Capital Markets, Blockchain & Tokenisation

It has been a busy 2 weeks at IntellectEU. Covid-19 has dramatically changed the way we work and is clearly having an impact on the economy. The past 2 weeks IntellectEU reassured continuity for current client projects, remote onboarding for new hires, and foremost the wellbeing of our people. Additionally, we came with the idea to start blogging, so welcome to our first blog post. In this post, I’ll introduce you to how capital markets work, and why we believe blockchain technology can have an impact on this industry. With this, I hope to start a discussion on the impact of tokenisation and open data platforms whilst concisely describing how some of the players interact with each other today.

MAD architects ‘Fake Hills’

To understand how the markets work, it’s important to get a clear overview of the “Who” and the “Why”. Capital markets involve many participants, each with their own responsibilities, needs, and regulatory constraints. But before we dive into the different roles it’s important to make a clear distinction between trading and post-trade processing. Trading is when a buyer (someone who wants to invest capital) and a seller of financial products (bonds, equities, options, etc.) are matched, typically using a stock exchange (e.g. Nasdaq, NYSE, Euronext, etc.). Post-trade processing only occurs when the trade is completed. The buyer and the seller will compare trade details, approve the transactions and arrange the transfer of securities and cash. This last process is what we call settlement. During this settlement period, the buyer must execute the payment for the securities while the seller must deliver the securities that were acquired.

Below, I’ll briefly describe the participants involved in the equities market, both on the trading and the post-trade processing side:

• Issuer: public companies or governments that issue stock (or other financial products). These are legal entities that have agency.
• Underwriter: sells the initially offered stock (or debt). Can be done by multiple underwriters (= syndicate)
• Investors: purchase and hold financial products of a company
• Institutional: mutual funds, pension funds, and hedge funds take positions that are pooled from many individuals
• Retail: individuals making own decisions on financial products to buy
• Trading Venue:
• Exchanges: regulated organisations that publish quotes to buy or sell a stock, also post-trade data (NYSE, Nasdaq, Euronext, etc.)
• Dark pools: not revealing information or details about trading, for big orders to buy/sell quietly. Operated by broker-dealers (JPM, UBS, CS, etc.)
• Brokers: facilitates trading on behalf of investors (= sell side). Participate directly on an exchange and provide additional services to investors.
• Custodian: is usually a bank doing safekeeping and administration of securities or other assets for customers and may provide various other services including clearing and settlement, cash management, FX transactions, securities lending, and collateral management. Customers are mostly brokers and investors.
• (International) Central Securities Depository: performs critical functions linked to initial issuance and distribution of securities on behalf of the issuer. Core services are safekeeping, settlement, notary services, and asset servicing. Issuance and distribution via CSDs include domestic, foreign and international new issues of global and domestic financial instruments.
• Issuer & Paying Agent: is an intermediary that can act between the issuer and the issuer CSD. It provides issuance services (corporate actions, accountancy, etc.) and is in most cases a bank.

Custody Chain

There are many other players in the market but for obvious reasons, I wanted to keep it as simple as possible in this post. Others include national numbering agency, trustee, transfer agent, common depository, and registrar.

In the next section, we describe how these participants in the stock market interact to form the lifecycle of a trade, initiated by the institutional investor. It all starts with the investor (individual or entity with excess capital) that gives money to an investment manager. This manager will decide which financial instruments to buy and sell. The portfolio manager will communicate trade orders through an order management system to the trader, who will make a decision on what the broker should be used and what algorithms. Broker-dealer communications go via an execution management system, the broker will route the order to (various) stock exchange(s) to buy/sell the required financial product. Once the trades are confirmed the broker will communicate this back to the investor. This process of matching orders to buy and sell a stock, and execution of the resulting trades are quite efficient today. Large stock exchanges, such as Nasdaq, execute over 10 million transactions daily. Most of them are fully automated (straight-through-processing). Most of the manual processes, inefficiencies, risk, and reconciliation happen in the post-trade process.

To understand the post-trade process we have to go back in time. Historically, securities were issued as paper certificates and the bearer was presumed to be the owner (bearer securities). This process was costly and risky, so they came up with the idea of central securities depositories. These entities immobilised the certificates and removed the need for physical settlement. When technology became more advanced securities were dematerialised — this refers to the substitution to electronically book-entry keeping of securities. In this new holding system an intermediary holds a record of the ownership of financial instruments. Will the next step be tokenisation? More on this later.

Now that we understand that financial instruments are held by intermediaries (brokers, custodians, etc.) on behalf of their clients with the CSDs, and change ownership via a book-entry accounting system, we can start looking into the settlement cycle. This starts after the execution of the trade (day T) and finishes typically one to three days later. Two main processes occur:

• Clearing: is the process of offsetting or netting trade obligations. This can involve a central counterparty (CCP) to protect participants from the risk of a trade failing to settle and having to be replaced at an unfavourable price.
• Settlement: is the process of transferring ownership. It includes two transfers, the delivery leg (move of the securities) and the payment leg (move of the cash). Some transactions such as collateral movement or securities lending are free-of-payment and only include a delivery leg.

During settlement we link the securities and cash transfer, this process is called delivery-versus payment. It ensures the delivery occurs, if, and only if, payment occurs. This process was put in place to mitigate counterparty risk (the risk that one counterparty will lose the full value of a transaction). A graphical example of the process is attached below.

The DvP Process

Within DVP we have identified three different approaches:

• DVP 1 is a system that transfers both legs on a gross basis. This reduces exposure among the participants during the settlement day. (Euroclear, Clearstream, Iberclear)
• DVP 2 settles the delivery leg on a gross basis and happens throughout the processing cycle, but the cash leg only settles on a net basis at the end of the day. Why would you do this? Because less cash liquidity is needed as a result of netting. (Nasdaq CSD Iceland, CSD Prague)
• DVP 3 settles both the delivery and cash leg on a net basis. This happens at the end of the processing cycle and reduces liquidity requirements. (OeKB CSD, SKDD, LCD)

Another important concept of settlement is finality. This is the moment after which a transfer order cannot be revoked — nor by a participant in the transaction nor by a third party. It’s important to manage and eliminate risk and many financial institutions believe distributed ledger technology can establish settlement finality.

So, now that we understand how the trading and post-trade processing work we can look into the tokenisation of securities. This is the process of issuing securities as digital tokens. It involves immobilising the book-entry securities and trading representations of them. The properties of this token can vary and the record of transactions can be held on a distributed ledger (for example The Corda Team The R3 Team). This is a network of nodes/organisations that keep a synchronised secured copy of the ledger. The validation of a token happens with the private key and permits the holder to unlock the rights related to this specific token. This means authorisation depends on this validity and not on the authorisation of the CSD verifying the identity of the account holder. As Bitcoin represents cash, we can compare a digital security to the digital version of a bearer security. The holder of a valid paper (= private key) is bestowed to the rights related to this paper/token. Another interesting feature is the potential to create “programmable securities”. Through the use of smart contracts (such as DAML) we can code self-executed actions based on predefined criteria. Think about a cash equity automatically paying out dividend to its rightful owner or routing tax payments directly. Other interesting built-in features in the token include KYC and AML regulatory requirements. So why is tokenisation so interesting for these big market infrastructures and financial institutions? They have the potential to dramatically reduce some of the costs, complexities, and inefficiencies in the post-trade process. Today brokers, custodians, and CSDs have thousands of resources committed to reconciliation, trade confirmation, and other back-office processes. A shared ledger eliminates the need for reconciliation and tokenisations increases STP. This could lead to a reduction in manual processes, overhead costs, and intermediaries. Tokenisation could only fully solve for counterparty risk if we have both the delivery and payment leg on the DLT. This could reduce settlement cycles and mitigate the principal risk. A shorter settlement cycle and lower counterparty risk could eliminate the need for a CCP. But do these participants really want shorter settlement cycles as this could exponentially increase liquidity requirements (need for cash on account to settle in real-time)?

At IntellectEU we believe tokens are the future of securities settlement but should be combined with rethinking and digitising the issuance process, governance models, and collaboration between participants. Many challenges remain, such as managing counterparty and replacement risk and (central bank) cash on the ledger. These are definitely challenges that can be overcome by an industry that has always been driven forward by innovation. IntellectEU is working with some of the largest stock exchanges and CSDs to reinvent themselves and discover the wonderful world of DLT & tokenisation.

For more information reach out to info@intellecteu.com or contact Thomas Bohner, head of Blockchain directly!

Sources:

https://ec.europa.eu/info/sites/info/files/170515-eptf-report-annex-3_en.pdf

https://www.bis.org/publ/qtrpdf/r_qt2003i.htm

https://www.investopedia.com/terms/p/post-trade-processing.asp