Tokenised Assets May Dramatically Transform Securities Trading

Over the past few years, financial institutions have dedicated substantial resources to technological projects that are designed to convert securities into tokenised assets. A tokenised asset is a digital representation of value or a proprietary right.

Their motivation is, among others, the potential of saving - astronomic amounts that are spent each year on the auxiliary processes of post trading, most notably clearing and settlement.

Tokenising and DLT (Distributed Ledger Technology) can materially improve the clearing and settlement processes, and consequently transform the world of securities trading.

Holding Securities in Electronic Form

Today, most securities of the share and bond types are kept in electronic form at entities that provide securities holding services. Those entities, also known as clearing houses or CSDs (Central Securities Depositories), are designed to “keep” the securities that are traded on the exchanges, ensure their proper registration and operate events in the life of the security, such as interest payments (for debt instruments) and dividend payments.

While some countries apply a direct holding model, pursuant to which any holder of a security can open an account with a CSD and deposit his securities, the more common model is indirect holding, in which the securities are held at the CSD through a chain of brokers, such as banks and investment houses.

Although the common model is more efficient for the CSD, it makes the transfer of information from the CSD to the end holders cumbersome and slower, entailing higher holding costs.

In both models, when a transaction involves the transfer of the security from one holder to another, the CSD performs the transfer (settlement) by crediting the account of one holder (or his broker) and debiting the account of another holder (or his broker), using a method known as an account-based approach.

In this method, the entire asset transfer process is based on the identity of the electronic account of the one holder and the identity of the other holder’s electronic account. The transferred asset (the security), in itself, has no identification that links it to its previous owner or to the new one.

This method is also used for money transfers in the banking system - the monetary consideration amount is debited to one account and credited to another account. The completion of the transfer is conditional upon the correct identification of the accounts of the transferor and the recipient, while the money itself is not identified with either of them.

Settlement Cycle

The settlement cycle may vary in different markets and for different types of securities, but is generally one to five business days.

The settlement process involves multiple risks, most prominently - the risk the one party will fulfill his part of the transaction and the other party will back out. For example: the security is transferred from the seller’s account to the buyer’s account, but, for any reason, the money is not transferred from the buyer’s account to the seller’s account.

Over the years, the financial system has applied various methods to address this risk, one of which is ensuring that the transfer of the securities and the money transfer are executed simultaneously. This mechanism, known as DvP (Delivery versus Payment), is designed to ensure that the “leg” of the transfer of the security (delivery) is performed simultaneously with and conditional on the “leg” of the money transfer (payment).

This mechanism has become the standard in the financial industry, but is not fault-free:

The money and the securities are transferred via two different platforms: the money is traditionally transferred through an electronic system of the central bank, while the securities are transferred, as described above, through the CSD. These two systems, that of the central bank and that of the CSD, use the account-based method, which obligates them to verify the identity of the transferor’s account and the identity of the recipient’s account prior to executing the settlement. Therefore, the process cannot be perfectly synchronized.

In practice, the money is first transferred through the central bank’s system, and only several seconds up to several minutes later, the securities are transferred in the CSD’s system.

Additional risks permeate the process as a result of the time-gap between the engagement in the transaction and its settlement, which may take up to several business days. The greater the gap, the higher the probability that either of the parties will experience a disruption, such as liquidity difficulties, that could prevent the settlement of the transaction.

Since the trading on exchanges is anonymous, the buyers and sellers cannot negotiate in the event of failure of settlement. Consequently, the exchanges undertake to complete the settlement of any transaction engagement, despite the timing differences. In doing so they are assisted by financial institutions known as CCPs (Central Counter Parties), which obtain margins from the sellers and the buyers in volumes that amount to trillions of dollars each year.

Apparently, a solution to both of the aforementioned issues could generate substantial savings and propel the financial industry forward to the next level.

Do digitalisation and DLT have what it takes? 

Most securities’ tokenising projects are based on DLT - a technology that enables the documentation of transactions on a decentralized network of individual computers, known as “nodes”, where each node holds a current copy of the transactions’ data, with no transfer of the data being required. DTL is generally based on cryptography, which allows each node to view the data, validate it, and sometimes also securely modify it, without the involvement of a single central entity.

Although the current electronic format (book-entry) is also a value representation, there are two material differences between the two:

The first difference is the identification and verification process preceding the settlement. In the current book-entry format, the transfer of securities from one entity to another is derived from the identity of the account of each of the entities. In opposition, for digital tokens, the transfer depends on the “validation” of the digital information that is encrypted into the token, linking it to its new owner. In a manner, this takes us back to the days when a security was represented on a physical certificate bearing the owner’s name. In the past, a physical certificate representing a bond and bearing its owner’s details, entitled the owner to receive interest (coupon) on preset dates, and to redeem the bond at the end of its term. In the world of digital tokens, the token holder is in possession of private information that is not available to the other holders, which is stored on a cryptographic “key”. Such key, which is also referred to as a “private key”, enables the token holder to “release” certain rights conferred upon him by virtue of his holding of the token, such as receipt of interest and redemption.

The second difference is the extent to which the system is decentralized, which is more than just technological. CSDs are by nature highly centralized - they store the securities of the holders in accounts that they create on their behalf, have exclusive access to the information (including its history) and selectively transfer it only to those that they define as authorized. In opposition, DLT platforms are decentralized in essence, enabling the viewing, modification and manipulation of the data.

Tokenising is expected to make these two ends converge: on the one hand, the technological developments of DLT will allow some degree of selectiveness on the level of authorizations and filtering of information. On the other hand, the CSDs will accommodate to the new world and somewhat ease their centralization, which will afford the holders some degrees of freedom in managing information, accessing it and updating it.

Cutting Back Costs and Inclusion

In addition to decentralization, the use of DLT also requires fewer intermediaries, includes a greater number of direct participants and enables end customers to open a direct account at a CSD. At present, only a select few intermediaries are permitted to participate at the CSD, resulting in a cumbersome and slow transfer of information to the end customers, which requires the involvement of high-maintenance back office and post trading systems.

In the future, when the information located on the network would be available, in full synchronization, to each and every participant, with no transfer being required, the information transfer and reconciliation processes will become redundant, making those resources available to additional participants.

The significance is that, in a world of digital tokens, the CSD would be able to provide services to multiple direct participants, which will receive reliable and trustworthy information in real time, through swifter processes and at reduced costs.

Nevertheless, the role of the intermediaries will not be eliminated, due to its importance in identifying the end customer for regulation purposes (including the prevention of money laundering and funding of terrorism) and curbing liquidity shortage in times of crisis.

Shortening the Settlement Cycle

In past decades, the financial world has dedicated substantial resources to shortening the settlement cycle. Historically, it took five business days to complete the settlement of a transaction after its execution (T+5), which is still the case in some developing markets. In 1995, the settlement cycle in the United States was shortened to three days (T+3), which became the standard in the Western world. In 2017, the United States further reduced the settlement cycle to two business days (T+2), which is expected to be shortened to one business day (T+1) in the third quarter of 2023.

Nevertheless, a real saving in resources and liquidity will only be achieved with an a fully diminished settlement cycle. This cannot be achieved with traditional technologies.

It appears that tokenising could enable the effacing of the settlement cycle (T+0), by simplifying the reconciliation processes, streamlining the back office and post trading processes and reducing the number of intermediaries. This would enable securities transactions to be settled shortly after the engagement in the transaction, thus avoiding third-party risks, eliminating the need for CCPs and margins and significantly reducing costs and expenses.

Nevertheless, it should be noted that the existing time gaps between the engagement in a transaction and its settlement depend on other factors besides technology. These additional factors, such as legal arrangements and the need to manage liquidity, require that the parties to the transaction (the buyer and the seller) be given time to “prepare” for its settlement. A complete effacing of the settlement period, while technologically possible in a digital world, also requires the adaptation of systems, regulatory adjustments and market education.

DvP in a Digital World

The settlement of a transaction in securities consists of two “legs”: the payment “leg” - transfer of the money from the buyer to the seller, and the delivery “leg” - transfer of the security from the seller to the buyer.

At present, each of the legs is settled in a different system - the securities are cleared in the CSD systems, whereas the money is cleared in the system of the central bank - both using the account-based approach.

In a digital world, tokenising can be applied to the payment “leg”, the delivery “leg”, or to both:

• Where tokenising is applied solely to the payment leg, the process of transferring the payment against the transfer of the security (DvP) is carried out based on an AvT (Account versus Token) mechanism - account-based transfer of the securities and tokenized transfer of the money.
• Where tokenising is applied solely to the delivery leg, the DvP process is carried out based on a TvA (Token versus Account) mechanism.
• Where tokenising is applied to both legs, the DvP process is carried out based on a TvT (Token versus Token) mechanism.

The table below presents the various DvP settlement options, as derived from the combination of the two methods:

The first two mechanisms, AvT and TvA, while partly based on tokenising, require the synchronization and uniformity of two different systems, which creates new challenges in the DvP process.

These challenges have already been experienced by the financial industry, which has been experimenting with tokenising in the past few years: a joint project of the International Bank for Reconciliation and Development and the Commonwealth Bank of Australia launched debt instruments that are represented by digital tokens, dubbed i-bond. These instruments are settled against money through the central bank, in the traditional methods.

Atomic Settlement

The third method, in which tokenising is applied to both legs of the transaction, facilitates a new quality of DvP, nearing perfection. The greatest advantage of the TvT method is its rare ability to perform a perfect simultaneous settlement of money and securities, which are both represented on digital tokens, through one DLT-based platform (single-ledger DLT).

DvP performed through a single-ledger DLT, in which the securities and the money are represented by digital tokens, is called “atomic settlement”. This process is perfectly synchronised and completely eradicating the risk of default of one leg of the transaction.

The mechanism used in atomic settlement is “smart contract”. Smart contract is a code or a protocol that self-executes actions when certain conditions are met.

In our case, a transaction in securities generates a smart contract in which a buyer and a seller commit to transfer to the other party money and a security, respectively, that they hold. Upon the engagement in the transaction, the smart contract verifies the validity of the transaction, the existence of the digital tokens in the possession of the buyer and the seller, and if all terms have been met - transfers the money tokens to the seller and the security tokens to the buyer, all this simultaneously and in full synchronization. If one of the terms of the contract is not met - the tokens remain in the hands of their owners and no settlement is performed.

There is the existence of a fourth option, where both the payment and the delivery are tokenised, but the transaction is carried out on two separate DLT platforms.

The gap between the two systems can be bridged by an innovative mechanism that “locks” the tokens for a specified time period pending the completion of settlement. This is called Hash timelock contract (HTLC). Despite its innovation, this mechanism generates new risks to the DvP process, which should be considered, and is therefore not deemed as pure atomic settlement.

Practical Applications

Atomic settlement already has a foothold in the financial industry, both in proofs of concept (POCs) by exchanges and central banks and in the real world. Some of the few examples are:

Project Jasper - A joint project of the Bank of Canada, the Canadian Securities Exchange, TMX and Payments Canada, is one of the most innovative DLT-based POCs carried out in the world to date.

Phase Three of the project demonstrates the settlement of transactions in securities where both the securities and the money are represented by digital tokens (TvT), through a single-ledger DLT platform, amounting to full atomic settlement. The delivery tokens represented shares that are traded on the Canadian Securities Exchange (TMX) and the payment tokens represented a digital currency that is backed by balances at the central bank (Bank of Canada). The settlement of the two types of tokens on a single platform and the atomic settlement achieved through them proved an unprecedented effectiveness.

Project Stella is a joint project of the European Central Bank and the Bank of Japan that studies financial applications in a DLT environment. Phase 2 of the project, which also focused on the settlement of transactions in securities where both legs are represented by digital tokens (TvT), studied the differences between the DvP quality achieved by the settlement of a securities transaction through one platform (single-ledger DvP) and that achieved by settlement through two different platforms (cross-ledger DvP).

In the real world, SDX, a digital exchange of the Swiss SIX Group, was established for the purpose of enabling the trading and settlement of digital assets in a DLT-based environment. SDX, recognized in September 2021 by the Swiss regulator (FINMA) will carry out, in the first phase, trading in digital tokens that represent debt instruments of the Swiss Government, against digital tokens representing money that is deposited at the central bank. Both types of tokens will be settled on the same platform.

Conclusion

Most of the challenges faced by the industry in recent years are technological - DLT technologies were relatively young, as were the accompanying development, integration and maintenance processes. In addition, the concept of distribution, while prevalent among crypto currencies (primarily Bitcoin), does not coincide with the needs of a hierarchical system such as an exchange or a clearing house, and therefore require privacy, information screening and authorization customizations.

Besides technology, there are other challenges with which the industry has only started to contend, such as: regulation, modification of business processes, the need for a more effective management of liquidity, cross-border transfer of securities, standardization of DLT systems among the various exchanges, and more.

Assuming that all these are solved in the next few years, the advantages offered by trading in digital assets and the tokenising of securities in a DLT environment, as elaborately described above, will create a new world for trading in securities, which is based on the ten following principals:

• Exchanges will allow trading in digital assets that represent shares, bonds and other proprietary rights.
• The digital assets will be held in futuristic DLT-based CSDs that allow digital assets to be held directly or through intermediaries.
• The assets will not be held in securities accounts, but in advanced applications (such as E-wallets).
• Any change in holdings will be reflected in real time in the holder’s E-wallet, without requiring the transfer of the information.
• The technological attributes of the digital asset will enable the (encrypted) linking of the asset to the owner, entitling him to the rights attaching to the security, such as interest and dividends.
• A transaction in a digital asset that is entered into on an exchange will be transferred for settlement shortly after its execution, eliminating the need to obtain margins from the buyers and the sellers.
• The transaction consideration will also be paid with a digital asset (currency), representing money that is deposited in an account at the central bank or in a commercial bank.
• The settlement of the transaction will be “atomic”, in a perfect DvP that eradicates the risk of default of one of the legs.
• The balance of the asset purchased or sold, and the balance of the money paid or received, will reach the buyer and the seller, respectively, within minutes from the execution of the transaction on the exchange, instead of the current several days.
• The new processes and the saving of time, brokers and margins will reduce costs, making trading in securities more accessible, affordable and friendly than ever.

Indeed, a brave new world.

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