The State of Security Tokens 2022 — Public Market Upgrades & Value Adds
Public Company Shares
Private markets aren’t the only realm due for a digital upgrade. While the public markets are active and liquid, we are far from peak efficiency. Seeing the sheer number of parties involved in each stock trade “behind the scenes” points to a new small fee at every step — a fee that typically comes out of the stock purchaser or seller’s pocket, rather than the intermediary’s. See the below diagram for a rough draft of the working settlement process, and continue on to learn where security tokens serve to ease these pain points.
DTCC & “Project Whitney”
The Depository Trust & Clearing Corporation (DTCC) is responsible for the plumbing that facilitates trillions of dollars of trade settlements, clearing, and security. As an overview, “The DTTC is responsible for clearing, settling, and disseminating sufficient information regarding various securities products — including alternative investment options, mortgage and government-backed securities, municipal and corporate bonds, and mutual funds.”
The DTCC was incepted in the late 1990s to progress the backend processes within the public markets, and this initiative was built upon previous ones including but not limited to:
- the massive surge in trading volumes in the 1960s
- managing book entry (“street name”) vs. bearer form certificates
- custodial improvements across the lifecycle of a stock
After being established for 20+ years, the DTCC is now exploring the use of blockchain technology and tokenization to further improve its operations. As previously mentioned, the public markets are far from peak efficiency, so the introduction of blockchain-based settlement will likely improve associated-party revenues and reduce direct expenses, which yields a greater “bottom line” for just about all involved.
Dubbed Project Whitney in May 2020, the DTCC was actually exploring a beta-test targeted at the private placements market (specifically through a Regulation D case study — a real-world example of which can be found in “Market Appetite” section). Nonetheless, the same principles the DTCC was targeting can be applied to the public markets for even greater test results. Look at the table below and consider parallel pain points in the public markets:
- Siloed solutions through demarcated exchanges (Nasdaq, NYSE, Toronto Stock Exchange, London Stock Exchange, etc.)
- Lack of industry standardization when it comes to Mortgage-Backed Security transactions, open-market bond sales, and access to other alternatives
- “After-thought” Accreditation services rather than initial whitelisting
The DTCC created an issuer name under “Apollo Labz” to test the minting of tokens that encompassed the necessary guidelines under a typical Regulation D placement including KYC/AML & Accreditation checks, initial lock-up periods, equity percentages, and cross-jurisdictional compliance. All of these factors were baked into the token upon issuance so that future management is near-fully automated. We call the token and the underlying asset “married” in this instance since the metadata will be coded into each token for life. There is no need to manage the data and the token separately, which is what’s needed in many operational processes today.
As one might assume, this separate management and “checks and balances” typically comes with an added cost, and that cost in this context includes the many divisions needed to handle KYC/AML, verify accreditation statuses, review and verify jurisdictional changes (i.e. trades that associate with countries in which the US does not do business with), and equity rights associated with the asset.
It’s feasible to project that tokenization will eliminate or at the very least consolidate several back-office functions, thus reducing expenses significantly and improving the bottom line. More specifics on these estimates can be found in the “Primary Issuance Market Snapshot” section.
Set to officially begin in early 2022, the DTCC’s “Digital Securities Management” initiative, which builds upon the findings in Project Whitney, will support pre-IPO equity securities on the public Ethereum blockchain. Assuming a successful launch, the DTCC will expand into “funds, debt, real estate, loans and other private instruments that are underserved today from a market infrastructure perspective.”
Lastly, and perhaps most importantly, in 2020 the DTCC cleared $2.3 quadrillion in securities transactions. That number is up 8% from 2019, and up a multitude from its 2007 number of $513 trillion. As more types of securities are processed — whether equities, bonds, real estate, MBS, swaps, etc. — that annual number is likely to continue increasing. As that increases, imagine how the backend fees increase linearly as well. The real value comes from automating those backend processes via a blockchain of choice, especially when considering Mike Cagney of Figure Technologies’ claim that his Provenance blockchain can save between 1–3% in management, processing, and settlement fees.
A savings of even that lower band 1% amount would account for an annual $23,000,000,000,000 ($23 trillion) in increased profitability throughout the entire DTCC network. That’s too significant to ignore, and the DTCC’s Digital Securities Management initiative should ideally yield similar results.
Immediate Settlement & Global Trading
Building off of this DTCC section, most publicly-traded assets currently settle at t+2. This means from the time of purchase or sale, while it may seem that a trade is confirmed, the trade is not fully settled in the buyer and seller’s account for 2 business days. In that meantime, only the digital representation (managed by a broker or similar third-party) is settled. Much like someone’s bank account can display a $5,000 ACH as credited to the account while the transaction itself is still technically pending, securities can do the same.
With blockchain, however, transactions can happen near instantaneously. Just how long this transaction takes to settle depends on the underlying blockchain itself and includes variables such as the number of transactions it can handle per second, how many validators it takes to truly “settle,” any gas fee preferences paid, and robustness of the network. Nonetheless, these usually settle in seconds, with a stretch to minutes. Given that, we can theoretically shift from a t+2 world to a t+0 world.
(Fun Fact: That shift is what gave the ATS tZERO its name.)
Alongside this settlement speed is another important upgrade — Global Trading. Rather than being limited to one’s domestic exchanges or trading venues, security tokens present the possibility for investors of nearly all nations to access the same investment opportunities. The current securities landscape is still demarcated — a sponsor can launch an investment product on the NYSE and still needs to issue a comparable product on the LSEG if it wishes to tap into a European investor base. That mentality and execution is outdated, and in a globalized world there should be no reason to “split” the liquidity pool surrounding basically the same products. More on this in the “Sample Tokenization Cases: Tokenized ETF” section.
The final leg of the “immediate, global, 24/7 trading” trifecta is, you guessed it, 24/7 trading. With blockchain technology automating a lot of backend and compliance work, there’s really no reason markets shouldn’t be operating 24/7. Blockchain already supports immediate settlement and a global base (so time zones don’t affect much), AND the crypto markets operate 24/7/365 as is. Why shouldn’t securities operate similarly?
While it’s great to claim 24/7 trading of security tokens, not all of the major ATS and trading venues support this yet — the main reason being the lack of liquidity solutions in the security token space. Until market makers, organic investors, and decentralized solutions work in tandem to facilitate liquid and precision trading, it’s not quite beneficial to extend the current pool of liquidity across a 24/7 period. The standard US-based “Monday — Friday 9:30am — 4pm EST” timeline is a solid foundation upon which industry trading venues and platforms may build, and will likely only be expanded upon once the industry signals its readiness to do so.
Rehypothecation Solution
In order to understand the importance of this real-time settlement, it is important to understand why t+2 and even t+1 could be harmful to investors and securities owners. In that 2-day period between purchase/sale and settlement, the broker that facilitates the trade is free to do as it sees fit with the security. So long as there is some representation of settlement (see: “Street Name” entries) by the end of the cycle, the broker may lend one’s shares out, use them as margin collateral, etc. Things get especially into the “grey area” when there are multiple brokers involved with the same security or asset. This is known as the Rehypothecation Problem.
An explanation from me would not do justice to the original source of this breakdown, so please see the direct excerpt from Inveniam’s own Director of Ecosystem Strategy, Michael Nadeau on the following page. (The DeFi Report)
The combination of 1) the security itself and information/data being “married” within the security token wrapper and 2) real-time settlement granted by the blockchain is what makes this such a promising and feasible Rehypothecation Solution.
