Securities finance experts are applying advantages from the new digitised world to address historical inefficiencies in securities lending, financing and collateral management.
Institutional investors are cautiously increasing their allocation to digital assets as they are attracted by the return and diversification opportunities offered by digital instruments and become more comfortable with the market infrastructure and risk management frameworks supporting these investments.
As asset owners extend their portfolios of traditional and digital assets, they require the tools (typically via their service intermediaries) to manage execution and post-trade requirements across their multi-asset holdings, including the ability to mobilise and allocate collateral across multi-asset inventories and to optimise liquidity usage across fiat and digital currencies.
For investments in ‘traditional’ securities, principles have grown up over decades that provide guidelines for safekeeping institutional assets. Standards have been refined, with input from the financial regulators and industry associations, to establish a set of guiding principles that are applied when appointing a custodian or holding securities with a central securities depository (CSD).
In the US, for example, the Securities and Exchange Commission (SEC) has established rules (under SEC Rule 17f-5) that require a US investment fund holding assets outside of the US to place these in safekeeping with an ‘eligible foreign custodian’. Similarly, SEC Rule 17f-7 specifies that, when employing the services of a central securities depository outside of the US, a US investment fund may only use a CSD that meets its ‘eligible foreign depository’ specifications.
Although developed initially by the SEC to apply to US investment funds (or intermediaries acting on their behalf), these have become a de facto standard internationally to guide custodian selection and CSD due diligence.
For fund custodians with activities in the EU, a liability regime has grown out of the Alternative Investment Fund Manager and UCITS V directives which makes the fund custodian directly liable for any “avoidable loss” of any financial instrument held in custody on behalf of a fund client.
For digital assets, however, an equivalent liability regime and set of custody standards is still in formation – and while this remains the case, some institutional investors have been cautious about increasing their allocations to digital assets. Moreover, financial authorities are still firming up their positions regarding how digital assets should be regulated.
Digital expertise
To support these developments, BNY Mellon formed a digital asset division in February 2021 designed to accelerate the development of solutions for clients wanting to build exposure to digital assets, including cryptocurrencies.
Mike Demissie, BNY Mellon’s head of digital assets and advanced solutions, says that the digital asset unit plans to deliver a secure infrastructure for transferring, safekeeping and issuing digital assets. In line with the organisation’s open architecture approach, this draws on digital expertise and technology from fintech and other collaborators with the goal of speeding up product development and helping clients to access the best available solutions in the market. “We see a great deal of interest in digital assets across our client base. Clients want exposure to digital assets, but this does not typically mean that they are looking for new service providers,” says Demissie. “As a trusted service provider, our clients are looking to us to extend our services to this new asset class.”
State Street established a new division dedicated to digital finance in June 2021. State Street CEO Ron O’Hanley says that the financial industry is gradually transforming to a digital economy and digital assets are likely to be one of the most significant forces that will shape this industry’s development over the next five years. “Digital assets are becoming integrated into the existing framework of financial services and it is critical that we have the tools in place to provide clients with solutions for both the traditional investment needs and their growing digital needs,” he says.
The new division aims to capitalise on State Street’s existing digital expertise and to extend this to include crypto, central bank digital currencies and tokenised securities. This will be built around the bank’s proprietary GlobalLink technology platform, with plans to develop this into a multi-asset platform supporting crypto assets alongside other asset types.
State Street managing director for digital product development and innovation Swen Werner says that State Street has been actively developing its digital asset capability for a number of years, but the speed and breadth of change is now getting stronger. “[State Street’s Digital Asset Division] is an investment in tomorrow, but a strong signal now to our partners, clients and the general market that we are open for business,” he says.
“This initiative cannot wait,” says Werner. “Regulators are reviewing applicable laws now and clients are looking to launch new digital fund structures. State Street is committed to having the right institutional framework to respond.”
Jens Hachmeister, Deutsche Börse’s head of issuance and new digital market, explains that Deutsche Börse Group has been building its digital markets strategy since 2015. This began with an exploratory phase, which lasted approximately three years, and from 2018 it has become part of Deutsche Börse’s core strategy. The financial infrastructure group has been evaluating how it can support digital assets and securities alongside traditional assets and how best to unlock the benefits made available through distributed ledger, smart contracts and other relevant technology in the field of digital securities.
Deutsche Börse Group’s strategy is to support the full digital value chain from issuance, through trading, clearing and risk management, through to settlement and custody — along with associated services that users require such as foreign exchange services, financing and data management.
“Our approach is to build a trusted ecosystem that supports a broad range of digital assets and digital securities across all parts of this value chain,” says Hachmeister. “We do this by acquisition or through partnership with other specialist firms, but also by developing infrastructure internally.”
In the post-trade area, Deutsche Börse is researching the design of what it calls a ‘next generation post-trade infrastructure’. This is building on recent developments in regulation, particularly the Electronic Securities Act in Germany and recent legislation in Luxembourg governing application of blockchain. Hachmeister says that these regulatory changes open new opportunities to digitise and dematerialise securities, extending potential for digital issuance of bearer bonds and a range of collective investments.
Hirander Misra, chairman and CEO of GMEX Group, provider of multi-asset exchange trading and post-trade solutions, says there is strong client demand for the full spectrum of digital and hybrid services. However, interoperability and time to market remain a challenge, with traditional infrastructure and multiple types of blockchain-enabled digital market infrastructure being severely fragmented.
A veteren of many industry start-ups — including multilateral trading facility (MTF) Chi-X Europe, where he was co-founder and chief operating officer in the early days of the MTF revolution — Misra says that a priority is to integrate digital market infrastructure and related services with existing market infrastructure and technologies, fostering interoperability between the two as part of a hybrid approach. “By doing so there is an opportunity to interconnect the whole capital markets value chain of participants across international nodes (jurisdictions), to trade, clear and settle traditional assets and digital assets and eradicate the age-old exchange silos,” he says.
This is also key in the securities finance and collateral management arena, where an enduring challenge has been to eliminate fragmentation in collateral pools, across jurisdictions and across product lines, enabling optimised collateral allocation from a centralised collateral inventory.
Securities finance priorities
Historically, silo-based approaches to business development have impaired fluid movement of collateral and liquidity – and it is important that these inefficiencies are not replicated as organisations build a multi-asset infrastructure to support both legacy and digital assets. When asset classes operate on different underlying infrastructure, this can present challenges in optimising and mobilising collateral and minimising funding costs. Against this background, firms are prioritising the need for a transparent view of their assets and liabilities and improved use of their inventory for collateral purposes.
To harness the benefits of securities tokenisation to support collateral optimisation, Deutsche Börse Group is a major shareholder in Luxembourg-based fintech HQLAX which aims to support collateral transformation trades but without the need to transfer securities between custody accounts of the trading parties.
Instead, a tokenised transfer of ownership takes place on distributed ledger technology, while the underlying securities remain static and are kept off blockchain (see the interview on p.26 of this issue). The platform is accessed via Eurex Repo’s trading system, with Deutsche Börse standing as “trusted third party”, holding baskets of securities at tri-party agents and custodians on behalf of market participants.
The basic principle involves keeping the underlying securities where they are and completing exchange of ownership on a layer above, specifically through tokenised transfer on a DLT-based registry, notes HQLAX’s chief operating officer Nick Short. The company is now expanding that original operating model in small, incremental steps as it brings new strategic partners on to the platform. These each have different needs and are connecting to the platform in slightly different ways — and HQLAX is delivering the interoperability required to connect together these previously fragmented pools of collateral.
Critical mass is building on the platform. Commerzbank, UBS and Credit Suisse have been active in the project since 2018 as early adopters and, alongside involvement from Deutsche Börse Group, there other major tri-party collateral players, notably Euroclear and JP Morgan. In January 2021, HQLAX completed a €14.4 million funding round with BNY Mellon, Goldman Sachs, BNP Paribas Securities Services (BNPPSS), Citi and Deutsche Börse Group. These companies will also connect to the platform and play different roles, for example with BNY Mellon as a tri-party agent and agent lender, and Citi as custodian. This brings additional trade flow and tri-party business to the platform. In June, HQLAX also added JPMorgan as a strategic investor in its Series-B funding round.
GMEX’s Misra predicts that, over the next two to three years, end-to-end platform-driven solutions will develop further, with a multi-custody approach ensuring not only that market participants have choice in selecting custody options but also that there is greater asset portability. This will ensure more effective credit allocation, netting and settlement across OTC and exchange-traded digital asset activity, with effective custody choice being at its core.
“While most digital asset initiatives in this space are unregulated, SECDEX [a GMEX Group company] and more broadly GMEX has core experience in servicing regulated markets,” says Misra. “Coming from a regulatory background, our GMEX Group senior management team has applied its knowledge and technology (including security token exchanges, and crypto index derivatives and clearing), along with its experience in running a robust and secure market infrastructure, to largely unregulated digital assets.”
SFT asked Deutsche Börse how these market developments will shape its strategy as a trading and post-trade infrastructure group, with more than €16 trillion of assets in its custody though its CSD and ICSD business and a global funding and financing division seeking to optimise collateral and liquidity mobilisation on clients’ behalf.
Clearstream’s Head of Banking, Funding and Financing, Tilman Fechter says that HQLAX is central to his division’s current development priorities and this will concentrate, at least in the near term, on building significant volumes in its existing use cases. “With a large community of major banks, custodians and tri-party agents as users and shareholders, there is a rich seam of new ideas guiding how the project can be extended to a wider range of transaction types and asset classes,” he says. “In the current phase of HQLAX’s development, however, the focus is to continue to build transaction volume through the platform — and this is progressing steadily.”
Looking ahead, asset owners (or financial intermediaries acting on their behalf) will potentially hold inventories of both ‘traditional’ and digital assets with Clearstream. It seems logical, therefore, that they will want to optimise collateral mobility and balance sheet efficiency across each of these collateral pools (‘traditional’ and digital assets) and to deploy these within liquidity coverage ratio (LCR) and net stability funding ratio (NSFR) buffers, to post as margin against bilateral and centrally cleared trades, and mobilise these assets for other uses.
So how will Deutsche Börse deliver this requirement? Tilman Fechter predicts that the securities finance marketplace will evolve through three phases. He identifies an ‘old world’ that has been dominated by non-digital (ie ‘traditional’ or ‘legacy’) assets. “This is a world where HQLAX is currently helping to manage collateral transformation through tokenised exchange supported on blockchain,” says Fechter. In this environment, HQLAX is serving as a translator, applying some of the advantages of the new digitised world to address the inefficiencies prevailing in securities lending and collateral transformation transactions in the ‘old world’.
Looking further ahead, Fechter says that there will ultimately be a ‘new world’, perhaps 15 or 20 years from now, where asset holdings are fully digitised and trading and post-trade services will principally involve servicing digital assets.
Between these two phases, however, there will be a hybrid environment which will involve a combination of ‘traditional’ and digital assets. “We believe that the winners, those who will capture most market share, will be those that can best service this hybrid state,” says Fechter.
Some fintechs have moved directly to the digital world and do not offer an infrastructure to support legacy assets. But, for Fechter, there will be no overnight transition from ‘old’ to ‘new’. Success — at least for the large established banks, broker-dealers and market infrastructure providers — will be built on the ability to service both non-digital and digital assets.
From a global securities financing perspective, this will require delivering collateral mobilisation and optimisation for both non-digital and digital assets during this transition phase, alongside the risk management needs (including clearing services, trading and post-trade support for exchange-traded and OTC derivatives) that this presents.
Hirander Misra says that GMEX, and its various regulated market infrastructure ventures, is looking closely at how centralised finance (CeFi) and decentralized finance (DeFi) intersect within a regulated environment. “With SECDEX Digital Custodian (SDC), assets in custody can currently be pledged and lent through collaboration with an existing DeFi player and we are looking to expand this with an API-driven [application programming interface] approach from our exchange and custody platforms as part of a hub model,” he says. This sort of model allows the assets to be held in custody and to be rehypothecated. “In addition we are looking to interface with a regulated digital bank to provide a hybrid CeFI and DeFI construct.”
Misra identifies a number of developments that are important to delivering more effective control and governance around digital asset activity and which are likely to translate into new opportunities and efficiency in securities financing transactions.
This will include delivering real-time netting and settlement, along with the opportunity to re-use assets. This will also include the development of more sophisticated, higher-margin products in the digital asset world, including lending and prime brokerage opportunities to improve return on digital asset inventories and to enhance market liquidity.
Central to the progress of these developments will be steps to harmonise regulations and market standards across ‘traditional’ and digital assets, streamlining oversight procedures and reducing fragmentation across ‘traditional’ and digital asset pools.
State Street’s Swen Werner also says that digital and legacy environments are likely to operate in tandem for the foreseeable future. “We have implemented IT solutions that allow us to combine the old and the new,” he says. “However, there are many differences that need to be accommodated in the digital asset space. For example, markets do not have a natural close of business, data standards do not always follow an ISO data dictionary or use SWIFT protocols, and requirements tend to change more frequently.”
Regulatory enabler
Early investment flows into digital assets were heavily dominated by high-net-worth investors and family offices, but large hedge funds and other buy-side firms have increased their investment over time as they become attracted by the investment potential that these offer and more comfortable with the custodial structures that sit around this.
Deutsche Borse’s Jens Hachmeister says that his organisation is observing broader adoption of crypto currencies and crypto assets by institutional investors. Two to three years ago, investment in these instruments was dominated by high-net worth investors, hedge funds and specialised investors. However, the investor landscape is changing and institutional investors are now dedicating an increasing component of their asset allocation to digital assets. This may be through direct holdings of crypto assets, or through exchange-traded notes (ETNs), derivatives or collective investments with exposure to crypto and digital assets.
In supporting this activity, Hachmeister explains that Deutsche Borse Group’s roadmap is driven only partly by new opportunities created by technology development. “In practice, regulation is always a main driver for real market adoption,” he says, “particularly as it is key for building trust and investor protection in markets.”
In the EU, the Markets in Crypto-assets (MICA) regulation provides a framework for regulating crypto assets and aims to provide a single licensing regime across all EU member states by 2024.
This will be important in driving convergence between the regulatory framework for crypto assets and the rules established under MiFID and MiFID II for traditional securities. Crypto asset service providers licensed under MICA will have passporting options, enabling them to market their business anywhere within the EU. They will also be required to fulfil EU organisational and capital requirements, including conducting AML and KYC verification on their customers.
In parallel, the European Commission has announced a pilot regime for market infrastructures — effectively a regulatory sandbox that allows the financial authorities, infrastructure providers and market participants to explore the development of a robust market infrastructure based on DLT.
GMEX ’s Hirander Misra observes that In the UK and EU, the fifth Anti-money Laundering Directive (5AMLD) requires providers of crypto platforms and wallets to identify their customers for anti-money laundering purposes. However, whilst security tokens and crypto derivatives are covered by MiFID II, spot crypto is still an unregulated asset class from the perspective of operating a trading venue and crypto custody in the UK.
Other market authorities, such as the Financial Services Regulatory Authority (FSRA) at Abu Dhabi Global Market, have introduced crypto asset exchange and custody regulations covering all these types of crypto assets, which brings them more into line with rules in place for regulated trading venues and post-trade infrastructure in the UK and EU.
Misra reports that the US digital asset market is evolving rapidly, with positive signals coming from the Options Clearing Corporation (OCC) regarding use of stablecoins.
However, there is still unevenness, from jurisdiction to jurisdiction and across instrument types, in how digital assets are regulated. “Although there has been engagement from various government bodies in the US, crypto still remains largely unregulated,” says Misra. “But security tokens are deemed to be securities by the Securities and Exchange Commission (SEC), and crypto derivatives are treated like any other derivative by the Commodity Futures Trading Commission (CFTC).”
Misra anticipates that further refinements to the regulatory framework in these Western jurisdictions are likely to make digital assets more attractive to both retail and institutional investors, while addressing some of the inherent risks. Meanwhile some other markets — Singapore, for example, and the Seychelles on a smaller but significant scale — continue to deliver creative developments to support digital asset activity.
The appetite for digital assets is rising from the buy-side, even if it is a small part of current asset allocation and even though some asset managers, such as BlackRock, are starting with regulated crypto derivatives. There is also increasing demand for structured products that can be listed (for example as exchange-traded notes, ETNs) on regulated exchanges to access a wider investor pool and associated liquidity.
State Street has noted how interest in investing in digital assets has shifted into the asset management industry, widening the source of investment flow beyond the early adopters which were largely asset owner (particularly HNWI) clients. This is partly driven by increasing regulatory certainty, a wider available spectrum of digital assets that includes security tokens or other tokenised instruments (e.g. cash or funds) and a deeper appreciation of how investors would like to benefit from digital investment structures. “In a nutshell: the industry is starting to understand how tokenisation can benefit their distribution efforts,” says Swen Werner.
State Street’s Werner feels that US regulators have placed the burden primarily on market participants to identify how digital assets can fit within the existing regulatory structure, particularly from a custody perspective. Given the unique attributes of digital assets, and the technology employed to support them, Werner believes that greater regulatory clarity will be valuable in this area — for example in defining standards of control and safekeeping by a custodian in the digital asset arena.
In building its digital asset capability, BNY Mellon’s Mike Demissie says that his organisation is focusing on extending the core services that it is best known for, such as fund services and custody, out to digital assets. BNY Mellon already provides fund accounting and administration for digital asset-linked products such as bitcoin exchange-traded funds (ETFs) out of Canada — and Demissie says that BNY Mellon’s multi-asset custody solution will go live before the year-end, enabling clients to hold underlying crypto assets alongside traditional asset holdings in one integrated platform.
In closing, Hirander Misra says that GMEX, and its digital financial services ventures such as SECDEX, are continually looking for opportunities to innovate as digital asset markets evolve. SECDEX is experiencing rising demand for security tokens and provision of white-label solutions for new areas such as non-fungible tokens (NFTs).
GMEX is also active as a technology enabler, focusing, among other projects, on core software and software-as-a-service solutions for trading, exchange and post-trade market infrastructure. “Demand from existing exchanges and post-trade venues continues to grow as they seek digital transformation, alongside demand from newer trading venues and digital custodians,” says Misra.
He also expects demand to increase for cloud-based microservices platform-as-a-service type models to provide solutions that reduce fragmentation between traditional and digital asset markets and associated post-trade infrastructure. The need for trusted, reliable utility infrastructure to service digital assets is greater than ever before, Misra concludes.
