Central Securities Depositories (CSDs) face an existential crisis in the face of the emergence of a new financial system powered by decentralized finance (DeFi).
All the functions — settlement, registration, custody, and asset servicing — performed by a CSD in a transaction can now be performed using blockchain technology. And the aspect of blockchain technology that underpins these functions is the digitalization of securities, or tokenization. To remain relevant in this new era of finance, CSDs need to adapt to tokenization of securities.
Additionally, the popularity of cryptocurrency custody can be gauged from the fact that $3.9B was invested in cryptocurrency custody until the third quarter of 2021, according to research firm CB Insights. This figure was higher than the investment in cryptocurrency custody in the previous six years combined.
In this paper, we take a look at what tokenization is, its benefits, and how it threatens the function of CSDs.
What is Tokenization?
Tokenization simply refers to the digitalization of securities. The ownership of the security is associated with a digital token on a distributed ledger, and the ownership can only be transferred with the transfer of the token, and vice-versa.
We have come a long way from securities being traded through the exchange of a physical certificate, to a process where the exchange happens directly through accounts at the CSD, custodian banks and other intermediaries. Tokenization is the next obvious step in the evolution of the way securities are cleared and settled.
Where we once placed our trust in the intermediaries, such as CSDs and custodian banks, to keep a record of the transaction, the trust function has now moved on to code. The transparent nature of the distributed ledger technology (DLT), which powers DeFi and tokenization, ensures that transactions can now be traded, cleared and settled directly between a buyer and seller.
This facilitation of peer-to-peer transactions, without an intermediary to facilitate the exchange, is the beauty of tokenization. The exchange is facilitated in real time, without any walled garden, in the internet of value without the use of legacy technology that relied on SWIFT messages.
«You cannot build the future of finance on legacy infrastructure,» says Monica Singer, the South Africa lead at ConsenSys. We all remember the era of CD-ROMs for music, taxi services for transportation, VHS tapes for movies. They all gave way to newer technologies that built the Spotify, the Uber, and the Netflix of today. This is what Ethereum, the platform powering DeFi, is doing today for finance.
To say that tokenization of securities is the future of clearing and settlement would be an understatement. Tokenized securities are already giving traditional finance a run for its money. In March 2021, the daily volume of cryptocurrencies traded in South Korea briefly surpassed the daily transaction volume on the country’s stock exchange.
Tokenized platforms are set to be equivalent in size to conventional securities exchanges in the coming five-ten years, the Future of Finance wrote citing a major financial market infrastructure.
How is Tokenization Threatening CSDs?
CSDs perform four main functions in a transaction— issuance, settlement, registration, custody, and asset servicing. Each of these functions is at risk of being disrupted by tokenization.
Let’s take issuance, for example. Instead of issuing securities in a traditional stock exchange using the current plumbing that depends on intermediaries like CSDs, companies can issue tokens to a digital wallet. Trades are then settled by an exchange of securities tokens against payments tokens, instead of being settled against a fiat currency issued by a central bank that uses the Real Time Gross Settlement system to perform the payments.
With the advent of Central Bank Digital Currencies (CBDC), atomic real-time settlement between securities tokens and CBDCs will be possible which will speed up the implementation of securities that are either tokenized natively or where the current financial instruments that are held in the dematerialised register are created as tokenized securities.
The digital wallets can be self-custody by the investor or the custody can be outsourced to a custodian. There are many new custodians in the market that are regulated in their jurisdiction already offering these services to cryptocurrency investors. It would be a natural progression for their services to expand into the custody of the private keys of securities tokens and tokenized securities.
What are the Benefits of Tokenization?
One of the key advantages of tokenization is rapid settlement of trades since exchanges for tokenized securities are open 24/7. Tokenized securities also allow for fractional ownership, which can easily replace the antiquated mutual funds business.
This is not all. There are many other benefits of tokenization, and we explore some of those below:
Tokenized exchanges attract higher liquidity because they allow investors to tap liquidity from previously untapped resources from the world over. One great example of this is Liquidshare, a fintech founded by eight major European financial institutions that ConsenSys helped set up. Liquidshare created security tokens for private companies that did not have the efficiencies of listed stock exchanges.
Such previously untapped sources of liquidity are available without walled gardens, restriction on working hours, public holidays or weekends, or dependency on the payment of fiat currencies only available at set times through intermediary banks.
Increased geographical access
Tokenization allows investors to access liquidity in geographies outside of their domicile. Currently, any investor needs to have an account with a broker or custodian banks in the country where they want to trade shares on that country’s stock exchange. This increases the cost of investments for a foreign retail investor. Additionally, the processes of settling trades through a custodian are slow and complex.
Since the tokenization of financial securities removes the need for an intermediary, any person with an internet connection can buy and sell tokenized securities, no matter where they are located.
Reduced Operational Costs
Smart contracts are a key feature of the Ethereum blockchain service, and they ensure that the terms of a transaction are programmed into the code of the transaction. Smart contracts for tokenized exchanges ensure that all the responsibilities of a CSD are programmed into the trade, facilitating the execution of corporate actions such as payment of dividends to shareholders, or payment of interest to bondholders. This reduces the operational costs of servicing these transactions.
An open-source ledger, one of the key features of blockchain, ensures that everyone can see the same version of the ledger in real time. The ledger is immutable, and transparent, which allows the issuer to see in real time who is transacting in their securities.
The ability to track transactions in real time has always been one of the requirements by issuers in legacy financial markets and very few in the traditional financial markets have been able to offer this functionality. The CSDs that do not have «name on register» functionality, and rely on nominee accounts in particular do not have this facility. This leads to reduced transparency in traditional financial markets.
Since the ledger, where tokenized transactions are recorded, is open-source, issuers as well as auditors see the same version of the ledger. This allows the audit of the ledger to be conducted in real time, which increases the ability of regulators to ensure the integrity of the transactions.
Issuing tokenized securities leads to lower direct costs, both to the issuer and the investor. This leads to financial inclusion as the barrier to entry to investments is lower in crypto markets when compared with traditional financial markets.
Ethereum standards make the exchange of value over the internet as simple and easy, as the exchange of information. This concept is known as the internet of value. As the internet of value is public and permissionless, the interoperability between many new asset classes will become a reality. We call this the money lego and the composability achieved through the open source nature of the DeFi protocols. This is impossible in the legacy financial markets being another reason why changes will become inevitable.
New Asset Classes
Tokenization is bringing new asset classes such as art, real estate, collectables, and new forms of money into the market. This gives CSDs an opportunity to offer investors custody services of all these new asset classes.
How is ConsenSys Helping to Build the Future of Finance?
DeFi is the basis for a new financial system using mainly Ethereum as the internet of value in Web 3.0. As we discussed above, the DeFi economy places trust in code, rather than on an intermediary. ConsenSys is helping to build this new financial system.
One of the main instruments that allows investors and market makers to participate in the DeFi economy are digital wallets. Digital wallets are a software that allows investors to hold their cryptocurrency assets, and use those assets to interact with various DeFi protocols for lending, borrowing, investment, and spending purposes.
ConsenSys offers two wallets to investors: MetaMask is a self-custody wallet for individuals, whereas MetaMask Institutional enables crypto investors and market makers to act on behalf of investors in the DeFi ecosystem.
The wallets are downloadable for free and anyone can use them to access the hundreds of protocols available to trade, get loans, buy insurance, make payments, trade tokens of any type without asking permission, or relying on an intermediary.
Consensys is also working with many asset managers around the world who want to benefit from securities tokens (securities issued in tokenized form) and tokenized securities (securities that are digital but are now converted into tokens) using Codefi Assets and Codefi payments technology.
How can CSDs be the Leaders of Change?
The paradigm shift in the financial markets, from legacy systems to the new DeFi ecosystem, presents CSDs with a great opportunity to be the leaders of this change.
The bridge between the legacy financial system and the DeFi ecosystem is waiting to be built. The rising demand for high quality assets to be used as collateral in various DeFi protocols points to this trend. Some legacy financial institutions are capitalizing on this opportunity. Take for example, Societe Generale, one of the largest banks in France. The bank proposed to borrow 20M Dai, a stablecoin crypto, on MakerDAO by issuing a bond. This innovative proof of concept is one example as to how the two worlds will eventually co exist.
CSDs have the ability to disrupt their current business model, by for example being an actor that holds a node, or supervise the nodes being kept by the actors that participate in the shared version of the truth being the Register of investors in a DLT protocol.
This time, the changes in the way that securities are traded are exponential. It took over 10 years for the transition from physical share certificates to dematerialised share certificates. CSDs did not have any competition as they are natural monopolies. This allowed them to take all the time they needed to change and to keep up with any technological changes that were needed as a result of dematerialisation of securities.
In the current reality, CSDs have many competitors that are waiting for no one and are creating this parallel financial market infrastructure using the internet of value.
Many CSDs are relying on the fact that the current legislation protects their monopoly. However, many European countries are taking the lead in bringing in new regulations to ease the path to tokenization. Countries including France, Luxembourg and Switzerland have been introducing «holistic frameworks or ‘Blockchain Acts’ covering DLT activity in markets». A recent OECD report noted Germany’s draft Electronics Securities Act as a good example of «tailor-made regulation for tokenised assets».
CSDs around the world have shown the ability to work together to collaborate and coordinate in the move from physical certificates to dematerialisation. Now, CSDs can use these associations to debate and move the regulatory needle towards innovation.
CSDs have the biggest opportunity to develop an international industry standard for a regulated financial market infrastructure using DLT and open-source technology, where interoperability and economies of scale in the internet of value is possible. This will position CSDs to compete with all the new service providers that will most certainly expand from cryptocurrency exchanges to offering all sorts of tokens on their platforms.
Another reason for CSDs to collaborate to ensure a wider adoption of tokenization is increased demand from issuers and investors for the functionality that tokenization brings. When asked about the role utilities play in transforming the securities service industry, Nadine Chakar, head of digital at State Street, says, «Only if they transform themselves....If they do enable our transformation, we will wholeheartedly embrace them, but we cant let them slow us down either.»