Wealth Management and Financing May 15, 2021

Securities Lending and the Digitisation of Securities Assets

The traditional securities industry developed first around physical certificates that represented the number of shares owned by an investor. Those physical assets gave way to electronic certificates that simplified and expedited the clearing of trades and other securities transactions. The industry is now poised to move into digitized assets supported by new market infrastructures and rules and regulations that will further enhance transaction flow while providing investors with assurances that their investments are safe, fully trackable, and protected.

A digital asset security is a product that has been issued and that can be transferred via distributed ledger or blockchain technology. Most investors are familiar with digitized utility tokens, such as the Bitcoin or Ethereum cryptocurrencies that are interchangeable with liquid cash. Digital asset securities rely on similar technology but are referred to as security tokens. Like physical or electronic certificates, security tokens represent an ownership stake in a publicly traded company and entitle a holder to a share in the company’s declared profits.

Government agencies, including the United States Securities and Exchange Commission and other international securities authorities, likely have the same regulatory authority over securities tokens as they do over physical and electronic securities, although there is an open question over whether the definitions in the agencies’ regulatory framework is broad enough to encompass securities tokens. Major international investment and commercial banks, including State Street and BNY Mellon, have formed internal units to build on their digital asset security presence in the securities markets. Given this push from the private sector, it is likely that the regulatory sector will soon amend its structures to verify coverage of securities tokens.

The challenge to the securities lending and finance sector of the industry will be to develop strong collateral management and central depository systems that address investor risk in securities borrowing and lending transactions. Virtually every stock loan transaction is currently conducted with non-physical certificates that are transferred electronically into custodian accounts. Unlike physical certificates, securities that are in an electronic format do not have a defined geographic location but are instead represented by entries in a custodial account. Digitised securities tokens are further removed from a presence at a single physical location. Regulators and industry insiders are developing mechanisms to make transactions more transparent to give investors a clearer picture of how their loaned or borrowed digitized securities assets are being managed.

The primary advantages of using digitized securities tokens in a securities lending transaction are the speed and efficiency that will characterize the transaction. Even with electronic certificates, one to three business days might elapse before the transfer of electronic collateral is cleared and acknowledged. Digitised securities tokens have the potential to introduce real-time transfers that will expedite the delivery-versus-payment aspect of a loan transaction. Theoretically, an investor will be able to see transaction proceeds in his or her account almost simultaneously with the transfer of a digitized security token, rather than waiting 24 or more hours as may currently be the case.

Some industry observers see a full transition to digitized securities assets occurring over three phases. First, all non-digital assets, including securities that are represented by physical certificates, will be transitioned to electronic certificates or directly to securities tokens. Second, industry participants will adapt their systems to reflect hybrid transactions that involve both electronic certificates and digitized tokens. Last, securities assets will be fully digitized with full implementation of industry structures that are designed to manage digitized securities tokens.

Some analysts see this process playing out over the next 15 to 20 years. The entities that facilitate securities lending and related transactions have already begun the transition to this new regime and will continue to lead the charge as securities tokens become the norm to represent collateral in the stock lending industry.