Tokenisation is asking CSDs if they have the courage to change

Even conservative observers of the financial markets believe security tokens may be about to embark on a period of exponential growth, If they do, tokenisation will threaten the ways in which CSDs currently support the securities markets. But security tokens also present CSDs with an array of opportunities to reinvent how they operate, from governing permissioned blockchain networks to orchestrating continuous auctions of best-in-breed post-trade services. If they have the courage to embrace change, they will find support in some unexpected quarters – regulatory agencies and tokenisation platforms.

A major financial market infrastructure has predicted that, within five to ten years, conventional securities exchanges and tokenised platforms will be of equivalent size.

Outstanding issues in the global bond markets ended 2019 worth US$106 trillion, and the value of the global equity markets added another US$95 trillion. 1.

So the growth potential of the security token markets is – and for once the term is not hyperbolic – exponential.

The security token markets, once under way, will grow exponentially

From a technology perspective, such claims are entirely realistic. A characteristic of markets driven by digital technology is that they scale quickly.

Indeed, the main obstacle to rapid growth of security token markets is not the technology at all – that is in place already – but the need for securities laws and regulations to catch up with the technology.

Although a number of jurisdictions have passed laws to accommodate securities tokens already, potential issuers and investors are waiting for the major financial centres to get comfortable with tokenisation technologies before they act.

Once major market regulators are comfortable, and a security token issue is seen to be a success as both a capital-raising and an investment, growth is likely to accelerate quickly.

Emerging market CSDs are excited by tokenisation and developed market CSDs are expected to be ready

Among the wait-and-watchers are central securities depositories (CSDs). As regulated, systemically important national infrastructures protected from external competition, most CSDs are presently adhering to their existing mandates to settle electronic debt and equity securities.

However, a number, especially in emerging markets, are alive to the possibility of securing new business from tokenisation.

The emerging market CSDs are willing to experiment with security tokens because they see an opportunity to service large but previously illiquid asset classes, such as real estate.
They see opportunities chiefly in their domestic markets but also in attracting inbound foreign capital.

However, even in developed markets, CSDs are under pressure to act, because the sub-custodian banks that act as the gatekeepers to their services (and which often serve as CSD board members and shareholders) are pressing CSDs to be ready for the advent of tokenisation.

The sub-custodian gatekeepers to CSDs are pressuring CSDs to be ready

This is because the sub-custodians detect their network management clients are under mounting pressure from their institutional buy-side clients to facilitate investment in crypto-currencies and (eventually) security tokens.

Readiness is of course a hedging strategy. Custodians do not believe that tokenisation will destroy their business, but nor do they see it as a great new business opportunity.

Which is why they hope achieving a state of readiness will not necessitate wholesale replacement of the existing technology platforms of the CSDs, since that would oblige them to invest in new forms of connectivity.

The experience of the ASX in Australia, which chose to replace its existing CSD system with a blockchain-based alternative, suggests that gatekeepers to and users of CSD services are reluctant to support new services if they entail investment in new systems.

Indeed, many tokenisation platforms now prefer to use standard messaging protocols such as FIX and SWIFT precisely because it eliminates a barrier to adoption by custodians.

Beneficial owner accounts are as good as digital wallets, argue some CSDs

For their part, CSDs are concerned that the benefits of tokenisation will accrue not to them but to intermediaries like the custodian banks and to issuers and investors, especially in markets where CSD users operate omnibus accounts that commingle investor holdings.

CSDs that offer end-investor accounts can argue that they already deliver the direct ownership benefits offered by a digital wallet for holding security tokens on a blockchain network.

That said, tokenisation has the potential to reduce the distance between issuers and asset owners to an infinitesimal space.

By coding entitlements, for example, tokens write the relationship into the asset itself.

CSDs will not integrate security token services with securities services but develop them separately

Innovations of this kind, which are already being tested in the DeFi markets, are likely to proliferate first outside the traditional, regulated debt and equity securities markets.

This implies that security tokens cannot be serviced by an unchanged set of CSD services. It also means that the innovation will occur in a parallel universe adjacent to the traditional markets.

Eventually, however, activity will shift from the traditional securities markets to the tokenised markets, and CSDs will be forced to follow or become irrelevant.

Cash-constrained CSDs foresee governance roles for themselves in blockchain networks

A question for CSDs is whether they can afford to invest even in this parallel universe.

Though sub-custodian banks grumble about CSD fees, there is not much room to cut them. Custodians nevertheless put CSDs under constant pressure to reduce fees and, whenever they succeed, are apt to retain the benefits by not passing on the reductions to clients.

Lack of investment capital is one reason why CSD thought-leaders predict an administrative rather than an operational role for CSDs in tokenised markets.

They see CSDs as “governors” of closed or permissioned token networks, deciding who can join and disciplining rule-breakers.

CSDs as governors might also take on responsibility for running Know Your Client (KYC), Anti Money Laundering (AML), Countering the Financing of Terrorism (CFT) and sanctions screening checks on participants as they are admitted to the network.

CSDs may indeed be valued by token network participants for fulfilling precisely these roles – certainly, that is one lesson of the ASX experience in deploying blockchain to provide CSD services – but it is unlikely that they will also own and control the technology underpinning the network.

A radical option for cash-constrained CSDs is to disintermediate the sub-custodian banks

A radical option for CSDs is to dispense with sub-custodians as intermediaries altogether and offer direct access to their services to network managers (and the buy-side) across national borders.

The global custodian banks have already adopted this approach in the euro-zone, albeit constrained by the inability of the TARGET2-Securities (T2S) settlement platform run by the European Central Bank (ECB) to provide asset-servicing, which forces them to retain sub-custodians to collect entitlements and manage corporate actions.

However, direct access to CSDs might also force smaller CSDs, as well as sub-custodians, to exit the business by sale or merger.

CSDs could also unbundle their services and offer users best-of-breed combinations of service providers on token networks

A less radical option is for CSDs to unbundle or decentralise the work they do.

They could do this by insisting their account-holders do the work instead.

Maintenance of an up-to-date registry of investors based on rapid absorption of transactional information, which accounts for three quarters of payroll at some CSDs, is an example of work that could be done in a distributed fashion – and tokenisation based on blockchain may eventually force that solution upon CSDs.

Indeed, one possibility is that the functions currently performed by centralised CSDs are divided between multiple providers.

More adventurous CSDs could combine governance and administration of networks with the selection, admission and supervision of independent service providers to the networks.

All the main functions of a CSD could be provided by specialists, orchestrated by CSDs

Issuance, registration, maintenance of the integrity of issue, settlement, safekeeping and (where they are provided) asset servicing, securities lending and collateral management could be provided not by centralised CSDs but by decentralised specialist firms that compete for the business, perhaps even continuously.

Software as a service (SaaS) from the Cloud already makes it technically feasible for buyers of services to put together their own best-in-class combinations of services.

Blockchain just promises to make that process faster and cheaper, and possibly to deliver it via continuous auctions on price and counterparty risk.

CSDs could survive such a radical change in their environment by abandoning the current centralised, integrated model of service and instead put together similar packages of services on behalf of clients.

In short, they do not need to build, own and control, say, a KYC, AML, CFT and sanctions screening service, in order to deliver one to users – they just need to select and supervise it.

Such a service might even enable CSDs to expand beyond their traditional clientele in the securities industry to attract business in retail banking, insurance, shopping, telecommunications, utilities and universities.

It is far from improbable. Central Depository Services (India) Limited (CDSL), for example, already provides insurance and educational credentials services to retail customers.

Tokenisation is coming within the scope of regulation

But whatever path the CSD innovators eventually take, regulators will follow, and may even lead. Although they created CSDs, regulators are less inclined to support the status quo than CSDs, as regulated national monopolies, like to believe.

Regulatory frameworks have changed already to accommodate tokenisation in Germany, Hong Kong, Singapore and Switzerland – albeit within the constraints set by the underlying principles that inform existing securities laws and regulations.

The risk-reducing properties of decentralisation are attracting regulatory attention

Having driven the dematerialisation of securities into CSDs since the 1990s, using the centralised database technologies available at the time, regulators are now concerned about the risks of over-centralisation of data sets, which include creating honeypots for hackers.

Decentralised technologies, such as Blockchain, have made it possible to reverse the centralising trend in financial market infrastructures that has prevailed since the early 1990s.

The pendulum may one day swing back in favour of centralisation, but for now it is firmly set towards decentralisation.

Indeed, participants in the DeFi market are already using Blockchain technology to experiment with decentralised alternatives to CSDs.

Their work is being studied by incumbent CSDs and their account-holders, though none has yet acted on what they have discovered.

CBDCs indicate regulators and central banks believe they can combine the stability of the status quo with the efficiency of tokens

Regulators will nevertheless not welcome any decentralisation that leads to the disintermediation of the entities that are accountable under the existing dispensation for protecting investors, providing operational resilience, mitigating systemic risk and ensuring continuity of services.

The imminent advent of central bank digital currencies (CBDCs) also means that central banks in particular will want to control, at least initially, access to purely digital forms of central bank money.

However, even in the narrow field of delivery versus payment in central bank money, the fact that central banks are even planning to introduce CBDCs indicates – among other things – that they recognise the efficiency-enhancing properties of settling token transactions in fiat currency on-chain rather than off-chain.

Token innovators are embracing regulation as the key to accessing institutional money and CBDCs

In any event, innovators in the tokenisation markets now fully understand regulatory caution and concern.

They recognise that, because they are providing regulated financial services, and because they want to appeal to institutional investors, and because they want access to CBDCs, they must engage with regulators.

This regulatory convergence is part of a wider pattern of convergence. Although traditional securities markets and tokenisation markets can be expected to co-exist for a long time, a process of convergence is under way already.

Just as tokenisation enthusiasts are accepting the need for regulation and seeking regulatory licences, regulated firms are accepting that tokenisation technologies are a motive force within their markets and exploring how they can apply them.

The securities and security token markets are converging and CSDs can assist the process

Where CSDs can further assist the pace of convergence is by providing mechanisms that enable different blockchain networks, and blockchain networks and traditional securities markets, to inter-operate. They are in a perfect position to do this.

First, by providing settlement capacity. One of the promises of tokenisation is the “democratisation” of investment through fractionalisation, increasing the volume of transactions.

Fractionalised crypto-currencies are already trading on multiple exchanges, with market participants moving efficiently between them, which suggests there is no bottleneck at the trading level.

However, friction does occur at the post-trade level, where tokenisation has yet to incorporate off-chain cash legs successfully, or fully realise the benefits of netting. This is of course precisely where CSDs operate.

Post-trade friction is a potentially massive opportunity for CSDs, especially if they are able to act as “switching stations” between blockchain networks and traditional exchanges. The enhanced liquidity will increase the pace of growth of the new markets.

CSDs can benefit from that growth, if they choose to do so, and the decision to act will become easier as growth accelerates. Easier flows between all platforms and networks will not only boost liquidity and increase transactional activity, but also bolster the business case for CSDs to invest in tokenisation platforms.

1. SIFMA, 2020 Capital Markets Fact Book

Written by Dominic Hobson April 2021