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Digital securities comprise stocks, bonds, funds and other assets, which have started gaining attention in the financial services industry. Analysts are expecting significant growth in 2020 and beyond. It took three decades for securities – stock and debt instrument certificates – to move from materialization to dematerialization. The trend now is that electronic form of securities will move to Digital Assets.

A digital security is a representation of financial asset classes like equities, fixed income, funds etc., where investment contracts and ownership are recorded and verified in a Blockchain network, using distributed ledge technology (DLT). A digital security, also known as a security token, represents the stock of corporations, debenture notes issued by financial institutions, Governments or corporations and underlying assets for Exchange Traded Funds (ETF), that are subjected to laws and regulations.

Digital Securities originated as a new paradigm in the capital market infrastructure; these have the ability to create more efficient financial markets, achieving operational and transactional efficiency, and to introduce disintermediation in critical processes like clearing, settlements and others.

Security Token Offering (STO) and the Future of the Security Value chain:

Security Token Offering (STO) is a process where an investor exchanges money for a security token representing their investment. These tokens are linked to underlying assets like stocks, bonds, Real Estate Investment Trust (REIT), commodities, funds and other instruments. Securities token are newly issued securities that function on a distributed ledger. Like traditional equity instruments, a digital securities investor will have financial rights such as ownership, dividends, bonus, profit sharing and buy-back options.

Here’s a pictorial presentation of a traditional security issuance (IPO) and security token offering in the primary market.

Traditional security issuance (IPO):

Traditional security issuance

Security token offering:

Security token offering

Securities trading in the secondary market:

Securities trading in the secondary market

Digital securities are encrypted and contain all the information related to underlying assets, market pricing, the best trade execution by the market marker and liquidity. Digital securities that are issued, traded and settled in a distributed ledger are stored in cryptographical digital wallets.

The security value chain comprises issuer onboarding, deal structuring, issuances of digital securities, listing and secondary market trading. Asset servicing will be established using a front to back office security token trade model with a permissioned ledger and smart contracts, which will help in the processing of corporate actions.

Benefits of Digital Securities:

  1. A digital security issuance under regulation will be cost effective and faster compared to initial public offerings
  2. Digital Securities brings greater transparency in asset ownership and record-keeping in the digital registry
  3. Increased scope of automation, especially in a compliance procedure like KYC/AML
  4. Digital securities can be traded globally; the investor can access the securities results, which helps in boosting liquidity levels
  5. Round-the-clock trading (24/7) across various geographies

Digital Securities Implementation so far:

Blockchain has been identified as key technology trends in 2020. Financial institutions like State Street, JP Morgan and others have started to launch digital securities projects. Here are some already implemented projects.

  1. I2DS/SETL was the first Distributed Ledger Technology (DLT) central securities depository approved by the French authority (AMF) that facilitates the issuance and distribution of negotiable European commercial paper
  2. Swiss Stock Exchange (SIX) launched a fully integrated trading settlement and custody infrastructure for digital assets
  3. Australia Stock Exchange (ASX) is rolling out a DLT-based clearing settlement and asset registration services platform, replacing the legacy CHESS application
  4. Clearstream High Quality Liquid Asset (HQLA) facilitates the exchange of digital assets for security lending and collateral management services

The Regulatory Landscape of Digital Securities

While regulators are analyzing changes in digital securities, at the same time, several position papers, documents and recommendations are being published, aimed at stakeholders and investors in the financial services industry.

As highlighted in the European Securities Market Infrastructure, Securities and Market Stakeholders Group Report - nations in the European Union (EU) are assessing regulatory frameworks for each use case, ensuring that digital securities DLT projects are compliant with local laws and regulations.

Countries like Switzerland, Italy and Luxembourg have incorporated a new provision within their legal framework where digital securities using DLT are recognized and regulated.

The US Security Exchange Commission has come up with guidelines for digital securities by introducing Howey Test for all digital forms of assets to ascertain whether they are liable to security guidelines.

Conclusion:

Digital securities are assets of the future in the financial instrument lifecycle landscape. The advent of digital securities will re-organize both primary and secondary markets, including security issuance, trading and settlement. Digital securities are widely accepted by financial institutions, academics and regulators. The EU and Financial Conduct Authority (FCA) authorities acknowledge that DLT solutions and digital securities adhere to transparency, efficiency and reporting. Ultimately, while digital securities show a lot of promise at the moment, opportunities remain unutilized. Long-term trends of digital underlying asset are very clear and more digital securities will enter the financial market in 2020 and over the next few years.

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About the Author

Veerabasappa Jayanna
Senior Consultant

Veerabasappa Jayanna, is a Senior Consultant with Mindtree's BFS vertical and a subject matter expert in Capital Market domain. He is responsible for delivering innovative solutions to our customers while leading domain consulting, alliance management, and domain competence building.

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