Securities services, Technology, Regulation
Post-trade’s quantum leap
16 July 2021
New technologies and the roll out of various regulations are rapidly transforming the post-trade landscape. flow attended the Network Forum Virtual Annual Meeting and reports on how these themes are shaping the future custody model
After swiftly pivoting its format from an in-person event to a virtual one in June last year, The Network Forum (TNF) Annual Meeting returned to digital devices for the three days 29 June – 1 July 2021, exemplifying the digital transformation seen in the industry. This year saw more than 800 registrants sign on to the event platform to discuss the emergence of new technologies and the evolving regulatory landscape. While the organisers are hopeful of returning to the more usual format in 2022, they remain ready to keep meetings virtual should the need arise.
Institutional investors slowly warm to digital assets
The ascendency of digital assets is well-documented. In April 2021, the market capitalisation of crypto-currencies – comprising of assets such as Bitcoin, Ether and Tether−exceeded US$ 2trn for the first time ever, fuelled by institutional inflows1. Meanwhile, there is also growing investor appetite for other types of digital assets, including:
- StableCoins – a type of crypto-currency pegged to Fiat money;
- Central Bank Digital Currencies (CBDCs) – a form of digital money issued by Central Banks; and
- Security tokens, a digitalised, fractionalised and fully tradable representation of a tangible financial instrument (e.g. bonds, equities, derivatives or even illiquid assets such as private equity and real estate).2
While some assets like security tokens or crypto-currencies could become more widely adopted, Samar Sen, Global Head of Digital Products at Deutsche Bank Securities Services, said distributed ledger technology (DLT)-supported CBDCs will be less of an investment tool and more of a mechanism to facilitate seamless and efficient payments and settlements across both the retail and wholesale markets.
PwC, which regularly publishes a CBDC Index, reports that more than 60 central banks now trialling the currency and Thailand, Hong Kong, Canada, Singapore, the UK and France are among the markets widely considered to be the leaders in developing wholesale CBDC projects3. China is also a prolific supporter of CBDCs with the PBOC (People’s Bank of China) currently in the process of launching a digitalised Renminbi. Similarly, the European Central Bank (ECB) is exploring the viability of whether or not to establish a digitalised euro.4
“We are fielding more questions from clients globally – including asset managers and high net worth investors (HNWIs) about how we can help them obtain exposure to some of these new digital asset classes,” commented Sen. With ever growing numbers of institutions looking to incorporate digital assets into their portfolios, alongside more traditional investments such as fixed income and equities, custodians are building new solutions to make this possible. While there is an abundance of non-bank crypto-custodians and crypto-exchanges in the market, the institutional investors who are beginning to explore digital assets want support from entities with institutional-grade infrastructure. Sen noted there had been several high-profile hacks and thefts involving crypto-currencies being held at unregulated crypto-exchanges, leaving out-of-pocket investors little recourse. “Digital assets have a prior history of suffering hacks and scandals, which means institutional clients want assurances that their digital custodians have institutional grade offerings and robust security protections,” added Sen.
Incumbent banks that are branching into digital custody – by offering tools such as private key safekeeping – must ensure their cyber-security measures are watertight. Similarly, Sen said providers must demonstrate that they are fully compliant with anti-money laundering (AML) and know-your-customer (KYC) rules and adhere to the Financial Action Task Force (FATF) standards. Sen shared that the existence of high-calibre digital custodians could encourage risk-averse insurers to offer protection policies for investors trading digital assets.
However, banks will still need to provide traditional services alongside digital custody if they are to thrive. “Traditional bank services such as settlement, foreign exchange, securities lending – along with ancillary products like fund administration and tax advisory – are our bread and butter,” said Sen. “We need to build an integrated experience for clients who are trading both traditional and digital assets.” This co-existence is explored by Paul Maley, Global Head of Securities Services, Deutsche Bank in Building a future custody model.
"We need to build an integrated experience for clients who are trading both traditional and digital assets"
Deutsche Bank’s Samar Sen participates in a panel titled: Crypto custody development – investigating impacts on the whole value chain
Regulating and governing digital assets
While digital custody offerings from traditional banks could provide the assurance institutional investors seek for trading digital assets, one major obstacle is the absence of consistent global regulations and standards. Whereas some countries including Switzerland, Germany5 and Singapore have taken a very forward-looking approach towards digital assets, one panellist at TNF said the US and several other major markets were lagging. However, the EU is adopting a progressive line on digital assets especially following the announcement of its proposed Markets in Crypto-assets Regulation (MICA).6 Under MICA, existing EU regulations such as Central Securities Depositories Regulation (CSDR) and (Markets in Financial Instruments Directive (MiFID) will be applied to issuers and investors partaking in what is known as the regulated digital asset market (e.g. security tokens). A panellist noted MICA will also create a sandbox regime for market infrastructures to support trading and settlement of these regulated digital assets using DLT.
Conversely, assets like crypto-currencies have been placed in the unregulated bucket while the EU has pledged to introduce investor protections and curbs against crypto-currency issuers/servicers. Although regulators are aiming for MICA to become law by 2022, a panellist suggested 2024 was a more realistic target − but warned the rules risked being out of date by then.
Tokenisation and ESG
For the many sceptics, digital assets – most notably crypto-currencies – are an anathema to environment, social, governance (ESG) principles, due to the enormous amount of coal-powered energy which mining them consumes; together with their anonymised nature and frequent involvement in nefarious criminal behaviour. Boon-Hiong Chan, Global Head, Securities Market and Technology Advocacy, Securities Services at Deutsche Bank, said the situation was more nuanced. He added that tokenised assets on a blockchain could actually enhance governance as they are easily traceable.
“Imagine we have a tokenised green bond issued on a blockchain. As the asset is traceable on a blockchain, the investor can more easily identify whether the bond’s use of proceeds are being deployed correctly – at least relative to a traditional green bond,” said Chan. In fact, the governance benefits of blockchain have been recognised in some markets already. Chan said the National Research Council of Canada – a government body – is using an open source, Ethereum Blockchain to publish information on government grants and contributions as part of a transparency drive exercise.7 Chan acknowledged the traceability benefits – enabled by blockchain – could also be leveraged in some of the more opaque areas of banking, including in project financing and supply chain financing.
"Tokenisation is being used to support various ESG causes"
“Tokenisation is being used to support various ESG causes”
Boon Hiong Chan, Global Head, Securities Market and Technology Advocacy, Securities Services at Deutsche Bank presents in the TNF exhibition area
Elsewhere, Chan highlighted how tokenisation is being used to support various ESG causes. As it allows investors to buy fractionalised units of tangible assets, he said the practice is encouraging greater financial inclusion, especially in emerging markets. This is evident in Thailand where the country’s Public Debt Management Office launched a bond issue on a blockchain-based platform.8 Whereas traditional bond issues in Thailand will typically have a minimum investment threshold of 1000 baht – which is prohibitively expensive for most ordinary retail investors – the blockchain bonds issued in the country are priced at 1 baht with a subscription charge of 100 baht making them far more accessible.9
Chan cited the UN World Food Program [WFP]-endorsed Fishcoin project as a further example of how tokenisation is playing a valuable ESG role. The Fishcoin initiative is designed to help improve traceability and sustainability of seafood supply chains by allowing consumers to track a fish’s journey from its origins to market and plate, while fishermen are compensated for recording the fish travel data.10
The relationship between digital assets and the environment is more complicated, however. Take, Bitcoin, for example. The process of adding blocks to the blockchains underpinning crypto-assets – such as Bitcoin – is energy intensive. This is because the mining process relies on a concept known as proof of work. According to the Man Institute: “This [proof of work] requires the Bitcoin miners to find a number, called a nonce, which is used to solve the cryptographic puzzle and generate the required hash. The proof is easy for any node in the network to verify, but extremely computationally intensive to generate. To create a secure cryptographic hash, miners must try many different nonce values.”11
Notwithstanding the sheer amount of computational power required to make this work, the cost of running vast air-conditioning units across data centres makes crypto-mining a serious emitter of greenhouse gases. Chan conceded these challenges, but added that market participants are trying to decarbonise crypto mining by embracing renewable energy sources such as thermal power.
Shifting regulations shape the industry’s future
Introduced in order to drive efficiencies in post-trade processes, the EU’s CSDR will take effect from February 2022, following its delay as a result of Covid-19. Under the Settlement Discipline Regime’s (SDR) requirements, CSD participants could be fined or subjected to mandatory buy-ins for late settlements, as regulators in Europe look to put an end to delayed or failed settlements.12 Emma Johnson, Head of Securities Services Market Advocacy at Deutsche Bank, said the European Commission (EC) was reportedly reconsidering aspects of the penalty regime. According to Johnson, the EC is now assessing whether the SDR’s mandatory buy-in obligations should become discretionary.
This comes following intense lobbying by groups such as the Association for Financial Markets in Europe (AFME) and the International Capital Market Authority (ICMA). A number of experts have repeatedly warned regulators that mandatory buy-ins risked undermining market liquidity, and could even exacerbate systemic risks, especially during crisis events such as COVID-19. “The majority of the industry believes buy-ins should be voluntary and not mandatory,” said Johnson, but conceded that a handful of participants still favour mandatory buy-ins. These organisations argue that voluntary buy-ins will not incentivise firms into strengthening their back-end processes to improve settlements while others point out they have already spent vast sums of money building the systems to comply with the mandatory buy-in regime13. Others have warned that some financial institutions may be reluctant to initiate voluntary buy-ins against their large trading counter-parties.14
"Mandatory buy-ins will require participants to undertake a huge repapering exercise"
The issue of buy-ins is a very contentious one. Unlike the US, Switzerland, the UK and many of the APAC financial centres – where mandatory buy-ins are not being implemented – Johnson warned the EU could risk losing market share at a time when it is attempting to recover from the pandemic. “While the industry is in favour of cash penalties, mandatory buy-ins are very complex, and it will require participants to undertake a huge repapering exercise,” she added. “This will be very expensive and time-consuming.”
An industry in transition
The post-trade industry has recognised the potential of digital assets such as CBDCs and security tokens offer, which is why many custodians, including Deutsche Bank, are busy exploring digital custody solutions. By doing so, the industry will be in a strong position to support clients embracing both traditional and digital assets. Regulations, most notably the CSDR, are set to reshape the industry. Although positive in that it could improve settlement discipline, experts warn that mandatory buy-ins – if the EU decides to go through with the policy – could potentially be destabilising for providers of post-trade services.
1 See Bloomberg (April 5, 2021) Crypto-market cap surpasses $2 trillion after doubling this year
2 See Defined in Chapter 4 of Deutsche Bank’s Regulation Driving Transformation (2019)
3 See PwC (April 2021) PwC CBDC Global index
4 See https://bit.ly/3ifMTJ1 at ecb.europa.eu
5 See https://bit.ly/3xHE156 at ledgerinsights.com
6 See https://bit.ly/3kmHZww at europarl.europa.eu
7 See Coin Desk (January 22, 2018) Canadian research body pilots Ethereum in transparency push
8 See Finextra (October 5, 2020) Bank of Thailand launched blockchain based government savings platform
9 See Ledger Insights (June 16, 2020) Thai government about to issue blockchain savings bonds to public
10 See Wealth Adviser (April 28, 2021) Study reveals growing demand for impact investing among retail investors
11 See Man Institute (March 2021) Bitcoin is set for a head-on clash with those investors who want their portfolios to be managed responsibly
12 See https://bit.ly/36AFxdJ at euroclear.com
13 See Global Custodian (June 30, 2021) European Commission to consider changes to the CSDR’s penalty regime
14 See See note 13
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