Central Securities Depositaries in the Age of Tokenized Securities

The distributed ledger technology offers a new way to transfer securities and record their ownership. When fully deployed, it could form the backbone of a new market infrastructure, and could even replace central securities depositaries as we know them today. The Federal Council however raised the possibility that certain distributed ledger infrastructures could be themselves qualified as central securities depositaries. This article reviews cases where the rules on central securities depositaries could apply in a distributed ledger technology context, and describes how the topic is addressed in the proposed Federal Act on Adapting Federal Law to the Developments of the Distributed Ledger Technology.

By Jacques Iffland / Ariel Ben Hattar (Reference: CapLaw-2020-05)

1) Central securities depositories in today’s markets

The last decade saw the completion of the dematerialization of securities. Today, securities no longer need to be represented by a physical certificate and, with the Intermediated Securities Act (“ISA“), a bank transfer from one securities account to another is sufficient for the ownership of securities to pass. The system put forward by ISA (and similar legislation outside of Switzerland) is heavily centralized, though. It is based on the idea that certain intermediaries, in particular banks, can be trusted to keep a record of ownership. Proof that one owns these “intermediated” securities is therefore no longer a piece of paper, but a record in the books of a (regulated) custodian.

Central securities depositories (“CSDs“) play two roles in this context. First, they keep intermediated securities in custody by acting as the ultimate custodian. To use the expression of the European Central Security Depositories Regulation (“CSDR“), they operate at the “top-tier level”, meaning that all custodians holding the relevant (intermediated) securities ultimately hold them through the CSD. Second, CSDs also provide settlement services by facilitating transfers of securities between custodians. These two roles are reflected in article 61 of the Financial Market Infrastructure Act (“FMIA“), which defines CSDs as organizations that operate “a centralized safe custody of securities and other financial instruments” (article 61(2) FMIA), or a settlement system, i.e. a system to “clear and settle trades in securities and other financial instruments” (article 61(3) FMIA). In either case, the activity of CSDs is based on “uniform rules and procedures“.

2) The disintermediation of securities markets – towards the end
of CSDs?

An important use case of distributed ledger technology (or “DLT“) in financial markets is the digitalization – or “tokenization” of securities. This term relates to a process through which a financial instrument is associated with a digital token recorded on a distributed ledger, so that the financial instrument cannot be transferred without the token and vice-versa.

The benefit of tokenizing securities is that it becomes possible to “disintermediate” the process through which securities are marketed to investors on the primary market and traded on the secondary markets. Contrary to intermediated securities, tokenized securities can be held and transferred without the involvement of any custodian. Control over tokenized securities does not depend on the ownership of a securities account. Rather, control is ensured through a so-called “private key”, a digital code that is used to generate instructions to transfer tokens from one distributed ledger address to another. As private keys are digital codes, they can be kept by anyone who has access to IT storage devices such as hard drives or USB sticks. Private keys can – but do not need to – be kept in safe custody with a third party.

The practical implication of this is that the issuance and trading of securities does not necessarily require the involvement of custodians or CSDs. Tokenized securities can be created by issuers themselves, and transferred directly to investors. As the SIX Group’s 2018 whitepaper on “the Future of the Securities Value Chain” notes, the tokenization of securities makes CSDs redundant, at least in theory.

3) The Federal Council report of December 2018

In its 2018 report on the potential of DLT in the financial sector, the Federal Council seemed to imply that “due to the broad and technology-neutral manner” in which FMIA defines CSDs, some DLT-based systems could be caught by that definition. The report mentioned that, as an example, trades in tokenized securities could be deemed to be cleared and settled on the basis of “uniform rules and procedures” within the meaning of article 61 FMIA, which would result in the operator of the system falling within the definition of a CSD, and as a result being subject to a licensing requirement in Switzerland. 

In the report, the Federal Council suggested creating a new type of financial market infrastructure combining trade and post-trade activities. This new infrastructure is now contemplated in the draft Federal Act on Adapting Federal Law to the Developments of the Distributed Ledger Technology (the “DLT Act“). The Federal Council, however, also noted that the delimitation of activities between the various types of financial market infrastructures contemplated in FMIA should be “clarified in details” at a later date.

4) CSDs and DLT

At a conceptual level, there are several situations where the use of a distributed ledger can raise the question of the applicability of article 61 FMIA. The following sub-sections examine in more detail to what extent the Swiss CSD regime could apply in a distributed ledger context. 

a) Distributed ledgers as CSDs?

Distributed ledgers can be used in various manners, including to effect transfers of tokenized securities. In addition, if a distributed ledger is used for such purpose, the ledger will in principle be the only way to record the ownership of the relevant securities.

The Swiss CSD regime only applies to organizations who operate a CSD. By nature, distributed ledgers are not “operated” by a single body or person. Distributed ledgers are based on IT protocols, and the entries in these ledgers are made and validated in a decentralized manner by a community of users. This is especially true for “public” distributed ledgers, where anyone can participate in the validation process by operating a “node”. As an example, the transfer of tokens on the Ethereum blockchain is validated collectively by the consensus of the many nodes of that blockchain (who may not even be aware that they are validating entries corresponding to securities). “Uniform rules and procedures” do indeed exist to validate entries into the ledger, but they are not used by “an organization” to keep securities in central custody within the meaning of article 61(2) FMIA or to clear and settle trades within the meaning of article 61(3) FMIA. The nodes are the building blocks of the distributed ledger, but they are not an organization, and due to the decentralized logic of DLT, they cannot be deemed to be constituent parts of a broader organization. 

Here, it is important to recall that the Swiss rules on CSDs were “inspired” by their European equivalent, in particular the CSDR. Although FMIA offers a simpler take on the regulation of CSDs, it rests on the same premise. The CSDR, as well as the European Settlement Finality Directive (“SFD“) on which it is itself based, assume that settlement operations are performed on traditional securities accounts, i.e. accounts held with an intermediary (including with the CSD itself). The very reason for enacting the SFD and the CSDR is that these intermediaries can and should impose certain obligations to ensure the proper functioning of settlement systems. Even if the term “account” is sometimes used to describe distributed ledger addresses, these cannot be assimilated to proper accounts held with third parties. Applying the rules on CSDs to public distributed ledgers would therefore be largely pointless.

But if a public blockchain, such as Ethereum, cannot be characterized as a CSD for the purpose of FMIA, what about “permissioned” (or “private”) distributed ledger? Contrary to public distributed ledgers that are essentially IT protocols not subject to any form of central governance, the validation of entries in the ledger of permissioned distributed ledgers is generally reserved to vetted participants. A vetting of the validating participants can mean that there is some form of central governance. It will, however, depend on the circumstances of each particular distributed ledger if the governance structure for granting of the permissions can be deemed strong enough for the distributed ledger and its participants to be considered an “organization” under article 61 FMIA.

b) Smart contracts to tokenize securities

To tokenize securities, one generally uses a “smart contract“, a piece of computer code that runs on the distributed ledger. In the context relevant for this article, a smart contract serves to create a “sub-ledger” within the wider distributed ledger. The sub-ledger maintained by the smart contract records the ownership of the security to which it is associated (with “tokens” being entries into that sub-ledger). The issuer of tokenized securities generally retains the power to amend the code of the smart contract or – at a minimum – to disable it. 

Clearly, the author of such smart contract cannot be deemed to be aiming for “the central safe custody of securities“, as provided by article 61(2) FMIA, and the smart contract does not perform any custody operations. However, could such smart contract be operating a “clearing and settlement system“? The answer is, in our view, negative. Clearing and settlement operations are not performed by the smart contract itself or by the entity that has the power to amend its code, but rather by the distributed ledger.

c) Trading venues 

In traditional securities markets, a distinction is generally made between trade and post-trade infrastructures. This distinction tends to vanish, however, when trades are entered into and settled by the same operator, as is increasingly common.

i. The new DLT Trading Venue

An important element of the proposed DLT Act is the creation of a new market infrastructure: the trading facility based on the DLT (the “DLT Trading Venue“). The DLT Trading Venue bears similarities with the multilateral trading facility (“MTF“) of article 26(c) FMIA, but it also introduces a few notable differences. Like an MTF, a DLT Trading Venue is a multilateral system, i.e. orders of various participants compete against each other, can only be operated by an entity holding a dedicated license, admits securities to trading and operates based on non-discretionary rules. Unlike an MTF, however, a DLT Trading Venue may only admit DLT-based securities, can admit unregulated participants, including individuals, and can provide post-trade services (a) in the form of centralized safe custody services for DLT-based securities or (b) by operating a settlement system for such securities.

Under the proposed DLT Act, the DLT Trading Venue license would only be available to operators who offer trade execution services (i.e. multilateral trading of DLT-based securities) and either admit unregulated participants, or provide post-trade services. This particular solution was chosen, according to the Federal Council, because it makes clear that a system cannot be at the same time an MTF and a DLT Trading Venue. Since the post-trade services described above mirror articles 61(2) and 61(3) FMIA, the proposed regime essentially means that DLT Trading Venues could also operate as CSDs. Even if, in that case, there is no clear criteria to distinguish the DLT Trading Venue from the CSD, the former is a lex specialis. As a result, operators of DLT Trading Venues who provide CSD services will not need to obtain an additional CSD license. 

Operators of venues admitting securities based on public distributed ledgers will have little use of the possibility to provide central custody services, as the idea of central custody in that context is of limited interest. Maintaining a settlement system appears more attractive: securities exchanges (article 26(b) FMIA) and MTFs cannot maintain accounts and perform settlement operations relating to trades executed on their platforms. These venues need to rely on a third party CSD or provide in their rules that settlement is performed bilaterally, between participants. 

Allowing DLT Trading Venues to operate a settlement system however comes with strings attached, as it means allowing the operator of the venue to maintain accounts and hold assets belonging to clients. To address the additional risks that providing settlement services creates, the proposed DLT Act gives the Federal Council the ability to impose additional requirements, including with respect to regulatory capital, risk management, liquidity and segregation requirements.

ii. Other FMIA-regulated venues

With respect to the DLT Trading Venue, the DLT Act would solve the question of the applicability of article 61 FMIA by recognizing that the venue can also act as a CSD. This particular solution is however unique in the proposed DLT Act, which raises the question of the applicability of the CSD rules to other venues regulated by FMIA. 

The first point to note in this respect is that the proposed DLT Act is not creating an exclusive regime, whereby only DLT Trading Venues would be authorized to admit DLT-based securities to trading. On the contrary, the proposed DLT Act is adding flexibility, by creating a type of venue intended to correspond to business models tailored for DLT. The lack of restriction on other types of venues is evidenced by the way the new license is framed. Under article 73a of the proposed DLT Act, DLT Trading Venues are multilateral venues that operate based on non-discretionary rules. Does it mean that DLT-based securities cannot be traded on bilateral venues or on venues operating based on discretionary rules? Surely not. Securities exchanges, MTFs and organized trading facilities (“OTFs“, article 42 FMIA) can also list or admit to trading tokenized securities. 

As discussed above, securities exchanges and MTFs cannot maintain accounts, and can therefore not perform custody or settlement operations. These venues are pure trading infrastructures, with no post-trade activity. There is no reason why they should be subject to the rules on CSDs. 

OTFs can operate differently. Article 43(1) FMIA provides that these systems can be operated by banks or securities firms, with access to the OTF being granted to clients who hold accounts with those entities. When two clients of a bank enter into a trade on the bank’s OTF, the bank will also organize the settlement of the trade. To the extent the OTF operator does so based on general terms that apply to those who trade on the OTF, one could argue that the settlement facility offered by the operator amounts to a settlement system. While the legal text of article 61 FMIA may lack the granularity to easily distinguish between what is a settlement system and what is simply executing trades between one’s clients, the intent of the legislator when adopting FMIA was clear. Operating an OTF is first and foremost an extension of traditional brokerage services, i.e. bringing together interests of clients to organize a trade. If the legislator had wanted to treat brokers engaging in those activities as CSDs, it would have said so and there would be dozens of CSDs today.

5) Conclusion

Even if CSDs were introduced as a type of regulated entity only when FMIA entered into force in 2016, they are already under threat of being outdated. Under these circumstances, one could have imagined that the applicability of the CSD regime would become less and less of a concern, especially in the DLT world, where centralization is generally frowned upon. Instead, the broad language of article 61 FMIA and the limited attention given to the rules on CSD in general contributed to the impression that CSDs could be more prevalent in DLT-based business models. As our analysis above shows, however, there are in reality very few situations where a CSD license could actually be required. 

Jacques Iffland (jacques.iffland@lenzstaehelin.com)
Ariel Ben Hattar (ariel.benhattar@lenzstaehelin.com)