I recently attended a webinar on digital settlement and custody. This is not a subject where I claim any special expertise, but I question if there is not more hype than reality in certain assertions about the new age we are entering. I recall, around a decade ago, the wild claims surrounding blockchain and achieving pariah status for challenging the mantra that distributed architectures would quickly sweep away the legacy centralised structures.
I readily accept that we are seeing the birth of a new asset class. Crypto currencies are hardly mainstream but they appear to be at the start of the pipeline that could lead them there. Digital central bank currencies are merely the digital format of fiat currencies, although I still struggle to see their true value added in the current non-cash payments environment. I understand the concept of tokens and have less enthusiasm for those that merely reflect listed assets and more where they are used to reflect partial values of a listed security, perhaps the capital value only, or are used to make investment possible in areas such as single properties or difficult to market items.
My biggest question remains the assertion that this digital revolution will lead to the death of both custodians and central depositories. I heard it proclaimed in the early days of blockchain and it appears to me to be as fallacious as it was then. My second question is timeline and the markets’ willingness to change a system that suits them to a great extent for a system that will challenge them for perhaps little added benefit. And my final question relates to regulation, for, despite the willingness of regulators to listen and learn, I doubt they are willing to risk any environment where there is a potential call on the State to bail out the financial markets.
Perhaps I have aged sufficiently to become a Luddite or part of the permafrost of seniors who want to stay in their traditional comfort zone. But, could the evangelists for the new world be a bit too fanatical about the reach of their new inventions? I am willing to hear all contra arguments but suspect the end game will be a hybrid in technology terms and an expansion of product in portfolios. But let me state my case on the three questions I have raised.
Why should the digital revolution destroy custodians and CSDs? I do not see how this can happen. The technology under discussion is digital, real time and secure. It is also distributed and, at its purest, it is not curated. The role of the custodian goes beyond settlement and core custody into asset servicing, portfolio analytics, cash management, and a host of other products, not least of which is complex data management. And the custodian, or depositary, is a guarantor for the safety of assets. The CSD has an operational value in assuring asset safety, albeit its financial obligations in the event of loss range from exempt through ambivalent to that which is commercially necessary. But the CSD has a critical role; it provides a curated environment, on a centralised platform, allowing trusted and mainly regulated counterparties to transact securely, in many cases for high values, in Central Bank Money. It is also part of the market infrastructure and is regulated as well as usually having a market-based governance structure. Both custodians and CSDs have disadvantages in terms of cost, legacy infrastructures and inefficiencies. These are their Achilles heels. The reality is that improved alternatives can be found for tranches of their service offering, but they are the easier parts to replace, and cherry picking them off would leave behind a substantial residual with added cost, risk and potentially a poorer end to end product.
Who benefits from digital currencies and securities? The reality is that a large part of cash and securities settlement and custody is digitalised and dematerialised. The trend is for further digitalisation of the old physical world with smart contracts and intelligent technical standards that will further concentrate transaction flows into the digital space. I noted already there are areas of value from the new digital world and the new technologies will have their part to play. But if I am able to operate in a dematerialised world using electronic payment systems within my preferred time frame, why would I change? Real time settlement could exist in the current environment but market practice and regulatory requirements prevent it rather than technology or investment instrument design. The trade needs to be executed, confirmed and reported, the buy-side needs to allocate, the administrator needs to approve, the custodian needs to settle. All this could be in real time but nowadays can take often up to two days. It could immediately be reduced to same day without major change in anything other than overcoming market inertia. And the question one needs to raise is whether the difference between instant and fast or same day settlement, in a global market with overlapping time zones, different priorities around change and often bespoke national policies around standards, is so meaningful, especially in terms of cost and risk, that a massive change of global infrastructure and instrument design is demanded.
Finally, what will regulators really do and, most importantly, what will they avoid? The reality is that the current centralised environment is controlled. The regulators believe they have created an environment where the catastrophes of the first decade of this millennium cannot be repeated. The capital behind the markets has increased dramatically, the structure of markets has been enhanced substantially and global standards have evolved that cover both infrastructure and participants in a large share of the global capital market cake. There are no chances of material relaxation of this carefully structured environment; new entrants will be required to provide at least equivalence in terms of risk management and financial support. No government will be willing to take the risk that they have again to bail out financial markets at the cost of austerity for years for their voters.
It is for these reasons that I see the logical path for both the new technologies and the new instruments as fusion rather than major disruption. In such a scenario, they may challenge, but they also enrich our environment.