What does Bitcoin mean in the context of the current global securities settlement system?

In this article we will discuss how does settlement of securities takes place, i.e. If “A” sells some shares to “B”, how do these shares actually move from A’s account to B’s? What is actually “moving”? What does it mean by “account”? Who is involved? What are the moving parts? We’ll start with a simple explanation of how the process works in case of paper based share certificates and then move on to the modern electronic systems.

The description provided in this article is based on the original blog by Richard Gendal Brown. We present a simplified explanation of the original blog entry for a quick and easy review of the securities settlement process.

The role of custodians: Selling shares if everything was paper-based

To begin with, let’s assume that individual A owns some shares of company X and wants to sell them. In a simplified world, A can either find a buyer for his shares on his own or go to a stock exchange to sell his shares. In order to avoid the effort of dealing with the stock exchange or physically visiting the stock exchange, A can subscribe to the services of a stockbroker who can carry out the trade on A’s instructions. In case the broker doesn’t find a prospective buyer for A’s shares, market participants know as market-makers come into play. The market makers provide a market to all buyers and sellers of securities while taking advantage of their specialization in a particular stock i.e. buying low and selling high and making a profit in the process.

To complete the transaction, there needs to be a physical transfer of the share certificate from seller to the buyer in exchange for cash. This physical transfer is carried out with the help of service providers called “custodians”, some of the examples of custodians are State Street, HSBC, and Citi bank. The role of custodians is to safe keep A’s (customer’s) share certificate and transfer them to the buyer of A’s shares when instructed by A or A’s stockbroker. So for example, when A’s broker finds a willing buyer at the exchange, he can tell A’s custodian to expect to receive cash from the buyer’s custodian and to send the certificate to the buyer’s custodian when this happens.

Role of a clearing house: Stepping in as the middleman and acting as a central counterparty

In theory, the whole set-up described in the previous paragraphs seems quite simple, but in reality there’s quite some work that must be done post-trade to get it to the point where it can be settled (matching, maybe netting, agreement of settlement details, agreeing on time and place of settlement, etc.), i.e. the process of clearing. And there’s a second, more subtle, problem: how does the broker know that the person he’s selling the shares to is good for the cash? And how does the buyer know that his broker will get the delivery of the share certificates?

A clearing house is intended to solve both these problems. Here’s how: after a trade is matched (both sides agree on the details), the information is sent to the clearing house by the exchange. And here’s the trick: as well as orchestrating the clearing process and getting everything ready for settlement, the clearing house does something clever: it steps into the middle of the trade. In effect, it tears up the trade and creates two new ones in its place: it becomes A’s buyer and it becomes the seller to the buyer. In this way, A has no exposure to the buyer: if they turn out to be a fraud, it’s now the clearing house’s problem. And the ultimate seller has no exposure to A: if A turns out to be a fraud, the buyer still gets his shares (the clearing house will go into the market and buy them from somebody else if it really has to). We call this “stepping in” process novation and say that the clearing house is acting as a central counterparty if it performs this service. Of course, this amazing service comes at a price: they charge a fee and, more importantly, impose strict rules on who can be a clearing member of the exchange and how they should be run.

How does the share issuing company “X” keep track of its shareholders?

We’ve discussed about buying and selling company X’s shares and this all happens without any involvement from the company at all. That’s fine in most circumstances but it does cause problems from time to time. Specifically, what happens when the company issues a dividend or wants its shareholders to vote on something? How does it know who its shareholders are? What happens after A has sold the shares using the system above to somebody else? How does the company get to hear about the new owner?
This is where another player comes into play: the registrar (UK) or share transfer agent (US). These companies work on behalf of the share issuing company (i.e. X in our example) and are responsible for maintaining a register of shareholders and keeping it up to date. If the company X pays a dividend, these registrar companies are responsible for distributing it. They rely on one of the participants in the process to tell them about share transfer.

Moving to the electronic systems: the central custodian of the custodians

Although simple to understand the concept, paper share certificates can be a big pain when it comes to practical purposes. They can get lost, one has to move them around, they need to be reissued if the company does a stock split, etc. It would clearly be easier if they were electronic.
For any given custodian, it’s not a problem: they can just set up an IT book-keeping system to keep track of the share certificates under their safekeeping. The custodian can just update its electronic records to reflect the new owner. But it doesn’t work if the buyer and seller use different custodians: you’d still need to move paper between them in this case. So this raises an interesting possibility: what if we had a “custodian to the custodians”? If the custodians could deposit their paper certificates with a trusted third party, then they could transfer shares between each other simply by asking this “custodian to the custodians” to update its electronic records and we’d never need to move paper again! We call these organizations central securities depositories (CSD). Modern central securities depositories do not keep a paper certificate anymore, i.e. we have moved from immobilization to dematerialization.

Can this work for Bitcoin?

To understand if the abovementioned system could work for Bitcoin, we need to understand the idea of colored coins first. Colored coin is a concept designed to be layered on top of Bitcoin, creating a new set of information about coins being exchanged. Using colored coins, bitcoins could be “colored” with specific attributes. This effectively turns them into tokens, which can be used to represent anything. Now, when we look at “colored coin” share representation schemes, we see there is the notion of a colored coin “issuer”: somebody who asserts that a given set of coins represents a particular number of shares in a particular company. So now we have a big question: who is this somebody? This matters because if the “somebody” breaks their promise or goes bust, you’ve lost your shares.

Now, if a colored coin scheme were “grafted on” to today’s system, it could work quite well if done right. Imagine a firm wanted to offer colored coins representing 100 Google shares. They could open a custody account, fund it with 100 Google shares as “backing” and we’d be done: such firms could perhaps compete on the completeness of their transparency. However, owners of colored Google coins would have counterparty exposure to this firm, which means the risk profile would be different than if they simply owned coins in a regular custody account.

Interestingly, one cannot overcome the problem entirely by having a custodian bank to be the issuer because it’s not obvious whether the colored Google coins issued by a custodian bank is the same as a share for the purposes of bankruptcy protection. As Richard describes in his blog, since there are no regulatory guidelines yet in place, one should seek professional legal advice before engaging in a transaction like this.

Therefore, we can safely conclude that the counterparty risk is borne by the user (buyer of colored coins) in both the cases described above; i.e. whether a company issues colored coins backed by Google shares or a custodian issues the colored coins backed by Google shares. However, there is one intriguing possibility with this approach: imagine what happens if Google were to issue colored coins representing its own shares. In this scenario, although the buyer of colored coins is not exposed to any counterparty risk, he remains exposed to the Google’s company specific risk or business risk.

However, if Google went bust, the investors would lose money regardless of how the shares were held. In other words, the investors would end up losing their money irrespective of whether they had actual shares of Google or the colored Google coins which represent the shares issued by Google itself or any third party (e.g. a custodian or another company).