Our Thinking
Jan 18, 2018 4 min read

Improving Global Investing

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Cross-border investing in listed securities can be a pain, which is not great for financial inclusion. If you happen to qualify for stockbroker account in multiple jurisdictions, then you can purchase foreign securities by maintaining multiple broker accounts, which is a management pain. Alternatively you can buy depository receipts of foreign stocks issued by global custodians on local exchanges, however that increases overall costs and often prevents the owner of the depository receipt from participating in voting, as well as other restrictions compared to direct ownership. A company may also dual list on couple of exchanges, but then has to manage the additional share registry / stock transfer agent costs required to keep and transfer registrations between national securities depositories. These frictions are in part caused by reconciliation complexities between jurisdictionally fragmented securities depositories.
This can inhibit transparency, and lead to increased systemic stability risks. The fragmentation impact is now also more acute as investing is more international. The obvious answer is a global securities depository, however would it be resilient enough to cope with all of world’s securities? Even if it was, where would it be hosted? And more importantly what would happen to countries when they are cut off from access by a hosting nation due to a conflict. Also, each country has it’s specific securities quirks, and to scale an organisation that can accommodate quickly enough such diverse and evolving needs with conflicting priorities is very hard. Almost inevitable failure to do so leads to fragmentation as smaller states are de-prioritised and are forced to split off to focus on their own needs.
In the un-regulated crypto market, things are a little different. Distributed ledgers on blockchain networks have effectively replaced securities depositories. They have achieved what capital markets have failed to do so far - create a global securities depository, and in doing so also removed the need for share registries and transfer agents. Asset issuance and registration is done on blockchain by mapping assets ownership to addresses, and enforcing key transfer rules.
Being fully replicated, you cut the Gordian knot - you host the depository everywhere instead of one country, so no one country can cut another one off. By de-coupling develop and operate activities and throwing away unilateral admin rights i.e. different people can write different smart contracts yet operate them on a shared network with immutable performance guarantees, you allow many participants to customise and extend to their needs at their own pace and not carry the risk of a hostile administrator changing the rules to suit them.
That's why we now see many different exchanges around the world effectively settling trades on the same distributed ledger across a very heterogeneous set of assets, which is much more efficient and user friendly, as you remove the inter-depository reconciliation frictions.
Settlement in crypto is still fragmented, and depends on which assets are being exchanged. When fiat is involved, the exchange typically handles that leg, as well as delivery-versus-payment, and deals with a commercial bank to deposit the funds. When coins on networks either without smart contracts or atomic swaps support are involved, or assets on different networks are exchanged, again the exchange handles delivery-versus-payment, and typically self-custodies assets.
However, when assets reside on the same network that also supports smart contracts, it’s now possible to settle without any exchange risk e.g. it’s possible to code up delivery-versus-payment as a smart contract to exchange ether for an ECR20 token. There is also no regulatory impediment to tokenise fiat e-money and hence exchange commercial fiat for ether or app tokens via smart contracts. Overall, it’s possible to remove the need for conventional settlement and paying agents, and fiat deposit accounts.
Clearing functions are still largely under-developed e.g. novation and netting. Some folks are starting to develop instant guarantees against double-spend to settle without waiting for x-deep block confirmations, arguably a clearing function. On Ethereum, which supports smart contracts and multiple assets, it’s possible to implement both netting and novation, as well as previously mentioned delivery-versus-payment capabilities as smart contracts and avoid adding clearing, settlement and banking intermediaries.
As a side note, crypto exchanges have also successfully compressed exchange and broker functions, as they allow direct access to end users. So overall we can see that if someone trades assets on the same smart contract capable network, it’s possible to compress down to just an exchange, which acts as exchange and broker, and the network with a bunch of smart contracts that act as share registries, transfer agents, securities depositories, settlement agents, clearing agents, paying agents, deposit agents, etc. This is a massive compression, and as all those smart contracts operate on the same data and within an atomic transaction envelope, such a setup can eliminate huge reconciliation inefficiencies, thereby reducing cost, time and risk factors.
At the same time, the crytpo exchanges have also taken on custody duties, which may pose long term risk. In regulated markets there are often laws against an exchange acting as a custodian, this to ensure segregation of duties so as to reduce systemic risk. Exchanges and custodians need to have different business models - one charges for transactions, the other for safeguarding. Assets should be held in segregated accounts so that the owner always knows the reason for a transaction, and not in omnibus accounts. They should be off-balance sheet, to ensure that crypto exchanges never prop-trade off assets under custody, or that client money is not locked out in case of default. The custodian should also be able to safeguard non-exchange transactions e.g. OTC and private exchange, payments, inheritance, accounting, tax, accounts for trustee, escrow, fund etc. purposes. Custodians should also help with confidentiality issues, as publicly the assets will be held under custodian's account. The custodian in turn could know the identity of the owner, perform KYC on them, and hence perform the AML and CFT regulator mandates checks.
So the crypto market has innovated, and those innovations may be applied to capital markets so as to improve their efficiency, especially for cross border investing. The market could be compressed down in the mid term to blockchain networks, exchanges and custodians.
Existing public listed securities regulation often demands an existence of regulated CSDs, however there is usually no such restriction for private equities. Private equity issuance has been shaken up with crowdfunding, however the secondary market is often either not permitted, or under-served. As such, it offers a perfect opportunity to test out this new market model, and if successful, apply it to public securities. It also worth pointing out that regulation is not technology specific, so it may be possible to do most of this without need to change it. There will be many hurdles to overcome, but the opportunity to reduce fragmentation to improve inclusion, transparency and stability is very much there.