04/01/2021 by Dominic Hobson 0 Comments
CSDs Are Closer to Extinction Than They Like to Think
Central securities depositories (CSDs) were imposed by regulators in the 1990s to solve the securities settlement problems of the 1980s. They have succeeded admirably in that task but so far only a handful have sought to move decisively beyond it and embrace the new opportunities created by the tokenisation of financial assets on blockchain-based networks. Instead, the majority of CSDs have appealed to their origins in the minds of central bankers and securities market regulators of a generation ago. Ironically, the trust imparted by their record of success and regulated status are precisely the qualities that would enable CSDs to exploit the tokenisation markets.
Central securities depositories (CSDs) were a regulatory response to the settlement backlogs of the late 1980s, which they eradicated, and regulators continue to value the work they do.
That work includes registration of title, safe title transfer, defence against financial crime and protection of nationally important market infrastructures and tax revenues.
However, regulators are also keen to encourage innovation and competition, and see consolidation and new entrants armed with new technologies as agents of both.
Tokenisation of assets on blockchain networks has the potential to disrupt CSDs in every service area: safeguarding the integrity of issues, settlement, safekeeping and asset servicing.
The principal barrier to the rapid growth of tokenisation – the lack of fiat currency settlement on the networks – will be lifted by central bank digital currencies (CBDCs).
The development of collateralised lending of cash and securities on blockchain networks addresses the constraint on instantaneous settlement set by the need to pre-fund accounts.
Tokenisation offers CSDs the opportunity to service previously illiquid asset classes (such as real estate and collectibles) and expand into adjacent fields (such as trade finance).
Other opportunities include network governance; token lending, financing and collateral management; digital wallet provision; financial crime checks; and platform inter-operability.
Yet only a handful of CSDs are using their trusted, regulated status to exploit these opportunities. Most plead legal and regulatory constraints, lack of customer demand or an inadequate business case.
Blaming regulators for discouraging innovation is not convincing. Regulators are actively seeking competition for incumbents and changing securities laws and regulations to facilitate it.
Lack of demand is not convincing either. The central forecast of one market infrastructure is that conventional exchanges and tokenised platforms will be of equivalent size within five to ten years.
Tokenisation is both an existential risk to CSDs and an opportunity to transform their industry. Unfortunately, CSDs view it in terms of adding efficiency to the status quo or re-platforming risk only.
Both views make it easy to reach a negative verdict about tokenisation platforms based on blockchain technology, because both are condemned to conclude the returns do not warrant the risks.
The CSD response to blockchain lacks the impetus imparted by a conviction that, as a transformative technology, tokenisation is both an existential threat and a once-in-a-lifetime opportunity.
CSDs are fixated by the risks and costs, even where the costs can be mitigated (as in pre-funding of accounts) or drastically reduced (as in the elimination of reconciliation processes).
Even shrinkages in new issuance and transactional activity in traditional markets and pressure from both the sell-side and the buy-side to cut post-trade costs are failing to change CSD attitudes.
Standards, to facilitate inter-operability between tokenisation platforms and traditional exchanges would be helpful, but an industry consensus on adopting them will be hard to achieve.
Calls for industry-wide agreement tend to exclude new entrants armed with new technology. New entrants will not ask the permission of incumbents before competing for their business.
The licensing of tokenisation platforms, and the likely introduction of CBDCs, indicate securities market regulators and central banks are not as wedded to the status quo as CSDs like to think.
Central securities depositories (CSDs) are relatively young. Though examples existed before the Group of Thirty (G30) published its seminal report of March 1989, it was that regulatory response to the global settlement crunch of the mid-to-late 1980s that spawned the creation of at least one CSD in every market through the 1990s. CSDs were set the goals of dematerialising paper certificates into electronic registers and shortening settlement timetables, and they have achieved it.
CSDs say regulators are reluctant to see their role disrupted
CSDs were a creation of regulators, and it is their regulated status which remains their primary defence against technological disruption. In the securities markets, regulators still want incontestable electronic records of ownership, safe transfer of title from sellers to buyers and mitigation of counterparty risk through settlement in central bank money on a tight timetable, and these are all benefits that CSDs provide.
It follows that regulators will be reluctant to endorse a transition to a new infrastructure which puts these benefits at risk. At the national level, they will also be reluctant to sanction any changes which put control of securities market infrastructure into commission. Regulators do not work quickly either, and incumbents are always content to wait for them to take a lead, so the prospects of productivity-enhancing change at CSDs in the near future look dim.
They are dimmer still once it is understood that national governments will not want to see settlement of government bonds pass out of their jurisdiction; or see Know Your Client (KYC), Anti Money Laundering (AML), Countering the Financing of Terrorism and sanctions screening checks become less stringent; or allow tax revenues from stamp duties and investor income and profits to be put at risk. Market participants will not be pushing them to change too quickly either. They want assurance – indeed, certainty - of their legal rights over assets and entitlements if a trade fails to settle or a counterparty fails altogether.
Regulators also wish to encourage innovation and competition
Yet regulators and governments also want to see innovation, and competition, especially in financial services. The more thoughtful leaders of the CSD industry are acutely aware that none of the benefits they provide is available only via the status quo. At the very least, it might be possible to secure them all without retaining a CSD in every jurisdiction. After all, it is regulators rather than market participants which have encouraged consolidation of the CSDs of the eurozone for more than 20 years.
So alert CSD managements know that regulation is not a reliable long-term defence of their existing role. Indeed, legacy technologies, not just at CSDs but at the firms which use them as well – as the ASX has found in switching its CSD to blockchain technology - might prove a more durable barrier to change. Long experience with financial messaging standards proves that any innovation that requires investment in new technology or processes will proceed patchily, with the industry ultimately moving at the pace of the slowest.
Tokenisation of assets on blockchain networks challenges CSDs in every function
However, developments in issuance and investing may accelerate change in post-trade functions. The tokenisation of assets – security and payment tokens in particular – on blockchain networks has in theory the potential to disrupt completely the current roles of CSDs in servicing issuers and investors. Equally, adaptation to tokenisation is rich in opportunities for CSDs to lead the transformation of post-trade services – precisely because users and regulators trust them.
The threat is clear enough. The tidy minds of regulators and lawyers, and their inability to change law and regulation fast enough to keep up with technological developments, means that the current post-trade dispensation consists of centralised utilities and databases. Blockchain, on the other hand, as a distributed (or decentralised) ledger, contests the need for the centralisation of anything.
In the case of CSDs, issuers on to blockchain networks will no longer need to issue securities into a centralised depository. Tokens can instead be issued directly into investors’ wallets. Nor will CSDs be needed to safeguard the integrity of an issue or maintain a register of investors when a distributed ledger keeps issues and holdings in line and updates the register of investors automatically.
The role of CSDs in settling transactions in central bank money by delivering securities to electronic accounts they maintain against payment into accounts controlled by commercial banks at the central bank is more vulnerable than it might appear if security tokens can be delivered “atomically” on-line against payment tokens.
Central bank digital currencies (CBDCs) and collateralised lending will catalyse tokenisation platforms
Certainly, once central bank digital currencies (CBDCs) provide a reliable alternative to payment tokens based on Stablecoins or crypto-currencies, one regulatory barrier to tokenisation will be lifted. CBDCs cannot eliminate the need for pre-funding of accounts – the securities and the cash or their equivalents have to be available if “atomic” settlement is to be achieved - methods of providing collateralised credit on blockchain networks are now in place.
Even the work of some CSDs in processing corporate actions will in theory be made redundant by smart contracts on blockchain networks. The smart contracts will publish news of entitlements to investors automatically and then receive, execute and report investor instructions without any manual intervention whatsoever.
These developments might sound futuristic, but speed and service expectations set by technological developments in retail payments (which are now instantaneous, or at least made to appear instantaneous) and investing (in crypto-currencies and their derivative, DeFi tokens) are seeping into institutional markets.
Tokenisation platforms offer new business opportunities for CSDs
Although this seepage does not imply an immediate transition to issuance of tokens on to blockchain networks, where transactions can be settled “atomically,” the emergence and growth of tokenisation platforms is still likely to create new opportunities for CSDs. The most conspicuous is the chance to service new asset classes, particularly illiquid investments such as real estate, fine art and collectibles that can be fractionalised as well as tokenised.
Less obvious is the fact that blockchain has prompted intermediaries and end-users to reimagine how securities transactions are executed, cleared, settled and custodied. It has also inspired new ways of working in adjacent areas such as payments and trade finance, where excessive levels of intermediation and an absence of agreed data standards has created the opportunity for outsiders to re-think the flows of data. CSDs could expand into these fields.
Some new opportunities are adaptations of existing services to token markets
But it is in their original business of securities that CSDs have the most straightforward set of opportunities. This is because they are already engaged in activities in the conventional securities markets which can be adapted to the same needs in tokenised markets, and so help those markets to grow, and the revenues of CSDs could grow with them.
The opportunities include governing admission to private, permissioned blockchain networks; supporting the lending and financing of tokens; settling and custodying crypto-currencies and DeFi tokens; safekeeping the securities behind asset-backed tokens; managing tokens as collateral; providing digital wallets to investors in tokens; running KYC, AML, CFT and sanctions screening checks; delivering tax reports; netting token trades; and facilitating settlement of transactions between tokenisation platforms and between tokenisation platforms and traditional exchanges. None of these tasks represents a radical break with existing functions.
The appetite for seizing these opportunities varies. Some established CSDs, such as SIX in Switzerland, ASX in Australia, Hong Kong Exchange (HKEx) and the Singapore Exchange, are embracing the opportunities enthusiastically. At least one new CSD in Europe (ID2S) is applying the new technologies to an established market. But most CSDs have adopted a passive stance.
The passive approach to tokenisation of most CSDs is puzzling
This is counter-intuitive, since it is now obvious that blockchain can help the securities industry achieve faster affirmation, confirmation and allocation of trades, especially across time-zones such as those which separate Europe and North America from Asia. It could bring existing settlement timetables closer to the same-day settlement (T+0) that tokenisation platforms are achieving already. Once the technology is operating successfully in one jurisdiction, it will be easier to transfer it to another.
So it is surprising how few CSDs have chosen to act. The commonest explanation of their timidity is that law and regulation forbid them from acting. Yet in reality regulators in both Europe and the United States are actively exploring ways in which they can encourage the digitisation of financial markets, and stimulate competition with the incumbents, and several jurisdictions have already changed their securities laws to accommodate tokenisation.
Legal and regulatory constraints and lack of demand are not convincing as explanations
So there are good defensive as well as offensive reasons for individual CSDs to engage with regulators to reform the regimes by which they are governed, and to use their trusted, regulated status to provide a reliable post-trade infrastructure for participants in tokenised markets.
It is at this point that the second explanation of the widespread inertia in the industry is advanced. It is that, even if changes to law and regulation do liberate CSDs to provide the services, not enough customers will use them to make the investment pay.
This is a conservative view. SWIFT, for example, is working to a central forecast that projects the market capitalisations of conventional stock exchanges and tokenisation platforms will be roughly equal, within five to ten years.
CSDs are mistaken in judging tokenisation opportunities by conventional criteria
The “lack of a business case” is of course a familiar justification for inaction in any industry. But its deadening effect is exacerbated in the case of CSDs by an incorrect framing of the opportunity.
Blockchain technology is conventionally depicted by the senior management of CSDs as neither an existential threat nor a once-in-a-lifetime opportunity to transform the industry. Instead, it is viewed as a means either of making parts of the status quo more efficient or as a re-platforming risk.
Both viewpoints are bound to argue for inaction. Making part of an existing process more efficient is unlikely to yield a sufficient return to warrant the investment. Indeed, the return may even be negative, in that every process is linked to every other process and changing one may necessitate changes to others.
Replacing all processes with a completely new platform, on the other hand, is risky. However great the potential gain in efficiency, transitioning an existing business on to a new platform is so expensive and complicated that every conventional financial model will always conclude that the costs and risks will always outweigh the benefits.
The leaders of the CSD industry are asking the wrong questions
This predicable outcome has an analogue in the day-to-day experience of senior managers and vendors of existing technologies. If this technology is so transformative, they ask, why have we not found a use for it yet? If the current technology is so inadequate, they go on to ask, why are the customers not defecting?
The second question is easily addressed. Since most CSDs are monopolies, the customers have nowhere else to go. The first question, by contrast, rests on the fallacious assumption that innovation is demand-led rather supply-driven.
It is an “if-it-ain’t-broke-why-fix-it?” view, whose proponents do not see business as a creative sphere of endeavour, or one which requires strategic vision, or even as one which must devise ever-more efficient solutions to the problem of efficiency. They see business as akin to punctuated evolution, in which organisms adapt not to new opportunities but only to severe environmental pressures.
On this view, it was possible 30 years ago to introduce CSDs because post-trade operations in the securities markets were trying to drive paper out of post-trade processes to avoid a repeat of the 1980s settlement crunch. In a securities industry that has comprehensively dematerialised already, the efficiency gain which blockchain can deliver today is commensurately smaller, limiting the return than can be derived from investing in it.
Yet something similar is happening in trade finance today, where blockchain has emerged as logical alternative to unstandardised, paper-based processes, and CSDs are not demonstrably staking a claim to apply their experience to the field.
The strategic response of CSDs to tokenisation is cramped by limited vision
Their absence is a good example of the limited vision imposed by gauging innovative technologies by conventional tools. If CSDs saw blockchain technology is seen as an opportunity to completely reinvent post-trade securities servicing, it would be easier to view trade finance in the same light.
True, some CSDs (such as SIX and ASX) have taken a more adventurous view. But most CSDs view blockchain more as a warning to others than an opportunity or a threat to them. The Initial Coin Offering (ICO) boom of 2017-18, for example, is routinely portrayed by CSD insiders as an example of what is bound to go wrong when regulated institutions like CSDs are not involved.
But there is another way of looking at it. It is to see ICOs and ICO technologies and methodologies as an instance of the creativity that can be unleashed - and of the enormous volume of capital that can be mobilised – when regulated incumbents are not in place to obstruct progress, as opposed to protecting investors from themselves.
Likewise, the need to pre-fund accounts is still routinely portrayed by CSDs as an argument against “atomic” settlement. Even though pre-funding is being solved on blockchain networks, through exactly the same collateralised credit mechanism used in conventional markets, it remains a useful bogeyman for CSD conservatives to raise: Who will provide collateralised liquidity if not us?
Pre-funding is also an example of the obstacles even something as useful as transparency can put in the minds of customers as well as service providers. Pre-funding is an explicit recognition of credit and liquidity costs that are incurred in current settlement systems, just much less visibly. Yet by making the cost explicit, “atomic” settlement has become hard to sell, simply because reality is hard to bear.
Savings on reconciliation processes are real and being captured now
This intuitive resistance to change - and sometimes wilful blindness to the possibilities - extends even to the most obvious opportunities. Everybody knows that reconciliation processes are the principal source of unnecessary costs in financial services, and that a distributed ledger visible simultaneously to all parties in a value chain is the obvious way to reduce or even eliminate such costs. Yet adoption of the technology is painfully slow.
In Italy, Spunt, a blockchain-based reconciliation platform that has enabled Italian banks to increase the frequency of account reconciliations from monthly to daily, is proving every day that blockchain technology can cut the costs and improve the performance of reconciliation processes.
Yet, even in a retail banking sector where incumbents face serious competition of a kind as yet unknown in the securities markets, it has still taken more than two years to increase the number of banks participating from 18 to 97.
An inadequate equilibrium has developed in the securities markets, by which incumbents appeal to regulators as defenders of the status quo and regulators try to encourage competitors to take the incumbents on.
It is an opportunity which the more progressive CSDs ought to be eager to exploit. As trusted, regulated institutions, well-versed in the strengths and weaknesses of user ownership and governance, and with long experience of leading operational change on an industry-wide scale, they are ideally placed to domesticate the technologies and methodologies created by the ICO boom and make them fit for the era of security tokenisation.
Shrinking securities markets and downward pressure on costs are having no effect on CSD attitudes
The question is what can encourage CSDs to seize the opportunity. The declining health of their core market over the last 20 years – fewer listed companies, fewer Initial Public Offerings (IPOs), shrinking liquidity in many stocks, a decline in market-making activity – ought to increase their level of interest in novel approaches.
Yet CSDs show limited interest in supporting new tokenisation platforms, despite the fact their involvement could do a great deal to encourage both token issuers and token investors, and so attract new issues of capital and different sources of transactional activity. It is as if the CSDs expect the traditional stock exchanges to seize the opportunity for them.
Equally, pressure from users to cut costs does not seem to have prompted any reaction from CSDs. Both the buy-side and the sell-side of the securities industry are experiencing margin pressure, and as a consequence squeezing post-trade service providers to cut their costs. Though this provides CSDs with a clear incentive to innovate, they have so far declined to act.
This is partly because vertically integrated trading, clearing and settlement silos are riddled with cross-subsidies and partly because the boards of user-owned and user-governed CSDs are unable to agree where the cost reductions will be made.
CSDs are also far from monolithic as an industry, and not just because a small claque of major national (DTCC and T2S) and international (Clearstream and Euroclear) CSDs sit atop a long tail of national CSDs, the smallest of which settle one or two trades a day and have no capacity for technological innovation.
Some CSDs are investor CSDs only, while others are issuer and investor CSDs. Some offer omnibus accounts operated by intermediaries only, cutting them off from direct interactions with issuers and investors, while others provide name-on-register services to beneficial owners directly, or a mixture of both.
Some CSDs offer segregated accounts, while others do not. Some CSDs exist to settle transactions only, while others fulfil a range of asset-servicing functions. Half of all CSDs are ultimately owned by stock exchanges. In short, there is no single CSD view available.
The case for standards is strong but an industry consensus will be hard to achieve
Some argue CSDs cannot effect meaningful change on their own anyway. They say every point along the post-trade value chain - the custodian banks, the investment banks, the asset managers and the central counterparty clearing houses (CCPs) - need to engage as well, and at both the national and the international levels – not least because CSDs account for only a fraction of total post-trade costs.
SWIFT, as a co-operative linked to all these participants, is sometimes mentioned as the natural convenor of such discussions. That is because one area where such discussions can obviously contribute is in the development of data standards to facilitate inter-operability between the post-trade functions of traditional exchanges and those of tokenisation platforms, and indeed between different tokenisation platforms.
Standardisation would obviate the risk of a Balkanisation of the global securities and token markets, and it is an obvious good in itself. It might also stimulate a meaningful discussion about how the entire post-trade processing chain can be reconfigured.
However, it is more likely to succeed if it focuses on those conventional asset classes where inefficiencies have proved most intractable, such as the corporate bond markets, which remain a byword for settlement failure. The efficiency gains in such markets, for intermediaries as well as issuers and investors, ought to be large enough to secure widespread support, albeit on a narrow front.
However, agreement to adopt a set of standards, let alone agree on a comprehensive reconfiguration of the entire post-trade infrastructure, is unlikely to emerge from an industry-wide search for consensus, when even the most limited cost reductions at the level of a single national CSD have yet to be achieved.
An industry consensus which excludes new entrants will miss the point
There is also an obvious difficulty with this search-for-consensus approach. It is that the challengers to the CSD monopolies will not be part of it, and nor do they need to be. Uber, for example, did not seek a consensus with licensed taxi drivers before entering their market. airbnb did not engage in a dialogue with hotel companies before entering their market.
Yet the attempt by a tokenisation platform to create a proprietary alternative to a CSD or group of CSDs could be precisely the blow which the CSDs need to arouse them from their strategic torpor, in much the same way that intranets inspired the creation of the Internet, or Citi inspired the creation of SWIFT in the late 1970s by threatening to create a commercial monopoly, or the threat of a Euroclear monopoly inspired the creation of what is now Clearstream in the early 1970s.
CSDs should not count on regulators and central banks to defend them from competition
At present, however, CSDs are inclined to dismiss the Uber or airbnb analogy, because they do not believe securities market regulators and central banks would permit a systemically important financial market infrastructure to be competed away in the same way as licensed taxi drivers or hotels.
This is true, yet it can postpone the reckoning only. Tokenisation platforms are receiving licences from the securities market regulators that CSDs are counting on to protect them and using them to gnaw away at the core revenue streams of the CSDs in the securities markets. The self-same central banks that the CSDs are also counting on to protect them from competition are working on the one component that will guarantee tokenisation platforms take flight: CBDCs.
At the point that CBDCs become available to settle transactions on blockchain-based tokenisation platforms, CSDs will find themselves in an existential predicament. Once CBDCs are available, regulatory and legal infrastructures will, almost by definition, have caught up with technological developments such as blockchain, and CSDs will no longer be able to hide behind their regulated status.
Indeed, regulators are already advancing towards the burgeoning tokenisation markets, precisely because they are innovating and growing so rapidly by comparison with the established markets, which were in any event buried under a wall of highly constraining regulation in the decade after the financial crisis of 2007-08. CSDs are not a source of anxiety to regulators today; tokens are.
Questions to be addressed at Future of CSDs II
1. What do CSDs do that no-one else can?
2. Is the growth trajectory of tokenisation large and fast enough to worry CSDs?
3. Do tokenisation platforms need CSDs?
4. Will CSDs wither away or be competed away or reinvent themselves?
5. Are CSDs culturally and materially equipped to rise to the challenge of tokenisation?
6. What opportunities do blockchain-positive CSDs detect in the technology?
7. How can the demands of regulators for both safety and stability and innovation and competition best be reconciled?
8. Standards are essential to inter-operability. How can they best be agreed and adopted?
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