Trading and Settlement in Digital Securities
The CMTA has shown something extremely important which is that it is possible to execute transactions, once these have been executed on a trading platform that it is possible to execute these transactions directly on the blockchain without creating counterparty risk, in fiat currency. Trading of securities always requires two legs or two parts. One is the security and the other is the cash side. A lot of effort is made to make pilots on the securities side.
This pilot here is interesting, because it combines both issues. And it's not trying to do cash tokens now and also bring them onto the existing blockchain, but to have a solution and use existing infrastructure for money and thus make a connection between the traditional world and the blockchain world. A key feature of the current proof of concept is the settlement of tokenized securities directly in fiat currency. Satoshi Nakamoto's whitepaper on the creation of a peer-to-peer electronic cash called Bitcoin was published in 2008. Ever since, the financial industry has been looking for ways to use distributed ledger technology in the capital markets. This effort was particularly sustained in Switzerland In 2018, Switzerland's financial regulator, FINMA, was among the first to provide guidelines on the treatment of digital assets in financial markets In 2020, the Swiss parliament also stepped in.
It approved an overhaul of the country's financial laws to better regulate digital assets. DLT is particularly interesting in the specific area of the capital markets, because if you think about it, everything in the markets revolves around keeping ledgers. Now, DLT is precisely a technology that allows you to keep ledgers in a way that is particularly reliable and flexible Much attention has been directed toward cryptocurrencies, but for most of the finance industry, the main focus is elsewhere.
So, tokenization is generally about efficiency. The main benefits are for us in just running a smoother, more streamlined operation, being able to issue tokenized investment products more easily with just almost infinite flexibility. This is very interesting for us.
In the long run, it will come down to this, that we will get automation especially on the lifecycle, meaning events, that take place on the product. We can more easily automate the financial sector available to us. And this actually simplifies the back office in these banks the day-to-day processes. The digitization of shares is nothing else than the recycling or modernization of a very old mechanism that consists of incorporating assets into a support. The difference is that until now we were talking about a physical support - a paper certificate - and that now we are talking about digital tokens registered in a blockchain.
In 2018, the Capital Markets and Technology Association was created in Geneva. It was founded by Lenz & Staehelin, the law firm Swissquote, the online bank, and Temenos, the producer of banking software solutions with the support of the Ecole Polytechnique Federal de Lausanne. The Association's purpose is to develop standards for using the distributed ledger in traditional financial markets. Today, it regroups more than 40 of the Swiss financial industry's key players including banks, fintechs, exchanges, law firms and trade bodies. The CMTA has adopted standards on subjects such as the digitalization of securities, the custody of digital assets, and their treatment under the Swiss anti-money laundering rules.
The CMTA is developing standards for the use of of a technology which is called Distributed Ledger Technology or DLT in the financial markets. It is illusory to think, that a single bank can define a standard From that point of view, we are very grateful, that there is an organization like CMTA that defines exactly such standards and tries to establish them accordingly. The CMTA project is to have the best of both worlds. It's having the fluidity, the ease of access to the capital markets of the digital assets world, while having the predictability and legal security of conventional finance.
In December 2022, after more than a year of work, a group of CMTA's members carried out a proof of concept for the issuance, trading and settlement of investment products. The project involved three banks: Credit Suisse, Pictet and Vontobel issuing investment products in the form of ledger based securities and trading them through BX Swiss, a Swiss regulated trading venue. As a stock exchange. BX Swiss is playing a central role in this proof of concept, and we have been leading the trading and post-trading working group with the banks.
Together with major Swiss banks, we wanted to deliver on the true promise of blockchain or distributed ledger technology, namely reduction of financial intermediaries and lower costs. We have demonstrated that we can settle a trade in a digital asset without the need for a central bank, digital currency or CBDC or a trusted stablecoin. You have to understand that this is a significant step towards the broad adoption of blockchain technology in the traditional financial system. One of the main originalities of the test was that the trades executed on exchange were settled bilaterally through the Ethereum blockchain in Swiss francs without using cryptocurrency. With transactions on the public blockchain the efficiency of tokenization comes into its own.
In the case of our POC, we really wanted to emphasize two main points: the first one being that we traded in a fiat currency, so not relying on cryptocurrencies or a stablecoin. And the second is that we were trading it through a regulated exchange like BX Swiss. We are among the first traditional stock exchanges to experiment an admission of a tokenized security on a public blockchain. And I stress the word public blockchain. Truly decentralized public blockchains offer a very high level of reliability, trust and transparency. Take Ethereum, for example.
There are thousands of very skilled people across the globe who constantly validate transactions and to constantly further develop the underlying technology. The only downside we see with using public chains are the relatively high transaction costs. That said, the Ethereum blockchain is working on projects that we call scalability - to scale up - and in a few years maybe one or two years we will have a network that is much faster, which will allow transactions at higher frequency and thus at lower cost. The significance of the proof of concept can be better understood by considering how securities are managed in traditional financial markets. Today, Securities are held by a custodians, mostly banks. Those banks, in turn, deposit the securities that they hold with central depositories called CSDs.
In Switzerland, the main CSD is SIX SIS, a company based in Olten. When an investor wishes to buy or sell a security, it generally gives a trading instruction to its bank. The buy and sell orders are communicated to a securities exchange where they are matched to generate trades. Once agreed, the trades must be settled. This involves transferring the purchase price owed by the purchaser to the seller and the securities promised by the seller to the purchaser. To achieve this, financial markets traditionally rely on centralized systems.
The banks are part of a clearing system usually operated by the National Bank, which carries out the cash transfers. The system debits the cash account of the purchasing bank at the central bank and credits the cash account of the selling bank. The banks, in turn, debit and credit the cash accounts of their respective end clients. The same happens on the paper side of the trades.
The CSD debits the securities account of the setting bank and credits the securities account of the purchasing bank The relevant banks, again, debit and credit the accounts of their respective end clients. The situation is different in a blockchain based market environment. Instead of a debit and credit of the participating banks’ account at the CSD, the transfers are recorded directly on the blockchain, where they are validated by a community of participants by means of a consensus protocol.
The operational setup that has been tested thus neither involves a central counterparty (CCP), nor does it involve a central security depository (CSD). And why? Because we don't need them to trade digital assets efficiently. Central counterparties are mostly meant to manage the default risk of the participants during the settlement cycle. And the settlement cycle in the traditional regime is relatively long. In Switzerland, it's T+2, meaning today plus two, two days for the settlement. And this using on-chain solutions you can greatly reduce the settlement cycle.
So we don't need a CCP and we also don't need a CSD because we are recording all the trades and digital assets on a public ledger. So at the end we can achieve significant cost reductions along the whole value chain of issuance, clearing, settlement and the safekeeping of digital assets. In the context of this test, BX acts in two ways, firstly as a traditional trading platform by doing what is called matching, i.e. there is a sell order,
a buy order and the exchange identifies them, link them together and the result is a transaction But BX also fulfills a role which is a post trade role, that is, once matching is done, BX organizes the execution of the transaction. To organize the execution of the transaction. It is necessary to have a license which is not simply a stock exchange license but that also includes the post trade aspect. The securities are associated with digital tokens recorded on the blockchain to become what Swiss law calls “ledger-based securities”.
Under Swiss law, the ownership of these securities follows the digital tokens For the purpose of the proof of concept the banks issued three investment products. Vontobel and Pictet each issued an actively managed equity certificate representing a basket of equities. Credit Suisse issued a structured note. These securities were associated with digital tokens which were recorded on Ethereum's Sepolia testnet.
From a legal point of view, the only really important thing that we have done for the tokenization process, is to add a number of clauses, a few more really, to the terms of the investment products that have been tokenized. The purpose of these contractual clauses, is to regulate the relationship between the product and the token, i.e. to ensure that for each token that is issued, it is associated with an existing product. And this is an operation which is actually very similar, even identical to what the CMTA already knows, and that we had experimented with the tokenization of shares.
The tokens were created using a modified version of the CMTAT an open source smart contract published by the Capital Markets and Technology Association. We have decided to use open source smart contracts for both the tokenization of the digital asset and the settlement. What we need are reliable and trusted standards and not proprietary solutions.
The higher the degree of standardization, the lower the costs. The use of standard smart contracts greatly reduces the integration efforts for the participating banks and security firms. And that's why we have agreed with the CMTA and the banks to establish the required smart contracts as open source right from the start. Smart contracts are pieces of code. They are software. It's relatively uncomplicated code that is needed in the industry but which is not going to be a differentiator for service providers.
It is not with smart contracts that someone will be able to promote their services. And the consequence of that, is that smart contracts are not a profit center. Nobody is going to make money with a smart contract. On the other hand, it is important that everyone has the same, and if possible that the smart contracts work. So, there is from this point of view a great interest in being able to have software codes that are standardized, that reflect a consensus of the industry and that work satisfactorily, and taking into account this necessity, an association, so a non-profit organization is actually a fairly natural platform to create this kind of thing. The Association itself does not sell anything, the Association offers an infrastructure and so, the structure of open source code is also a structure which is relatively natural.
The goal at the end of the day must be for the financial center, that we offer a standardized solution, so that all players, i.e. all issuers, use the same standard. One day we differentiate ourselves not by the tokenization of the Smart Contracts, but by the product itself.
We see in the software development. Today, much of the software is open source. One of the advantages, on the one hand is transparency. We know that when you use it, the code is really public, everybody can see it.
So this is a form of guarantee, a form of insurance against malicious features, bugs, that could be included in this code. The process for creating ledger based securities has been known for some time, so the focus of the proof of concept was not the issuance of securities tokens. Rather, the focus was on how trades in ledger-based securities can be settled. In other words, how the tokens can be transferred from the seller to the purchaser while the purchase price is transferred from the purchaser to the seller. There are several ways to achieve this result.
The most commonly used consists in pre-funding the relevant trades Pre-funding involves transferring both the security tokens and the cash to the exchange, prior to each trade. Once a buy and sell order are matched on the exchange and a trade is entered into, the exchange debits the cash account of the purchaser and credits the cash account of the seller. It does the reverse with the securities accounts of each party. The downside of this is that both the cash and the securities must be transferred to the exchange in advance. One alternative is to transfer the securities and the cash only after the trade has been entered into.
This is more complicated, though, because the transfers of the securities and the cash must be synchronized. It is important to avoid a situation in which the seller transfers the tokens to the purchaser but does not receive the purchase price in return or a situation in which the purchaser pays the purchase price but does not receive the tokens in return. In traditional capital markets, synchronized transfers are achieved through a delivery versus payment or "DvP" settlement. DVP is a process in which a security is only transferred upon simultaneous transfer of the purchase price. If markets for digital assets are to develop, the DVP function needs to be created on the blockchain.
This was a key objective of CMTA's proof of concept. Delivery versus payment it is a question of a fundamental problem, because one of the two parties have to pay in advance. Normally this is solved by contracting a third party to do this simultaneously. In the current proof of concept we use Smart Contracts as an innovation and this allows us to manage the settlement in a centrally controlled, automated way on a public blockchain network.
In simple terms, what DVP will do in terms of technology, is to ensure that two assets will be exchanged without one being able to be sent while the other is not. This is what is sometimes called in the blockchain world the atomic swap. Replicating a DVP function on the blockchain is reasonably easy to do if the ledger-based securities are traded against a cryptocurrency. In that case, a smart contract can be used to swap the security token against the payment token.
The transfer of the two tokens is simultaneous. None of the parties incurs a credit risk. The situation becomes more complex when trades are to be settled in Swiss francs. There is currently no official Ethereum version of the Swiss franc. A payment in Swiss francs involves either transferring physical coins and notes, or a transfer from one bank account to another.
When more than one bank is involved, an interbank clearing system is needed. In Switzerland, this system is called the Swiss Interbank Clearing or SIC. It is operated by SIX by mandate of the Swiss National Bank. Coordinating a cash transfer through the SIC system and a token transfer on the blockchain requires specific functionalities. In CMTA's proof of concept, this was achieved via an application called "DLT2Pay" from the German company targens and the use of a DvP smart contract.
The DvP smart contract was created by the CMTA and makes it possible to swap tokens on the Ethereum blockchain. CMTA benefited from the technical expertise of Taurus a Geneva based fintech and the assistance of targens in this aspect. One of targens' products is a payment bridge, that connects any DLT or blockchain network to any payment protocol. Taurus, as a FinTech, a technology company and as an expert as well in security, Taurus was able to contribute to the development of secure smart contracts and also to their deployment. The deployment is when we go from smart contracts in a test to smart contracts really deployed on the real blockchain.
At Taurus, we have engineers specialized in blockchain technology in particular security experts and we have made their skills available for the test. With DLT2Pay the purchasing bank mints a "Payment Order Token" on the blockchain, which contains a unique, digitally represented payment instruction to the SIC system. Once a trade has been executed, the exchange communicates the details of the trade to each bank. Using DLT2Pay the purchasing bank will issue or mint a payment order token. The payment order token is minted or transferred on a ledger address controlled by the exchange where it is held until completion of the settlement process. The selling bank allows the transfer of security tokens representing the investment products to a ledger address controlled by the exchange Upon receipt of the Payment Order Token the DvP smart contract verifies that the selling bank has allowed sufficient security tokens to be transferred to the ledger address controlled by the exchange.
If the allowance is insufficient, the trade is not settled and the payment order token is deactivated. But if the allowance is sufficient, the security tokens are automatically transferred to a ledger address controlled by the exchange where they are held in escrow until completion of the settlement process. Once both the Payment Order Token and the security tokens have been transferred to a ledger address controlled by the exchange, the payment order token is activated and its status on the blockchain is changed to "Payment Initiated".
The DLT2Pay solution then conveys the payment instruction to the SIC system and the payment is processed as a regular SIC payment. Once the system acknowledges the payment, the DLT2Pay solution triggers a new change to the payment order and tokens status on the blockchain as "payment confirmed". Upon such event, the DVP smart contract releases the security token from escrow and transfers it to the purchaser's ledger address. If for any reason the payment cannot be completed on the SIC system within 48 hours, the payment order token is deactivated and the security token is returned to a ledger address controlled by the seller. What does the proof of concept demonstrate? Many of the implications of this new way to issue and trade securities remain to be fully grasped. But the proof of concept demonstrates that it is possible to issue securities in the form of digital tokens, to admit ledger-based securities to trading on a regulated exchange, and to settle trades carried out on exchange in fiat currency on a peer to peer basis without any of the parties incurring a credit risk.
The potential ramifications are deep and manifold. The proof of concept shows that the potential of digital assets extends far beyond cryptocurrencies and has far reaching implications for the financial industry in Switzerland and abroad. I think this has the potential to be more than just in a POC, because we prove that you can have settlement with a traditional currency like the Swiss franc, which was not a given. And seeing all the the problems that have taken place with stablecoins elsewhere. I think this is something that can actually carry, trust and and is going to help us combine, again, the benefits of blockchain with the benefits of the traditional payment system. Primarily, with the concept, we have focused on settlement and I think for the future it will be primarily important to define the tokenization of the smart contracts in such a way that the product and its characteristics are neatly mapped on the blockchain.
As a stock exchange, we have always aimed to facilitate the listing and the trading of financial instruments in a very regulated, trusted and safe environment. To achieve this, we are not dependent on the form of the financial instrument, so it doesn't make a difference for us whether the issuer is choosing a traditional security or a digital asset. In the long run, we think there will be a shift from the traditional securities to digital assets and this will happen over time.
For us, we don't really care so much how long this process will take as we can play on both fields. And another development which is implied by the CMTA test, and which is a perspective opened by this kind of test - is the whole perspective of rationalizing and making the process more fluid: the creation of securities, the whole process from the conception to issue, the admission to trading and then the execution - are processes that at this time are largely manual, that involve a large number of intermediaries and are therefore very expensive. And the prospect of digitalization is to be able to simplify these processes and make them more fluid in a way that is very important in a way that takes days today, can in the future potentially be done in a few hours, or even in a few minutes, or even in a few seconds.