Growth of tokenized securities trade pushing post-trade principles

DTCC paper identifies post-trade responsibilities that should be undertaken to establish confidence in security token platforms and protect market stability

Security tokens are becoming more widely traded on platforms around the world, with NASDAQ seeing them as “set to take center stage in 2019” and a regional news outlet calling them the next trend in crypto-asset trading.

The trading of security tokens (tokenized representations of underlying assets like shares or bonds) often features post-trade processing that uses distributed ledger technology (DLT), which means there is a strong need for security and reliability to protect market stability. The potential market for security tokens is expected to grow to US$24 trillion in 2027, according to technology media website Hackernoon.

A white paper released on March 13 by the Depository Trust & Clearing Corporation (DTCC), a global provider of clearing and settlement services for the financial services industry, outlines seven key principles for both regulators and market participants for the post-trade processing of tokenized securities using DLT.

“What occurs after a trade is executed is critically important and this issue has not been broadly discussed within the context of tokenized securities or crypto assets more generally,” said Mark Wetjen, managing director and head of global public policy, DTCC, in the white paper.

While earlier crypto booms like initial coin offerings in 2017 eventually came to an end due to underperformance and scams as well as regulatory concern, security tokens might be more viable and enduring to invest in. That’s because they are based on claims to assets like equity or bonds which provide a form of reassurance to investors. However, this can only work with the necessary measures and policies in place, which is what DTCC is emphasizing.

“The framework DTCC has developed identifies the key issues that we believe need to be addressed by those seeking to establish policy, rules or best practices to govern the conduct of entities providing post-trade services for crypto transactions. In our view, these issues are fundamental to protecting investors and establishing trust in the safety and soundness of security token platforms,” said Wetjen in the white paper.

DTCC emphasized the Principles for Financial Market Infrastructures (PFMI), global standards for traditional market infrastructure policy, as a possible model to define responsibilities for security token platforms. In some cases though, existing rules might not necessarily apply to security tokens.

Hong Kong’s Securities and Futures Commission (SFC) released guidelines for cryptocurrency funds and trading platforms in November 2018, and invited platform operators to enter a regulatory sandbox. However, these guidelines did not specifically apply to security token platforms, and it is not certain when Hong Kong authorities will grant specific approval to security token platforms. 

The white paper outlines seven key responsibilities for any platform that provides post-trade processing of security tokens. These include a demonstrable legal basis for its activities, an identifiable governance structure, identifiable risk management procedures, identifiable procedures to ensure settlement finality, and security token issuance, custody and asset servicing. Also, a platform should be resilient and be able to manage private and confidential recordkeeping.

Security token platforms should have a clear, transparent and enforceable legal basis for its activities in all jurisdictions. To this end, DTCC believes it is vital to identify the law that best applies to the activities and user relationships of these platforms. If a platform is utilizing a permissionless (anyone is allowed to join and every user able to contribute) network, how a governing law is adopted is unclear and presents a challenge. For permissioned networks (access is restricted to approved participants), the central authority managing the platform can manage some of the policy issues.

Platforms should have appropriate governance arrangements to support their operations including rules regarding functionality and risk management. The arrangement would depend on whether the platform is utilizing a permissionless or permissioned network.

Regardless of structure, security token platforms should have a sound framework for managing legal, credit, liquidity and operational risks.

While some of these platforms can reduce credit and liquidity risks due to the shortening of trade settlement times, real-time gross settlement (RTGS) systems present a challenge. This is because participants are required to keep sufficient liquid assets on hand so they can settle their transactions in real time. This would be a concern to institutional investors who would need to tie up significant amounts of liquidity in a RTGS system.

Platforms should be able to provide clear and certain final settlement. This means completed transactions need to be considered “final” both according to the rules of the market (operational finality) and the governing legal framework in the jurisdiction where the transaction has been conducted (legal finality).

Platforms should have appropriate rules and procedures in place to ensure security and manage risks associated with safekeeping. Platforms should have robust accounting practices, safekeeping procedures and internal controls. Platforms should also be able to facilitate asset servicing such as dividend processing on the securities it is responsible for.

Given the platforms’ strong dependence on technology, operational risk such as fraud, data loss and system outages will need to be dealt with by providing resiliency and security.

Platforms need to outline how privacy and confidentiality of records are managed while maintaining accessibility to regulators and appropriate third parties such as external auditors. Policymakers can consider imposing a single reporting system to reduce the burden of data reporting obligations.

DTCC stressed that these requirements are essential otherwise security token platforms would be operating in a way inconsistent with the public interest and would not attract institutional investors. 


19 Mar 2019


Capital Markets

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