Equity Tokens and the role of Custodians & Depositaries

As Blockchain technology is maturing at an astronomical speed, we see that there is a typical use case that is getting more and more momentum. This is the use case for Equity Tokens. If we look at the definition of an Equity Token, we can say that an Equity token is a cryptographic representation of an asset representing a certain value. This asset can be real estate, company shares, Fund participation shares, commodities, bonds, loans, etc.

By registering those property rights in a single distributed ledger (Ethereum) and updating this ledger automatically every time the property rights are bought and sold, blockchain technology also makes it possible for members of the network to exchange the rights efficiently, peer-to-peer, between Wallets on the network. In other words, unlike the current securities markets, The Ethereum Blockchain manages counterparty risk without going through a trusted and centralized third party.

The potentially revolutionary implications of this combination (Equity Tokens issued, traded, cleared, settled, and safe-kept on a Blockchain) for established securities markets, the instruments that are traded on them, and the institutions that trade, settle, safe keep and service them, are obvious. In this blog, I would like to make an argument for the new roles of Custodians and Depositories, as I believe that they can play a vital (new) role in this emerging Blockchain ecosystem.

The current securities market

The current securities market consists of an extended infrastructural system of stock exchanges, central counterparty clearing houses (CCPs), central securities depositories (CSDs), automated clearing houses (ACHs), and real-time gross settlement systems (RTGSs). These structures are surrounded by networks of brokers and custodian banks to interact with them. Together they basically perform all the processes needed in the securities markets: Issue, trade, clear, settle, safe-keep, and service financial assets.

In addition, far from being distributed, the system of today is highly centralized. Central banks issue fiat currencies, which central governments underwrite. Domestic payments in fiat currencies are ultimately settled through centralized RTGSs operated or supervised by central banks. Cross-currency payments are settled via CLS, a centrally organized industry consortium. In the securities markets, trades are agreed on centralized stock exchanges or trading venues, confirmed via centralized matching engines, cleared through centralized CCPs and settled by delivery against payment in central or commercial bank money in centralized CSDs using existing business and technical ISO Standards such as ISO 15022 and ISO 20022.

In theory, a marketplace based on a single but distributed ledger powered by Blockchain technology such as Ethereum has no need for this complicated set of inter-locking market infrastructures and institutions. This is one reason why central banks, RTGSs, CLS, stock exchanges, CCPs, and CSDs are exploring the application of Blockchain technologies to the roles they currently play. But the challenge issued to existing market infrastructures reaches beyond the application of distributed ledger technology to existing services. Securities have to be serviced. Transactions in Securities have to be settled and purchases of Securities safe-kept.

It is important to remember that current market infrastructures were not merely a result of the technologies that existed when they were established. They were founded and continue to exist because they clear a major obstacle to growth in the volume of financial transactions, both domestically and across borders:

They create a safe and efficient environment that instils trust for the participants and the public.

Trust increases transactional activity and reduces transaction costs. If a seller cannot trust a buyer to deliver the cash and a buyer cannot trust a seller to deliver the goods or services or securities, and either or both do not trust the environment in which they trade, less business will be done at much higher cost because each counterparty will have to do their own due diligence on the other and on the wider trading environment.

The need for trust

The key element of a trustless Blockchain is the absence of any centralized intermediary or governing authority to police and facilitate transactions, by providing an immutable, digital audit trail of transactions that all members of the network agree is true. In short, evangelists for the trustless Blockchain argue that it eliminates the need for the classical trustees. As Satoshi Nakamoto put it in his original paper outlining how Bitcoin would work,

“the main benefits are lost if a trusted third party is still required”

 

However, a crucial lesson for the crypto-asset markets is that this trust is not wholly dependent on the market infrastructures and the technologies they deploy. Much also depends on the surrounding corpus of law and regulation mostly instated for the protection of consumers against fraud and risk mitigation.

We have identified 2 classical roles in the existing financial system that will prove to be crucial in this new -Blockchain-based- ecosystem. These are the Custodian and the Depositary.

What functions should a Custodian execute?

Looking at the specific nature of Equity tokens issued on a trustless Blockchain, we can roughly distinguish 2 functions where custodians can play a vital role:

1. The security basis of any Blockchain is the so-called “public/private key pair”, often referred to as a “wallet”. A wallet consists of a public part, the wallet number, and a private part, the “private key”. In theory, Equity Tokens are held securely in these digital “wallets”. In practice, the private keys that are the sole guarantor of ownership are vulnerable to catastrophic loss. Custodians can reduce the risk of loss by monitoring ledger-based registers of ownership, (www.etherscan.io) operating an independent register and providing physical custody services for the afore-mentioned private keys.

2. When tokens are issued, it needs managing throughout the entire lifecycle. The company will pay out dividends, coupons, redemptions, hold shareholder meetings where shareholders can vote. The Custodian as an independent third party is perfectly suited for this important task (control and process). The Custodian is able to perform these tasks using the Distributed APPlication that offers the required functionality.

What functions should a Depositary execute?

A Depositary has a responsibility in checking and confirming non-custodial assets and provide guarantees to investors. In case of funds holding real estate or private equity stakes (non-custodial assets), a Depositary checks ownership and transactions.

We could argue that all this is provided for by nature when using assets on the Blockchain. However, we expect that the capital market will slowly evolve from the current centralized administration (with tons of reconciliations) to decentralized. And in that transition, the Depositary will be an important factor in our new ecosystem. We need a party that can guarantee holdings and transactions to all participants.

The Depositary can take responsibility by:

– Operate a node in the private Blockchain of an Exchange. (When decentralized exchanges are becoming commonplace)

– Administer a multi-signature wallet for clients and countersign each trade.

Conclusion:

The above functions suggest that, while the distributed nature of the Ethereum network on which Equity Tokens are issued and traded is rich in the potential to support new forms of financing and ownership of Equity, it does require traditional pieces of infrastructure to bring safety, trust, and efficiency to this market. In particular, Equity Tokens need a different form of governance and operation. This where the custodian and the depositary can play a vital role.

The future will show which Custodians and/or Depositaries are up for this challenge!