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The transformation of the CSD industry edged closer in the summer of 2019 when Orange, an outsider to the securities industry, backed the first new CSD in Europe to go live with blockchain technology. Less than two and half years later, Orange reversed its decision. The closure of ID2S has prompted questions, not only about the effectiveness of blockchain technology in post-trade activities, but whether it is even possible to innovate in the European CSD industry. Dominic Hobson, co-founder of Future of Finance, asked Andrea Tranquillini, who led ID2S as CEO, what the experience can tell us about the role of innovation in post-trade services.
Hobson: Innovators saw ID2S as confirmation that change was possible in post-trade services in Europe, so the decision to close the company is distressing for anybody who believes there is a better way of issuing, trading and settling securities, and especially for you. What went wrong?
Tranquillini: The answer to that question is complicated. It has three different dimensions. There is an IT dimension, a regulatory dimension and, finally, a business dimension.
Hobson: Tell us about the IT dimension first. Did ID2S prove that blockchain technology is not well-suited to the CSD industry?
Tranquillini: No. Quite the opposite, actually. Blockchain, as a specific implementation of Distributed Ledger Technology (DLT) was perfectly adapted to the goals that ID2S set for itself. This would be true of any blockchain technology. We happened to use technology developed by SETL, but other blockchain protocols would have worked just as well. In other words, there are no fundamental obstacles to the application of DLT to the core functions of a central securities depository (CSD), which consist chiefly of recording newly issued securities in a book-entry system (the notary function) and settling transactions by delivering securities against payment between sellers and buyers. Of course, each blockchain protocol has its specificities but all of them are capable of delivering the services required. DLT also delivers what it promises: greater agility and a lower cost of implementation than the traditional technologies used by established CSDs. So adoption of DLT is not the problem that sank ID2S. Other factors are. SETL recently issued an assessment of why DLT has not been widely implemented in the financial services industry. Of the reasons they cited, I would endorse two in particular. First, legacy systems. At financial market infrastructures such as CSDs, systems tend to survive several generations of chief technology officers. As a result, they are based on complicated, costly and inflexible platform architectures. Legacy systems also make it difficult to integrated older systems with the new – a problem exacerbated by the fact most CSD users suffer from variants of the same problem. Secondly, adoption of new systems requires long-term vision by senior management, because it does put at risk the short-term P&L, even if it transforms the long-term P&L. Unfortunately, a visionary mind-set is not always present.
Hobson: What about the regulatory dimension?
Tranquillini: Using DLT as the basis of a book-entry system is a relatively well-recognised approach, which does not trouble regulators. Where regulation does struggle to adapt is in the area of settlement on the ledger (so-called “on-chain” settlement) and with the concept of digital or digitised securities. There are several initiatives in train at the European level to recognise the use of DLT as an appropriate technology for financial services and for FMIs in particular. In September 2020 the European Commission adopted a package of digital finance measures. They included legislative proposals to adapt regulations to facilitate the development of digital assets and to encourage the adaptation of FMIs to ensure digital assets do not undermine operational resilience, investor protection and financial stability. The proposed Regulation of Markets in Crypto-Assets (MiCA) regulation even aims specifically at “boosting innovation while preserving financial stability and protecting investors from risks.” Yet, despite these apparent adaptations, regulation in Europe is actually suppressing innovation, not boosting it.
Hobson: How?
Tranquillini: Because the European Central Bank (ECB) has made it clear that digital securities transactions cannot settle directly between digital wallets on the DLT network (the so-called “on-chain” settlement). Instead, settlements must continue to take place “off-chain” in a CSD – in particular at TARGET2-Securities (T2S), the pan-European settlement service operated by the ECB. This mitigates the benefits of using blockchain technology to issue, trade and settle digital securities.
Hobson: So what the ECB gave with one hand, it took away with the other – it made using of the services of a CSD such as ID2S compulsory, but denied ID2S the competitive advantage of using DLT?
Tranquillini: Exactly. Many of the benefits of issuing and trading digital assets on DLT stem from the ability to settle transactions token versus token between digital wallets “on-chain.” But by specifying that tokenised assets are securities, without revising existing securities laws to accommodate the specific characteristics of digital assets, the European regulators are saying that settlement finality in digital asset transactions cannot be achieved outside a traditional CSD.
Hobson: The ECB of course operates a CSD that is not covering its costs. Is its thinking entirely self-interested?
Tranquillini: “On-chain” settlement is seen by regulators as increasing operational risk. It follows that any financial instrument issued, traded and settled “on-chain” will be penalised in terms of its liquidity, its credit rating, its eligibility for use as collateral and its scope for wide distribution. As a result, there is no incentive to issue and settle “on-chain.” Indeed, D7, the digital asset initiative launched by Clearstream to make the German bond markets more efficient, is able to automate the registration of new digital issues but transactions must still settle “off-chain” in T2S. This means that, whatever the original form of issuance of a security, changes of ownership must not only be recorded on a book entry system at a CSD but also settle in an environment where settlement finality can be achieved in a legal as well as a practical sense. DLT is not considered to be an environment in which settlement finality is legally achieved. That said, ID2S was established in France, the only European Union (EU) country to recognise DLT as the equivalent of a traditional book-entry system via Ordinance 2017-1674 and Decree No. 2018- 1226. Those measures established that securities credited to a distributed ledger have the same legal effects in terms of settlement finality as book-entries.
Hobson: So why could ID2S not succeed from France as its legal jurisdiction in attracting business from elsewhere within the EU?
Tranquillini: The French jurisdiction did help in removing the barrier to usage of DLT, and through passporting ID2S was authorised to operate under English and Irish law as well. Indeed, ID2S was the first CSD to host dematerialised international securities under English law. But a number of other factors conspired against sustained success. First, the prolongation of the Targeted Longer-Term Refinancing Operations (TLTROs) of the ECB, first introduced in 2014, provided a strong alternative source of short-term funds to commercial paper for financial issuers. The Pandemic Emergency Purchasing Programme (PEPP) introduced in March 2020 then had the same effect for corporate issuers. As a result of these adverse developments, our volumes never reached the projected targets. Needless to say, a prolonged period of zero to negative interest rates did not help either. Secondly, the international central securities depositories (ICSDs) were understandably reluctant to connect to ID2S as investor CSDs. Had they connected, it would have boosted secondary market liquidity, but it would also have given ID2S access to their clients, which they did not wish to do.
Hobson: I am surprised that was permissible under the Central Securities Depositories Regulation (CSDR), which insists on open access. Why was such a stance permissible?
Tranquillini: Actually, CSDR does not oblige CSDs to accommodate bi-lateral links of the kind that would have benefited ID2S and the clients of both ID2S and the ICSDs. In that sense, CSDR is less effective than the second iteration of the Markets in Financial Instruments Directive (MiFID II), which obliges any Market Trading Facility (MTF) to allow transactions to be cleared or settled by any CSD or CCP via a bi-lateral link. CSDR affords a protectionist option.
Hobson: What about the DLT Pilot Regime announced by the European Commission – wasn’t that meant to encourage regulated firms such as ID2S to develop DLT-based settlement services by giving them exemptions from certain regulatory requirements, such as the obligation to settle and record transactions in a CSD? Wasn’t that meant to be the game-changer for tokenised securities?
Tranquillini: The DLT Pilot Regime is frustrating, because the limits on the market capitalisation of equity issuers (€200 million) and the size of bond issues (€500 million), and the overall limit of the total market capitalisation of securities that a DLT-based CSD can record (€2.5 billion), are set too low for a new market entrant to gather momentum by developing a critical mass of issuance. Without the critical mass of issuance, it is impossible to recover the costs of building the infrastructure and establish a commercially viable service offering. ID2S published a paper pointing this out and discussed its contents with both the Autorité des Marchés Financiers (AMF), the French securities regulator, and the European Securities and Markets Authority (ESMA). The market is being over-regulated out of existence before it has even begun. The combination of MiCA and the DLT Pilot Regime effectively leaves the incumbent CSDs in place, by protecting their “off-chain” settlement flows, and making it impossible for new entrants to build a critical mass of issuers.
Hobson: What about the third factor you mentioned – the business dimension?
Tranquillini: Since DLT reduces long-term costs, the business case for adoption of the technology depends on commercial rather than financial considerations: in short, how can a new entrant attract sufficient business to be viable? Here, it is hard to be hopeful. Numerous Proofs of Concept (PoCs) have proved that debt issuance on DLT is more efficient, but it has not led to adoption. A chicken-and-egg dilemma is at work. Both issuers and investors want liquidity, because that lowers the cost of finance for issuers and provides efficient secondary market trading for dealers and their buy-side clients. But a new entrant, by definition, cannot provide liquidity until it attracts new and existing issuance and trading activity.
Hobson: Is there any incentive for incumbent post-trade service providers to adopt DLT?
Tranquillini: Why should they? The conventional technologies work, the profit margins are handsome, the domestic CSDs are monopolists, the cross-border duopoly is stable and neither the issuers nor the investors are demanding change. Change entails costs and the risk of an IT project that might fail. Some think the entry of Euronext into the post-trade space after the acquisition of Monte Titoli might challenge the status quo, especially across borders in Europe, because they are using Dublin to list securities and the four CSDs within the group as distribution channels. But in reality I expect Euronext will be busy for some time consolidating its acquisitions. Also, the acquisition of BME by SIX has not produced any material effect.
Hobson: Which FMIs in Europe do you believe do have a credible DLT strategy?
Tranquillini: SIX, with SDX, and Deutsche Börse Group, with D7 and 360X, seem to have concrete plans to adopt DLT and host digital assets. Jens Hachmeister is a visionary. But, apart from ID2S, there is no instance of a CSD using DLT for both its core functions and ancillary services. At ID2S we believed that the entry strategy for a new player should be around offering new financial products that could leverage DLT or blockchain, because the technology could attract a wider set of investors and so broaden distribution. Instead, the expected regulatory changes in the EU seem to be designed to preserve the status quo. That pleases the incumbents because it keeps post-trade services stuck in the conventional mode. At best, we have purely nominal issuance of digital assets and no prospect of “on-chain” settlement in the near future.
Hobson: Do you think issuers and investors need to be bolder in pushing for change?
Tranquillini: Certainly, they should have no concerns at all about the quality of the technology. New financial products based on the tokenisation of assets lead to improvements in operating models, lower costs and reductions in risk. Liquidity is a different matter. No issuer wants to risk paying a higher price for capital and no risk committee would allow an investor to place a significant portion of its portfolio where there is a liquidity issue. But then it is issuers and investors which create liquidity, and their conservatism inhibits it, as does the current regulatory set-up in Europe. Also, not all the intermediaries – by which I mean chiefly fund managers and custodian banks – are focused on digital assets or see them as an opportunity to increase their assets under management or custody. New technology can cut costs but technology alone cannot secure issuance flows or create liquid secondary markets. That needs issuers and investors as well as their intermediaries to engage and take a long-term view of the benefits. In essence, we need an infrastructure that can address the concerns of the regulator and prove that DLT does not increase settlement risk by making it possible to settle transactions “on-chain.”
Hobson: So, is there a way to deliver that infrastructure?
Tranquillini: Yes, I think there is. First and foremost, European legislators need to take advice from independent industry experts. The legislative and regulatory measures proposed so far seem to protect the interests of the incumbent FMIs. Most market participants take their cue from regulators, not market opportunities, so regulators are dashing their own hopes of encouraging change. Secondly, change must be driven jointly by the users of FMIs as well as the operators of FMIs. The creation of a user-owned CSD in a jurisdiction where the regulation favours change – which might be read to mean outside the EU, at least in the short term – is the best hope for rapid adoption of DLT. A user-owned CSD would solve the twin issues of liquidity and secondary market trading, because it would be controlled by issuers, investors and service providers such as custodian banks and paying agents. Such a CSD should also be capable of issuing tokens into digital wallets “on-chain” and settling transactions between digital wallets “on-chain” as well. There is no other way that tokenisation of securities in a CSD can succeed.