Blockchain technology enables real-time settlement finality in the securities world. This may mean the end of a number of players in the post trade area. For a long time, central securities depositories (CSDs), as intermediators in the post-trade processing chain, were expected to become obsolete.
CSDs, but also other existing players in the post-trade environment, are however changing their mind on these new technologies and on their future position in the blockchain world. Increasing regulation, legacy systems and costs pressures, are drivers for CSDs to at least embrace some aspects of blockchain. They are increasingly considering them as enabler of more efficient processing of existing and new services, instead of a threat to their existence. It is interesting to see that some of these actors – who could be potentially big losers in a distributed ledger technology (DLT) or blockchain system – are open to innovation with blockchain and willing to invest in DLT. Last January SWIFT and seven CSDs worldwide agreed on a Memorandum of Understanding to explore the use of blockchain technology in the post trade process esp. e-proxy voting.
Where do CSDs stand now?
Complex and fragmented post-trade infrastructure
The current post-trade infrastructure is highly complex and fragmented, crowded with intermediaries, and dealing with outdated legacy systems and technologies. Much of the complexity and fragmentation of the post-trade world is the result of the various participants (custodians, issuers, registrars, CSDs) holding their own, separate ledgers in order to carry out the processes. Consequently, they spend much time and resources on reconciliation and risk management, in order to ensure that transactions can be (and are) appropriately carried out. The completion of securities transactions is as a result a costly and risky business. This has important consequences, efficiency-wise.
Situated at the end of the post-trading process, CSDs are systemically important intermediaries. In the post-trade process the CSDs play a special role both as a depository, involving the legal safekeeping and maintenance of securities in a ‘central depository’ on behalf of custodians, in materialised or dematerialised form; and for the, involving the issuance of further securities by issuers, and their onboarding onto CSDs’ platforms.
Is there a future for CSDs in a disruptive blockchain world?
Blockchain: disruption in securities post-trade
DLT has the potential to heavily disrupt existing post-trade processes in financial services, impacting the business model of a number of intermediaries. This raises significant questions for the present actors in the post-trade world as their role may change dramatically or even disappear. For some actors in the post-trade world, DLT could completely replace their businesses or even make them obsolete. And others should question what will be their added-value within future DLT services.
With blockchain, that is linking trading partners directly, everything will be in place in the ledger at the time of the transaction. Institutions will no longer have to maintain their own databases in the future with DLT, as there will be only one database for all participants in the transaction.
With DLT, all of the complex systems and processes to transfer cash and equities from one account to another are not required. Everything can be embedded into the blockchain. Buyers and sellers can match transactions in seconds and all parties are aware a transaction has been done. This will heavily ease the reconciliation process. Blockchain could ultimately become the standard for financial transactions and real-time settlements, increasing transparency and efficiency in a highly fragmented industry.
There are already many proof of concept blockchain projects under way. These projects are increasingly proving that we can transfer existing post-trade processes to the blockchain. Examples such as DLT platforms that are dedicated to crowd funding and lending that bring together borrowers and lenders. It is also possible to duplicate asset servicing functionality, such as corporate actions management, on the blockchain.
The extent to which blockchain will disrupt existing processes in financial services is still unsure. Some say a complete disintermediation of middle and back office processes is under way, removing most (or even all) intermediaries from the post-trade processes, while others say the impact of this emerging technology will be less forceful, with a (limited) number of existing intermediaries such as CSDs continuing to play an important though somewhat different role.
CSDs are increasingly questioning their existing role in the development of financial market infrastructures if blockchain – or distributed ledger technology – takes off.
World Forum of CSDs: changing attitude
In December last year the World Forum of CSDs in Hong Kong took place with delegates representing CSDs across the globe. Fintech and how new technologies including blockchain would shape the future of the CSD industry, were key topics throughout the main conference.
From the various sessions it became clear that CSDs are changing their viewpoint on these new technologies (e.g. blockchain) and now also are considering them as enabler of more efficient processing of existing and new services, instead of a threat to their existence. This shift and change in attitude towards blockchain technology is important as it gives the technology the chance to move forward in an accelerated pace.
Euroclear report: CSDs Matter in Blockchain Settlement System
In an earlier report (December 2016) “Blockchain Settlement: Regulation, Innovation, and Application”, Euroclear looked at the regulatory and legal aspects of the use of blockchain technology in post-trade. It stated that “regulators should not fear the use of smart contracts and distributed ledger technology any more than any other automated computer-based process prevalent throughout the settlement industry.”
With the implementation of a blockchain-based settlement process there is no need to change the existing regulatory architecture, according to the report. By allowing regulators to participate as a node in the blockchain system, they could have complete oversight of all the transactions occurring within the settlement system and receive transparent transaction data in real time. This could, subsequently, represent a significant improvement in data provision to regulators than is presently possible and may allow them to exercise tighter and more granular supervision of activities in the securities market.
The report also found that central securities depositories (CSDs) would play an important role in a blockchain-based settlement system.
“CSDs could have an important role to play in a blockchain-based settlement system. As ‘custodians of the code, CSDs could exercise oversight of, and take responsibility for, the operation of the relevant blockchain protocol and any associated smart contracts.” Euroclear Report
While the Euroclear Report states that CSDs are trusted central entities that facilitate the settlement process, it is believed that the distributed ledger technology system would be a natural evolution of this facilitation role. CSDs will continue to perform an important role as trusted,
centralised financial market infrastructures (FMIs) FMIs, providing gatekeeping services and oversight of the relevant blockchain.
CSD Working Group of DLT
A group of the world's biggest central securities depositories (CSDs) have united in July last year to build their own blockchain consortium. They have agreed to explore how DLT could save money and bring new efficiencies to post-trade processes.
"We realized there are lots of consortia, but mostly they are for banks. If we talk about CSDs, we don't have our own consortium aimed to our needs. The idea was to create one." Artem Duvanov, director of Moscow Exchange Group's National Settlement Depository
Early CSD members of the consortium, called the CSD Working Group on DLT, include DTCC, Strate (South Africa), SIX Securities (Switzerland), Nasdaq (CSD in Baltics and worldwide CSD technology provider), DCV (Chile), Caja de Valores (Argentina), The National Settlement Depository (Russia) and ADX (United Arab Emirates).
The official stated objective of the CSD Working Group on DLT is to demonstrate the business value of blockchain technology and give the participating CSDs a better understanding of how blockchain technology might change their roles in the future. A second objective of the group is to show the value of collaboration between the CSDs worldwide in its own right.
CSDs in the various regions are not currently building a single solution. Rather, each group is building its own platform designed to interoperate with the others. As an example, the Moscow Exchange Group's e-proxy voting solution is built using Hyperledger Fabric, while in Strate's early experiments they were using both Chain, Hyperledger, Corda and Ethereum.
“To fully capitalize on that distribution the goal of the consortium is to gather leading CSDs from each of the regions, and then grow from there.” “By working together to ensure that CSDs from each region are represented the consortium could potentially unleash network effects previously unimagined by any single member.“Monica Singer, CEO Strate
DLT proxy voting system
The CSD blockchain consortium is pushing ahead with plans to develop a distributed ledger-based e-proxy voting system. Proxy voting and corporate actions have been selected by the group as the perfect starting point for applying DLT to the post-trade. The system would automatically allow (or disallow) voting privileges for members based on what voting rights they had within a particular organization.
Last November the consortium published a document outlining the technical product requirements for such a proxy voting platform to be used in general shareholder meetings, “built using distributed ledger technology and 'synchronized' with Swift's messaging standard ISO20022.” According to the project’s outline, the group added the ISO 20022 financial messaging standard in an effort to ensure that each consortium member’s technology interoperates, and that the final product can be applied across a broad spectrum of services.
"ISO 20022 will provide a great foundation, in terms of both existing business content and approach." "That can accelerate the implementation and acceptance of DLT technology for industrial solutions." Damien Vanderveken, Head of The R&D, SWIFTLab and UX team within SWIFT
The International Securities Services Association (ISSA) recently endorsed the CSD Working Group on DLT. The Association has included it as part of a new work stream within the association’s existing Working Group on DLT, giving this initiative greater industry visibility. Thereby they confirmed the importance of the CSD Working Group on DLT.
As part of ISSA, the CSD Working Group on DLT will initially focus on digital assets with a goal of establishing a business framework for how these assets could be used in the post-trade space. The framework will identify key definitions, classifications, services, and post trade service provider roles. Findings from the use case on digital assets are expected to be published in Q2 2018.
“There is a lot of potential for DLT in securities processing and the work being led by the CSD Working Group on DLT is tackling a key challenge related to emerging technologies, which is a clear lack of standards. As the industry evolves, DLT-specific standards, such as ISO 20022, will provide a great foundation, in terms of both existing business content and approach.” Thomas Zeeb, CEO, SIX Securities Services and Chairman, ISSA and Chairman of the International Securities Services Association (ISSA)
Last January the CSD Working Group on DLT and SWIFT have signed a Memorandum of Understanding (MOU), focused on the CSDs’ joint efforts to develop the applied use of blockchain technology in the post-trade sector.
Apart from SWIFT participating members include Abu Dhabi Securities Exchange (United Arab Emirates), Caja de Valores (Argentina), Nasdaq Market Technology AB (US), National Settlement Depository (NSD) (Russia), SIX Securities Services (Switzerland), Strate Ltd (South Africa), Depósito Central de Valores (DCV) (Chile). Additional depositories are expected to join.
Goal is to work together to explore how blockchain could be used for post-trade processes, what new kinds of products could be built using it, and how existing standards could support it. The participants of the projects see a potential for improvement for instance in respect to the depots of voting rights. Another goal is helping to define the role of financial market infrastructure providers, permitting to identify, define and develop use cases in the securities depositories’ industry (including smart contracts, to account for and store promising digital assets, resulting from ICOs).
"It's a complex area, and there are regional variations in the way that it works, so one thing is to bring the CSDs around the world [together] to actually focus in on the commonalities." "It's not something where we've seen a lot of cooperation in the past, because different markets do things differently. But this is a chance to do something even more different." Stephen Lindsay, Swift's head of standards
Setting industry standards
The group will focus on creating and adapting common standards and principles for the use of DLT among securities depositories and the financial industry, promoting the adoption of those standards and principles to other parties, including regulators. As a part of the MOU, the members have defined the product requirements for an electronic voting solution based on DLT technology, which includes common principles and common financial message exchange standards (ISO 20022).
“To ensure interoperability and smooth migration, it is crucial that new technologies support existing common standards such as ISO 20022.” “The promise of technology on paper is great, but a key component around standardization is currently missing. There is clear value in re-using established business definitions and facilitating interoperability among DLT implementations, which this project will demonstrate.”Stephen Lindsay, Head of Standards at SWIFT.
“As Depósito Central de Valores, we are interested in being up-to-date on developments related to DLT technology” “This group of institutions – representative of the global market of securities depositories and industry providers – provides engineers and analysts who are experts in the business, in standards and also in technology. Together they will find solutions using DLT, which will finally facilitate interoperability among global operators of securities markets.” Fernando Yáñez, General Manager of DCV.
Other blockchain projects with Working Group members
Russia’s CSD develops blockchain platform with Waves National Settlement Depository (NSD), Russia’s central securities depository (CSD), and Waves, a decentralised platform for launching crowdfunding campaigns and issuing digital assets, are cooperating in a blockchain project. They are developing a new platform that “will securely host and store tokenised and crypto assets, settling transactions and providing identification for owners of cryptocurrency wallets.” The first prototype is expected to be ready in the first half of 2018.
“The platform would not only provide technological and legal protection of all parties involved, but also extend variety of post-trade services for investors, custodians and new institutions emerging in this sector of economy,” Eddie Astanin, chairman of NSD’s executive board
Nasdaq to deliver blockchain e-Voting solution to Strate Nasdaq and Strate, the South African CSD, last November announced the agreement for Nasdaq to deliver a new blockchain solution that would bring electronic voting to the South African capital markets. Strate will thereby leverage the solution to improve voting efficiencies and increase shareholder participation in South Africa. The solution will allow Strate, in conjunction with key stakeholders in the market, to provide general meeting services and give shareholders an easy, user-friendly and secure tool for voting remotely. The solution is based on the successful proof of concept (PoC) developed for Nasdaq's Estonia market.
"We are very excited about our initiative with Nasdaq and what it means for the South African financial markets." “The solution aims to service our clients' needs across the market from transfer secretaries to issuers, custodians, asset managers and those holding shares in listed companies. Given that it is an end-to-end solution – from the time a meeting is announced and all the way through the voting process to the publishing of results – it means that all stakeholders will truly benefit within the process." Tanya Knowles, Managing Executive of Strate
"By leveraging blockchain, we are able to reduce friction in the voting and proxy assignment process and also ensure that all information is transparent to stakeholders when required and with the proper security, governance and risk procedures in place. We are proud to welcome Strate and the South African capital markets to the Nasdaq family and to support their efforts in evolving their governance processes through new technological innovation." Lars Ottersgård, EVP and Head of Market Technology, Nasdaq.
Liquidity Alliance work on solution for cross-border collateral mobilization Four members of the Liquidity Alliance’ (an international group of CSDs), The Canadian Depository for Securities Limited (CDS), Clearstream (Luxembourg), Strate (South Africa) and VPS (Norway) have launched an cooperative initiative leveraging blockchain technology to ease cross-border mobilisation of security collateral. With this solution they aim to overcome existing hurdles when moving collateral across various jurisdictions, making the transfer faster and more efficient.
Their Distributed Ledger Technology (DLT) based ‘LA Ledger’ prototype will enable a centralised, faster and more efficient allocation of fragmented security positions to cover financial obligations of market participants in multiple jurisdictions. The ‘LA Ledger’ will initially be implemented as a prototype based on the Hyperledger Fabric blockchain.
“With this initiative, we pursue an innovative partnership approach that will allow us to jointly embark on distributed ledger technology with a use-case that is highly relevant to the wider industry.” Glenn Goucher, President and Chief Clearing Officer, CDS.
“LA Ledger is designed to simplify cross-border collateralisation away from using multiple complex and non-standardised links towards smooth movement across various jurisdictions.” John-Arne Haugerud, CEO VPS.
CSDs playing the Governance role
There are various reasons why CSDs may play a role in the post trade blockchain environment. The specific markets involved – whether we are dealing with exchange-traded or ‘over-the-counter’ (OTC) securities, ‘vanilla’ products or derivatives – as well as the jurisdictions in question, however will determine how far their role will develop.
Notary function Blockchain may enable tokenisation and the use of smart contracts. All these are new components in the value chain. There may be a need for secure maintenance of personal encrypted keys. This may mean that a digital actor will be needed to manage this tokenisation, and creation and maintenance of smart contracts. In my mind that will be the CSD.
Tokenised assets exchanged on a distribute ledger may still require CSDs to hold the equities, which the token represent. CSDs would thereby fulfil a crucial notary function, both as tokenising agent and as operator of the escrow accounts in which the real assets are hold.
“It is not improbable. CDSs are, after all, the entities into which equities are issued already. The CSD is responsible maintaining the integrity of the issue, so it is the “single source of truth” about how many assets are in issue.”
Reconciliation Blockchain could certainly help automate some components of the settlement process, such as reconciliation and corporate actions. A DLT-based reconciliation tool, with multiple trading firms participating in a record-based system, could still occur within the CSD, which may act as the single point of reference for reconciling the various records.
Elective corporate actions The user group for a permissioned blockchain network can choose who should validate the transactions recorded by the ledger – and the user group could simply give validation rights to every node. Alternatively, this could be the role of a trusted third party, or a combination of both a trusted party and the nodes. Relying on a trusted third party to validate transactions, as happens today, would imply a logical role for CSDs.
Getting issuers to publish elective corporate actions, such as rights issues and proxy votes, directly onto a blockchain, might be a difficult step to realise. This should logically entail the involvement of central securities depositories (CSDs).
Authorisation and administration Another area in which CSDs can help is the following. While regulators will set the standard for admission to the network, the admission tests are likely to be administered by other parties. The most likely candidate for that role of trusted gatekeeper to DLT networks are the CSDs. They are already the first home of financial assets issued, and guardians of the integrity of every issue they accept.
“The regulators are unlikely to want to immerse themselves in the operational details of the authorisation process.” “They will sub-contract that work to a trusted intermediary (read CSD).” Nicolas Bon, EquiChain CEO
Record of title for securities In many cases, the law mandates how title to property transfers. The law as it’s currently structured thereby envisages a role for the CSDs. Under European law, the CSD Regulation specifies that, for transactions in securities that take place on a trading venue, exchange, or multilateral trading facility, securities must be recorded in book entry form in a CSD.
Therefore, under the current law, to enable having a blockchain-based system of transfer of title to securities, the blockchain would need to be the system that the CSD operates, which is not truly distributed. Or one would need to create a new legal regime that recognizes that the transfer of title on a blockchain is effectively a transfer of title to the relevant property, and allows that in the context of securities trading. And that would take a lot of time to realise.
Governance The movement from a post-trade system based around the existing infrastructure to a DLT-based system, without updating the regulatory and legal regime, could introduce a new systemic risk into the financial system. Regulators and legislators are unlikely to be comfortable in allowing the wholesale replacement of the existing infrastructure with DLT-based solutions.
That’s why CSDs could come into play to retain the governance role — to ensure that what happens within their systems is unchallengeable. They are best placed to retain a ‘policing’ or governance role in a blockchain framework. Their role should be the management of an insolvency of a party, particularly if there is a position that is not settled and the relevant contract is not yet completed.
Is there a future for CSDs
Yes. I do not expect CSDs to disappear in a blockchain world. Blockchain could certainly help automate some components of the settlement process, such as reconciliation and corporate actions, but CSDs are likely to play an integral role in any blockchain environment. But they will look quite different from we know them today.
CSDs however need to adapt to increased competition e.g. from (group of) custodian banks applying for a CSD license. CSDs should also evolve to meet new demands asking for delivering added value services in the new blockchain environment.