The deflation of a tech bubble is apt to obscure the fact that not all investment in new technology is wasted. Just as the FAANGs emerged from the TMT bubble of the late 1990s, the useful and scalable applications of blockchain are almost certainly being built now. Their impact on CSDs could be as little as three years away, thinks Thorsten Peisl, CEO of DLT specialists RISE Financial Technologies. His advice to CSDs – invest now – is scarcely unexpected of a technology vendor. But it would be a mistake for CSDs to be too cynical or cautious, since DLT has the potential to create digital-speed network effects of the kind that have overthrown incumbents repeatedly and rapidly.
Distributed ledger technology (DLT) is through the tertiary stage of the celebrated Gartner Hype Cycle. The Trough of Disillusionment is giving way to the Slope of Enlightenment. The Proofs of Concept (PoCs) are done. The technical problems are solved. DLT applications can perform at scale. The challenge now for central securities depositories (CSDs) is to position their services for the Plateau of Productivity, when this new technology will finally start to transform the commercial economics of the core services of a depository: the transaction-processing, safekeeping and servicing of financial assets.
Scalable blockchain applications are no more than 36 months away
“CSDs should be working to a three-year time horizon,” says Thorsten Peisl, chief executive of RISE Financial Technologies, which specialises in DLT-based platforms. “They need to act now not just to take advantage of the opportunities blockchain is creating for CSDs to work with issuers and investors in new ways and with new asset classes, but to protect their existing market position from being eroded or overrun by disruptive new entrants. They should identify a tightly focused high value use-case and look to implement the technology now.”
He adds that Rise is developing a technology designed to make it easy for users to do this, which the company is initially applying to the depository receipts markets. “One of our major efforts is doing exactly that: focusing on a well-defined use-case,” explains Peisl. “It is a tokenisation engine fully integrated into capital markets. The initial use-case is focused on cross-border transactional capabilities to support depository receipts, but it is readily extensible to any asset type. However, with a network that will cover the 40-plus depository receipts markets already in the making, out initial use capability is a great way for CSDs to engage with DLT in a very focused and pragmatic way.”
Many CSDs will struggle to act on this advice because they lack the resources to invest. Though they can buy technology from a vendor such as Nasdaq, that still requires significant investment. Joining a consortium or a collective initiative led by a vendor – of the kind Rise is leading in the depository receipt markets – could be a more plausible alternative. In theory, consortia and vendors can spread the costs of development and maintenance over multiple clients and asset classes and are condemned to continue to invest in their own systems anyway. Rise now offers a generic DLT-driven private permissioned network platform that it calls the Distributed Utility (DU). Applicable to any financial asset class, the DU offers not just a technology platform, but operating standards, a legal and governance structure, and compliance, risk management and financial modelling tools as well.
It sounds complex but is in reality a simple proposition. Essentially, issuers, governing bodies, service providers and investors are becoming “nodes” – or appointing an agent to run a “node” for them – on a private, permissioned DLT-powered network. So-called “governance members” set the policies by which the network operates, control admission to the network, and resolve disputes between members according to the rules. Issuers issue securities directly to investors through the DU. The service providers, meanwhile, compete with each other, on price and quality, to provide issuance, placement, custody, valuation and asset-servicing to issuers and investors running on the network. Services previously sold as part of a package can be unbundled and sold separately by competing providers.
CSDs can host direct issuer-to-investor interactions
“The main opportunity for CSDs is to create a more powerful connection between issuers and investors,” says Peisl. “But being a governance member is a natural role for a CSD to play as well. It is a role they have already identified for themselves in the crypto-asset markets.” In fact, he thinks the DU provides the ideal platform for CSDs to take advantage of the coming tokenisation of financial markets by providing a multi-asset class platform. “CSDs are already guardians of the integrity of issues of securities and help protect investors in securities by maintaining a register of holders,” says Peisl.
He adds that he thinks issuance services in general are a great opportunity for CSDs. Issuers are under increasing pressure from regulators – through measures such as the Shareholder Rights Directive of the European Union (EU) – to keep their investors better informed. That is hard to do, especially in markets where underlying investors are hidden from view by nominee accounts and registration processes which are so slow the shareholder register is never up-to-date.
Greater efficiency in post-trade processing can help CSDs compete
But this is only one way in which the ability of the DU to empower investors to hold digitised securities in their own name can protect CSDs from obsolescence. Because a DLT-based platform is based on a ledger which updates the register of shareholders automatically every time securities are bought or sold, it eliminates the complex and time-consuming sequence of reconciliations which take place between asset managers and brokers and brokers and global custodians and global custodians and sub-custodians and sub-custodians and CSDs. “A dynamic registry of securities holdings enables the streamlining of multiple and often manual, processes,” explains Peisl. “This enhances not only issuance but post-trade settlement and servicing as well. For CSDs, it could make their market more efficient and globally competitive.”
A number of CSDs are already pondering whether they can compete with less efficient CSDs in other markets – encouraged, in the case of the EU, by the Central Securities Depositories Regulation (CSDR) – but it remains a counter-cultural notion. For Rise, on the other hand, CSDs are an ideal client base. “Financial market infrastructures are systemically important institutions, which participants in the cash and securities markets are almost always obliged to use in order to issue and settle transactions in securities,” explains Peisl. “Most are also neutral intermediaries, which enjoy high levels of trust. This puts them in a strong position to influence the speed at which new technologies are adopted, by making adoption a condition of service, or demonstrating the benefits with early adopters, and by accelerating network effects.”
That said, Rise does expect the costs of investing in the DU to be borne, at least initially, by the CSDs rather than their users. “Trying to transition CSD users to a new platform in a `Big Bang’ will not work, as innovators found with attempts to create a Global Registered Share market 15 years ago,” says Peisl. “CSDs will have to maintain legacy connectivity and even legacy post-trade processes to accommodate users that lack the money or incentives to adopt the new system quickly. Of course, that does have the advantage that cost is not a barrier to intermediaries, such as custodian banks and broker-dealers, adopting the new system.”
The message of blockchain technology is stark: disintermediate or be disintermediated
There is another barrier though, for the tempting benefits of adopting DLT lie mainly with issuers and investors rather than intermediaries. Most obviously, investors obtain superior ownership rights. An investor which buys and holds securities in an account bearing their own name rather than the nominee account of a custodian bank enjoys a direct relationship with the issuer and incontrovertible evidence of ownership. The same benefit has value for issuers too: they have full transparency into who really owns their securities. There is a growing acceptance that issuers will one day issue equity and debt securities directly into investor accounts – including retail investor accounts – at the CSDs.
Users of CSDs are mostly intermediaries, such as custodian banks and broker-dealers, which act on behalf of corporate issuers, asset managers and end-investors. Their incentive to adopt more efficient technology is correspondingly low, since they are the prime beneficiaries of extended chains of intermediation characterised by cumbersome reconciliation processes. But that is not an argument for intermediaries to do nothing. The prudent ones, predicts Peisl, will prefer redefining themselves step-by-step to being redefined by someone else overnight.
As it happens, CSDs face a similar dilemma. “The primary business of a CSD is not only settlement,” says Peisl. “It is keeping a ledger. So anything that changes the capacity or intent of ledgers is both a threat and an opportunity. The opportunity is the opposite of the threat: it is to disintermediate rather than be disintermediated.”
Network effects accelerate adoption and recovery of investment
He has two further pieces of advice for CSDs willing to take his advice and gradually transition their existing client base of issuers, investors and intermediaries to DLT-based networks. The first is to focus on use-cases that are not just high-value, but rich in the network effects that can propel rapid growth. Peisl even thinks CSDs should be prepared to work with consortia if that accelerates network effects. The second piece of advice amplifies the same point: make sure that any implementation is inter-operable with any other implementation by a CSD, including existing ones.
“Siloed competing DLT networks will always be less valuable as drivers of growth,” says Peisl. “The industry should give priority to developing standards for inter-operability, because that is what will drive growth in this area fastest. Financial market infrastructures generally have regulatory credibility in their own markets, but blockchain can extend that credibility across national borders, giving users access to additional asset classes and increasing business for CSDs.”
 See ISSA, Infrastructure for Crypto-Assets: A Review by Infrastructure Providers, October 2018.