Digital assets and do we need them?

By Charles Kerrigan & Jonny Fry

Posted: 30th January 2019 10:03

The US equity market is one of the most regulated and valuable in the world, but dependent on only a handful of entities, which, if compromised, say by a cyber-attack, could wreak havoc on the world economy. Nearly all the stocks and shares in the US are owned by Cede and Co. Like most people you may not know them. In fact, all the rights investors think they have to dividends and votes are dependent on their broker who in turn relies on a business called The Depository Trust Company which holds the shares in a nominee called Cede and Co. It is this business that has the investors’ rights.
 
It is amazing to think that just a few decades ago, the New York Stock Exchange would shut down every Wednesday to process trades and settlements via couriers on bikes physically carrying stock certificates between buildings on Wall Street! This led to the “Paperwork crisis of the 1960s”, in 1968 when the volume of stocks traded rose to 15 million shares per day. About 100 brokerages failed as America ceded its shareholders to intermediaries. Following the crisis, The Depository Trust Company was created in 1973 and the National Securities Clearing Corporation (NSCC) in 1976. These two merged in 1999 to create The Depository Trust and Clearing Company (DTCC). This signified that the digital era had come to Wall Street. However, progress has been slow and the US, like many other global equity markets, still today works with largely paper based systems.
 
Cede and Co holds $30 trillion in shares and settles more than a quadrillion dollars in trade value a year. However, equity trading has not yet fully digitalised the end-to-end process. Pre-trade order routing and electronic trading of securities have become low cost and frictionless, but the same improvements have not arrived to impact on clearing, settlement and custody.
 
Are nominees peculiar to the US?
 
If you think Cede and Co’s holdings are large take a look at DTCC-Euroclear which holds over $57 trillion of assets and settles over 90 million trades per day for 140 countries.
 
[Item A] DTCC:
 
130+ Countries:Custody and asset services provided for more than 130 countries valued at $57+ trillion.
90 Million:Approximately 90 million transactions processed every day.
45 Years:DTCC are the premier post-trade market infrastructure in the industry.
23 Locations:Serving a global client base across a broad range of asset classes.
5 Asset Classes:The first and only global trade repository for the derivatives market.
 
Source: http://www.dtcc.com/about
 
How blockchain and digital assets could help
 
Nominees could face competition from blockchain technology if we continue to see bonds being issued on blockchains as we saw BBVA doing last year. It is claimed that issuing bonds on a blockchain could reduce the issue cost by over 50%. This could open up the bond market for smaller bond tranches and smaller companies. Using a blockchain to issue bonds potentially removes the need for an independent custodian, as there is a record of the issuer and holder held in a cryptographic manner on hundreds if not thousands of computers. Further, these records can only be altered if the relevant parties agree.
 
Having a digital ledger could be a benefit for regulators as they would have an accurate, up to date record of what is owned by who. If the assets themselves were digitised, then it would be possible to only allow buyers that are authorised to own certain assets to them. For example, private investors with limited funds are not often allowed to invest in what are classed as high risk assets such as futures and options. If these assets were digitised it would be possible for an investor’s status to be checked before a trade was carried out, removing many of the existing post trade compliance suitability analysis.
 
Blockchain-based digital assets have emerged to solve a number of problems enabling greater transparency, proxy votes, and dividend distributions, based on the number of minutes that securities are held for. They allow for individual ownership and enable instant settlements so there is no counterparty risk, eliminating potentially billions of dollars in intermediary fees. We are starting to see digital exchanges being launched that will allow the trading of digital assets 24/7.
 
New investors
 
Blockchain technology is global. In the Middle East, Emirates Islamic was the first Islamic bank to use blockchain technology. In 2017 the bank integrated the technology into cheque-based payment processes, improving their authenticity and reducing the potential for fraud.
 
The UAE-based Al Hilal Bank became the world’s first Islamic Bank to complete a sukuk transaction on the blockchain. A sukuk is a financial certificate, like a bond, that complies with Sharia-Islamic religious law. Having a range of digital assets that are investable under Sharia law will not only make them appealing for this sizeable market but also enable companies to raise capital from investors in these fast growing economies.
 
Increasingly younger investors, millennials, are more digitally savvy and do not want face-to-face relationships with stockbrokers or a local bank. They are looking for mobile digital services. Digital exchanges offer the potential for these younger investorsto access a much wider selection of investments.
 
Typically 66% of UK large cap growth funds do not outperform the FTSE 100 index, they charge fees and can only be traded once a day. Alternatively, digital exchanges allow, for example, investment in a basket of commodities that are required for electric car batteries. If you believe that electric cars are going to be more popular in the next few years, then we are going to need more commodities to make the batteries. Currently it is difficult for a private investor to have exposure to physical commodities as most funds invest in companies that mine commodities not the commodities themselves. An Electric Car Battery digital security could be linked to a basket of commodities, then bought and traded 24/7/365 on your mobile phone.
 
Back office challenges
 
It is difficult for company registrars (i.e. the firms that keep a record of companies’ shareholders) to keep up while equity markets are trading. It is only at the end of the day when the stock markets close that the registrar knows finally who the shareholders are in a company.
 
In August 2017, the Delaware General Corporation Law was changed so that shareholder registers and trades in the United States could be held electronically on distributed electronic ledgers. A real time digital record would enable all parties including the regulator to see who the owner of a security is, when it was bought, and for how much, in contrast to the current situation where the majority of shares are held a nominee. Facebook's 50 day average number of shares traded is 27 million which is equivalent to over $3.6billion of shares traded a day. Yet Facebook has only 3,967 Class A shareholders and 52 shareholders for its Class B stock. The majority of Facebook shares are held by nominee companies.
 
Why compliance may drive change
 
Financial services companies are drowning in compliance and in new regulations that are being created. A report which surveyed 250 global firms found that a staggering $780 billion a year is being spent on compliance. As you can see below, global financial institutions were fined nearly $27 billion in just the last 10 years, since the financial turmoil following the collapse of Lehman brothers in 2008.
 
[Item B] Value of fines imposed for non-compliance with Anti-Money Laundering (AML), Know Your Customer (KYC) and sanctions regulations in the last decade, by country.
 
USA:$23.6bn
Europe:$1.7bn
Asia Pacific:$609m
Middle East:$9.5m
 
Source :www.fenergo.com/press-releases/global-financial-institutions-fined-$26-billion-for-aml-kyc.html
 
Legacy systems that were designed for paper based processing, are unsuitable for digital economies.
 
Blockchain could be used to improve regulatory reporting in terms of transparency, data quality and governance, identity management, authentication, as well as KYC and suspicious activity reporting. These are time-consuming processes, requiring significant paperwork and involve a lot of people. Typically, customers must provide documents issued by government institutions or trusted companies to banks to verify their identity. Banks can increase their efficiency by using blockchain identity solutions. Customers could have a single cryptographic identity, which they could share with the institutions when they want, making on-boarding of new clients far cheaper and faster.
 
Combining blockchain with artificial intelligence would allow regulators to interrogate digital data and run “What if scenarios” to try and identify where there are stresses in the market and potential vulnerabilities to the financial system. They could set up smart contracts to alert them if breaches have occurred (i.e. rising customer complaints, or funds that had too much exposure to certain assets or a bank that was close to breaching its solvency margins). Using blockchain technology, shareholders could once again have a direct link to the companies they own shares in and be given rewards and perks for their loyalty of ownership.
 
What next?
 
Digital assets are being supported by digital exchanges. The DX-Exchange is a NASDAQ powered Digital Asset exchange backed by Bloomberg. It is a European Union regulated cryptocurrency exchange based in Estonia offering tokenised securities (digital assets). The platform will allow traditional and cryptocurrency users to invest in stocks and each token will be backed by equities on a 1:1 basis, issued via smart contracts. Investors can buy and sell public companies listed on the world’s biggest stock exchanges including NASDAQ, New York Stock Exchange, Hong Kong and Japan.This is a 24/7 secure and compliant trading environment which is likely to bring liquidity and further interest in Digital assets.
 
It is very interesting that the Digital Assets are being adopted by governments as on 19th January 2019 Saudi Arabia and UAE announced that they are to launch a Cryptocurrency . This announcement is seen as a step away from the reliance on petro-dollars and is another sign of the Middle east embracing Digital Assets.
 
Digital assets can offer exposure to bonds, equities, property, commodities i.e. almost any existing asset class. They can offer exposure to new asset classes in the form of digital tokens. They can make trading more efficient. Whether you are an investor or a business, as part of your digital strategy you should have a digital asset strategy.
 
***
 
The contents of this note are the (optimistically provocative) personal views of the authors and do not represent legal or investment advice or the institutional views of CMS LLP or Team Blockchain.
 
 

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