The US equity market is one of the most regulated and valuable in the world, but dependant on only a handful of players, which if compromised, say by a cyber-attack could wreak havoc on the world economy. Jonny Fry, CEO TeamBlockchain LTD explains how digital assets on blockchain will offer greater security, liquidity and investment exchange and growth potential for both high net and smaller traders.
Nearly all the stocks and shares in the US are owned by Cede and Co…WHO, you may ask? All the rights investors think they have to dividends and votes are dependent on their broker who in turn relies on an outfit called The Depository Trust Company that holds the shares in a nominee called Cede and Co. It is this outfit that has all the investors’ rights, so imagine the brouhaha if it was hacked or some other calamity fell upon it!
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 “Paperwork Crisis” lead to a stock market crash 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 in 1973 was created and then followed the National Securities Clearing Corporation (NSCC) in 1976, when 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 However, progress has been slow and the USA like many other global equity markets suffer from the same outdated bureaucratic, largely paper-based systems still today.
Cede and Co holds $30 trillion in shares and settles more than $1 quadrillion in trade value annually. However, equity trading failed to fully digitise the end-to-end process. Pre-trade order routing and electronic trading of securities had become extremely low cost and frictionless, but the same improvements have not arrived to impact on clearing, settlement and custody.
Are nominees peculiar to just the USA?
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 day for 140 counties.
How blockchain and digital assets could help
DTCC-Euroclear could face competition from blockchain if we continue to see bonds being issued on blockchains as was witnessed with BBVA in 2019. Given the claim that issuing bonds on blockchain could reduce the issue cost by over 50%, this could open up the bond market for smaller bond tranches and smaller companies. This is because 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. Furthermore, these records can only be altered if the relevant parties agree.
Having a digital ledger could be a huge benefit for regulators as they would have an accurate, up to date record of what is owned by whom. If the assets themselves were digitised, then it could be possible to only allow buyers that are authorised to own certain assets to trade. 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 and many derivatives. If these assets were digitised, it would be possible for the investor’s status to be checked before a trade was carried out, so 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 24/7/365, not like some existing exchanges that open for a few hours, five days a week!
There are currently over 2 billion Muslims living in countries that have young fast growing populations, so it is significant that we have seen blockchain technology being adopted in Islamic countries. Emirates Islamic was the first Islamic bank to use blockchain technology as early as 2017, integrating the technology into cheque-based payment processes, so improving their authenticity and aiming to reduce 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 in Abu Dhabi. A sukuk is an Islamic financial certificate, like a bond, that complies with Sharia’h (Islamic) law. Having a range of digital assets that are investable under Islamic law not only will make them appealing for this sizeable market, but also enable companies to raise capital from these potential investors and fast growing economies.
Increasingly younger investors, millennials, are more digitally savvy and do not want existing service providers like stockbrokers and to discuss their financial affairs with their local bank. They are looking for online, often via their phone, accessible digital services. This demand was dramatically seen in 2017 and 2018 when we saw Initial Coin Offerings (ICOs) raising capital from thousands of small investors globally. Digital exchanges offer the potential to embrace these new younger investors. It is going to be harder for the existing national regulators to stop their citizens trading in multiple jurisdictions and getting exposure to a much wider selection of investments that typically have been the preserve of institutions and the super-rich.
So what sounds more appealing? – “invest in a UK large cap growth fund” only to discover that typically 66% of such funds will not outperform the FTSE 100 index. At the same time being charged 1%+ p.a. compared to an index fund and you can only buy or sell the fund once a day. Alternatively – “invest 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 these batteries. Currently, it is almost impossible for a private investor to have exposure to physical commodities as most funds invest in companies that mine commodities not the actual 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! Umm, where can I buy this?
Back office challenges
It is well known that company registrars i.e. the firms that keep a record of who a companies’ shareholders are, are usually wrong all day while equity markets are trading. Indeed, it is only at the end of the day when the stock market closes, will the registrar know who the shareholders are in any given company. In August 2017, in the US the Delaware General Corporation Law was changed, so that shareholder registers and trades could be held electronically on distributed electronic ledgers, referred to as blockchains. If there were a real time digital record it would be possible for all parties including the regulator to see who the actual owner of a security is, when it was bought, and for how much. As opposed to the current situation where the majority of all shares are held by a nominee. To give you an example Facebook’s 50 day average number of shares traded is 27 million, which is equivalent to over $3.6 billion of shares traded a day. Yet if you look at the number of shareholders Facebook has it is only 3,967 Class A common and 52 shareholders for its Class B stock. Despite the fact it has over 25,000 staff! The reason is that the majority of Facebook and other US quoted companies like IBM, Microsoft, Apple and UK quoted companies like Shell, HSBC, Barclays have their shares held by nominee companies.
Why compliance may drive change
Financial services companies are drowning in never ending compliance regulations, with a staggering $780 billion annually being spent on compliance.
Clearly change is required and having a series of out dated legacy systems, procedures and controls are not able to cope with our ever increasing digitised economies. A dramatic example was the resignation of TSB’s CEO in 2018, when the bank experienced IT challenges resulting in customers unable to access their bank accounts.
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. Currently these are time-consuming processes, requiring significant paperwork and involving numerous entities, resulting in high costs. Typically, customers must provide documents issued by government institutions or trusted companies to banks to verify their identity. However, 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. While on the face of it is attractive to remove intermediaries and slash costs, using new technology ought to be used to improve risk management controls and avoid bigger potential headaches for tomorrow.
One good example of how Digital Assets are being embraced is the launch of the DX-Exchange which is a NASDAQ powered Digital Asset exchange. It is backed by Bloomberg and 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 actual stocks and each token will be backed by equities on a 1:1 basis, issued via smart contracts. So enabling investors the ability to buy and sell “leading” public companies listed on the world’s biggest stock exchanges including NASDAQ, New York Stock Exchange, Hong Kong and Japan, i.e. companies like Google’s parent company Alphabet, Facebook, and Amazon. This will allow investors to trade real stocks 24/7 in a secure and compliant trading environment, without having to wait for markets to open. This, in turn ought to mean there’s more liquidity in the market, which if proved correct will further fuel interest in Digital Assets.
Digital assets can offer exposure to bonds equities, property commodities i.e. almost any asset class and can be traded more efficiently. Whether you are an investor looking for a new opportunity or a company seeking new investors Digital Assets are surely worthy consideration.