In the modern digital age, the advent of computerisation has created pathways and connected us in ways we could never have imagined. This is in stark contrast to how the capital markets have developed, where investors and issuers have never been further apart than with the current system of intermediated holdings of securities.
Indeed, the opening up of the global capital markets across national borders has to date been possible only through the interpolation of long chains of custodians between issuers and investors. Historically, securities were held directly by the investors, with their names and holdings listed in the register of the securities maintained by the issuer.
Direct holding of securities provided investors with legal ownership rights in the securities themselves. In intermediated holding structures, the investor’s rights have been diluted to a claim against its direct intermediary in respect of that intermediary’s rights against the next intermediary in the chain (and so on) until the ultimate intermediary that holds the direct ownership interest in the shares.
This multi-chain system has been necessary for the advancement of the capital markets and is certainly not without its benefits, including the boosting liquidity and access to capital, as well as the creation of certain efficiencies that are only possibly through nominee (or omnibus account) structures. These benefits, however, have opened the doors to new risks ranging from misappropriation of securities and duplication of credit entries in client accounts and holdings which are not backed by the intermediary’s own holdings, to the risk of insolvency of any number of intermediaries in the custody chain (over and above the risk the issuer’s insolvency risk).
Custody chains are made up of a series of independent contractual links reflecting the preferences of the custodians concerned, which dilute the content of the rights of the investors. The insertion of intermediaries therefore relegates investors’ rights to the least favourable terms between two intermediaries in the chain.
Existing securities and financial regulation can mitigate but cannot eliminate the issues and risks inherent in securities intermediation, particularly when it comes to insolvency risk. The potential for blockchain in this area is obvious, and if it is eventually accepted as a solution on the basis of common international standards, it could revive the possibility of direct holdings of securities across borders and eliminate many headaches with which the current system is fraught. A distributed ledger system, independent from one central intermediary will translate into a direct relationship and easier interaction between issuers and investors, and could also result in a consolidation of the trading, clearing and settlement of securities into one contemporaneous process. DLT systems could indeed reduce or even eliminate the T+2 period required for settlement by directly linking payment to delivery. The double-entry problem of intermediated holdings could also be solved through blockchain technology through the public verification and consensus mechanism.
Academics like Philipp Paech and Eva Micheler all advocate for the introduction of blockchain solutions within the securities markets, and it is clear that this will eventually be the case, although it remains to be seen to what extent as the use of intermediaries may remain desirable in several scenarios. However, Paech hammers home the fact that unless the law keeps up with the fast developments in technology, particularly on issues of enforceability, the markets will self-regulate and rely exclusively on operational structures that offer practicality over legal certainty. Legal uncertainty increases the cost of capital and a higher chance for bad market players to abuse the system, so it is important that legislators begin to embrace the innovation offered by DLT sooner rather than later.
With the inevitable application of DLT to traditional securities markets, it is therefore important that existing securities and financial markets regulation is reviewed and updated to provide this certainty and provide adequate protection to investors, something that is already being contemplated (or at least studied) by European legislators as well as European supervisory authorities such as the European Securities and Markets Authority.
Blockchain solutions in the financial markets sphere will certainly untangle the confusing knots that obscure the status and rights of issuers and investors, mitigating a number of legal and practical risks currently befouling the markets. This notwithstanding, new legal concerns will emerge from a disruption of the heavily-intermediated holding chain system that exists today, which concerns will need to be addressed. The commendable approach taken by Malta in introducing a unique legal framework to govern DLT arrangements (as well as virtual asset offerings and services) currently aims to provide the much needed legal certainty in the crypto-space and, once the relevant subsidiary legislation and rules begin to be fleshed out by the legislator (and regulator – the Malta Digital Innovation Authority), is intended to also provide certainty to issues created as a result of the application of DLT in more traditional industries such as the financial and capital markets.
This article was first published in The Sunday Times of Malta, 2 September 2018.