London School of Economics Paper Says Blockchain Could Reduce Custody Risks

A new paper from the London School of Economics argues that the existing infrastructure for holding and transmitting securities puts asset owners at risk – and that blockchain applications could alleviate some of these problems should adoption take place.

Penned by Eva Micheler of the LSE’s Law Department and Luke von der Heyde of South Africa-based law firm ENSafrica, the paper posits that while the evolution from paper-based securities to wholly electronic settlement led to faster communication times, there have been negative trade-offs along the way.

According to the authors, "computers have all but eliminated transaction risk while at the same time introducing custody risk".

The application of the technology to securities trading and settlement has attracted significant attention from the financial industry worldwide. A number of banks have been testing blockchain-based systems and prototypes, and more than a few startups working in the industry are devoted to this specific application.

According to the paper, the technology offers possible benefits to those actually buying and selling securities, at the potential cost of intermediaries who charge fees along the way.

The authors write:

"There is no need for separate trading, clearing and settlement venues. There is no exposure to the risk of any one central provider failing. Buyer and seller can interact directly with each other. They can exchange securities and cash directly and in real time."

Digital risks

Micheler and Von der Heyde argue that despite the gains in communication speeds, the current securities settlement environment has resulted in investors becoming "investors separated from issuers through intermediation".

"This has made the enforcement of rights very difficult if not outright impossible. It stands in the way of shareholders exercising voting rights. Investors bear the risk associated with all intermediaries that operate between them and the issuer," the authors state, going on to argue:

“Regulators struggle to keep up with increasing levels of intermediation spanning across borders. The introduction of computers has made trading easy, but holding assets more difficult.”

Further, the paper argues, it’s the digitization itself that has led to wider networks of intermediaries, further fueling these issues. These problems related to investor rights, the authors go on to say, extend to scenarios in which an issuer encounters financial problems.

Early stages

Echoing similar sentiments within the securities industry, Micheler and Von der Heyde note that applications are primarily in the early stages, and any broader usage is subject to the shifting regulatory and market landscape.

However, they close by arguing that asset owners should play a role in assessing the technology’s use for the securities sector alongside market incumbents and regulators.

The report concludes:

“And finally leaving regulators aside the ball is in the court of asset owners[,] some of whom have the muscle to ask questions about how their assets are held. They are also able to involve themselves in the current discussion about how the new technology, if it is to be used, should be implemented.”

The full paper can be found below:

Holding, Clearing and Settling Securities Through Blockchain Technology

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