100 tokens currently enjoy a collective market capitalisation of more than US$12 billion. The prices of individual tokens have proved extremely volatile and liquidity limited. Investor protection failures might well encourage regulators to discourage further experimentation.

On the other hand, DeFi token experiments in collateralised lending, derivatives, leveraged trading and decentralised exchanges supported by liquidity providers are based on sound technical standards such as ERC 20. They could lead to the development of scalable crypto-currency equivalents of the money and repo markets, derivatives and stock exchanges.

One reason such experiments provide useful knowledge is that the DeFi token market, like the crypto-currency market before it, has had to develop its own issuance, trading, settlement and custody infrastructure. The existing infrastructure of the traditional securities markets is still closed to innovations of this kind.

Token markets are re-discovering what securities markets know: the value of liquidity provision

It is nevertheless striking how the token markets are rediscovering the utility of roles familiar in the traditional security markets, such as agency brokers, lead brokers that step in to provide liquidity occasionally, and market-makers which provide liquidity continuously. However, firms remain small. The entry to the securities token markets of the quantitative trading firms that provide liquidity in the securities and commodities markets could still deliver a massive boost to liquidity.

Tokenisation of corporate bond markets and Exchange Traded Funds (ETFs), both of which are intrinsically illiquid, would almost certainly attract trading firms making markets in these instruments. Derivative instruments based on underlying tokens (a technique already available in the crypto-currency markets), and especially price indices, would help too.

That said, any price index is of course dependent on liquidity encouraging transactional and price formation activity, creating a chicken-and-egg problem. The much-vaunted transparency of the token markets means there is a lot of data freely available already, and application programme interfaces (APIs) make it easier to integrate multiple data sets.

However, neither the crypto-currency nor the token markets are large enough yet to support data vendors and derivative and indexed products of the kind that boost liquidity in the traditional securities markets.

In the final analysis, nothing would do more to boost liquidity in security token markets than an influx of institutional investors – and the best way to attract them is to lower the risk of participation in the token markets.

Safe custody is vital to the growth of the security token markets

One service which helps to provide that confidence is a reliable safe custody service for tokens. Established financial institutions recognise this. Nomura, for example, has launched Komainu, a digital asset custody service, in conjunction with cryptocurrency wallet provider Ledger and cryptocurrency asset manager CoinShares. It is regulated by the Jersey Financial Services Commission.

Fireblocks has adopted a security token custody service based on multi-party computation (MPC). This is operationally more efficient than physical storage of private keys to an asset and co-ordinating multiple signatures to transfer an asset. It eliminates the single point of compromise and mitigates the risk of thefts of assets by insiders, which account for a large proportion of the losses by crypto-currency exchanges.

Lost keys and tokens can now be cancelled and replaced automatically, provided the tokens are issued on to a private, permissioned blockchain. These processes had until recently to be completed manually. This is a non- trivial task. If private keys and their back-ups are both lost, the code has to be re-written and a different version of the token issued, so completing it manually for thousands of sets of keys is expensive and time-consuming.

The role of token custodians must expand beyond custody and settlement

The role of the tokenised asset custodian is now expanding beyond pure safekeeping. Issuers are looking to them to complete KYC, AML, CFT and sanctions screening checks, settlement and client reporting. This is not just because custodians are the logical choice to do this work. At this stage in their development, the token markets are relatively small and illiquid. As a result, it is usually more expensive to access a security in tokenised form than to buy it directly.

So the token markets need to develop additional value-added services to attract investors. Giving investors a high level of confidence in the custody arrangements is a sine qua non. After all, in the traditional securities markets, custody is extremely cheap – one basis point or less on the value of assets in custody – and the price of safekeeping private keys has to at least match that.

Cheap and safe custody is a foundational service only. Faster or even real-time settlement of transactions can be helpful in reducing counterparty credit risk, but also requires both security token and payment accounts to be pre-funded, which adds to costs. Delivery of tokens against payment in CBDCs or payment tokens is also hard to envisage without agreement on a standard method of settling security tokens.

So the more compelling attractions are likely to be efficient onboarding, comprehensive reporting and efficient asset servicing. Specialist providers could compete to supply them on blockchain networks, either continuously or by contractual arrangement.

Digital identities could help to secure regulatory support for security tokens

Another product, digital identities, which would enable service provider to confirm the identity of counterparties without onerous and manual KYC, AML, CFT and sanctions screening checks, could also speed up the on-boarding of issuers and investors.

Regulators are certainly encouraging the concept of digital identities. In March 2020 the Financial Action Task Force (FATF) published guidance on how digital identities can be used to comply with the customer due diligence requirements set out in commendation 10 of its 40 recommendations on combatting money laundering and the financing of terrorism.

This followed an earlier updating (June 2019) by FATF of Recommendation 16 – which requires financial institutions on both sides of money transfers to identify the originators and beneficiaries of wire transfers to ensure they are not money launderers or terrorist financiers – to cover the crypto-currency markets. The so-called “Travel Rule” applies Recommendation 16 to Virtual Asset Service Providers (VASPs) such as crypto-currency exchanges and wallet providers.

In the United Kingdom the Financial Conduct Authority (FCA) became from January 2020 the KYC, AML and CFT supervisor for businesses carrying on “crypto-asset” business. Its compliance requirements include initial and ongoing customer due diligence, especially on customers from high risk jurisdictions. The FCA also warned in March 2020 that Bitmex, the Hong Kong-based crypto-currency exchange, was providing products and services in the United Kingdom without authorisation.

The FCA is clearly signalling that it expects innovative firms to meet the same standards as established firms when it comes to investor protection and KYC. This has implications for DeFi token enthusiasts combining applications already running on blockchain networks to create entirely new financial products and services.

DeFi tokens may mark the fault line between two competing versions of a tokenised future

The DeFi tokens currently pioneering collateralised lending, derivative instruments and decentralised exchanges, for example, can in theory be “composed” in much the same way that Uber combines telephone, mapping and payments applications to provide a transport service.

This opens the possibility of fast-to-market, completely transparent products being launched and traded across platforms in ways the traditional cash and securities markets cannot match, because they are divided into regulated silos that cannot (and do not wish to) share information.

The “composability” of applications on blockchain makes it easy in principle for, say, a stablecoin to become a component of a new product by combining its listing on a ready-made crypto-currency exchange with a tool for pledging it to a lender and another tool for investing it in a money market fund with a fourth tool for placing it in a basket that is used to create a derivative instrument.

The developer who creates the combined products does not have to make any of these components, and at present is not regulated in the same way as a traditional financial institution.

By contrast, the banks engaged in the security token markets are all regulated institutions and have chosen to work closely with regulators in developing products and services. It will be difficult for them to work with VASPs that have a more adventurous attitude towards regulation, so inter-operability between the traditional inhabitants of the securities market (which own the clients) and innovative newcomers (which own the ideas) hinges on a convergence of views in the field of regulation.

Questions to be addressed at the next clearing and settlement discussion

How have regulatory attitudes toward security tokens evolved?
What influence are CBDCs having on the development of security token markets?
Will stablecoins survive and thrive?
Has security token issuance moved beyond the experimental stage yet?
Have central securities depositories evolved their offering to accommodate security tokens?
What can participants in the security token markets do to accelerate adoption of digital identities?
What have the markets learned from DeFi tokens?

The Future of Finance is always open to hold further meetings to answer these and other questions and to continue the conversation. If you would like to sponsor such a meeting please contact Wendy Gallagher at the number or email address below. Also view our upcoming meetings elsewhere on http://www.futureoffinance.

Wendy Gallagher
Tel: + 44 (0)7725 160903
Email: wendy.gallagher@futureoffinance.biz