If blockchain technology accomplishes nothing else in the capital markets, it is at least drawing attention to an unsettling fact: In the United States, publicly traded stock does not exist in private hands.
It is not owned by the ostensible owners, who, by virtue of having purchased shares in this or that company, are led to believe they actually own the shares. Technically, all they own are IOUs. The true ownership lies elsewhere.
While private-company stock is still directly owned by shareholders, nearly all publicly traded equities and a majority of bonds are owned by a little-known partnership, Cede & Co., which is the nominee of the Depository Trust Co., a depository that holds securities for some 600 broker-dealers and banks. For each security, Cede & Co. owns a master certificate known as the "global security," which never leaves its vault. Transactions are recorded as debits and credits to DTC members' securities accounts, but the registered owner of the securities — Cede & Co. — remains the same.
What shareholders have rather than direct ownership, then, "is a [contractual] right against their broker," said Marco Santori, a partner at Pillsbury Winthrop Shaw Pittman who leads the firm's blockchain technology team. "The broker then has a right against the depository institution where they have membership. Then the depository institution is beholden to the issuer. It's [at least] a three-step process before you get any rights to your stock."
This attenuation of property rights has made it impossible to keep perfect track of who owns what. In fact, discrepancies between the records of various counterparties occur every day, though they are usually resolved without incident. But in a crisis, when liquidity dries up and the system seizes, these discrepancies could mean that more securities are outstanding than were actually issued — leaving some investors out of pocket and with nothing to show for it.
Another risk pertains to settlement. Within the three-day period required for securities transactions to settle, those securities travel through the balance sheets of multiple intermediaries. If one of them goes bust — as Lehman Brothers did, as MF Global did — somebody who thought he was buying 1,000 shares of Apple, say, instead winds up being a creditor of a bankrupt firm. "They're still trying to figure out what companies Lehman Brothers owned," Santori said.
While such disasters are rare, the DTC system introduces needless counterparty risk, some argue. "It really doesn't matter — until it's the only thing that matters," said Caitlin Long, a blockchain advocate who recently left Morgan Stanley after 22 years on Wall Street.
An effort is now underway in the state of Delaware, where most publicly traded American companies are incorporated, to offer a competing system based on blockchain technology. Its proponents claim that it will provide all the benefits of electronic trading while restoring direct ownership to investors. An amendment to state law making this possible is set to pass next year.
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In the meantime, most holders of stocks and bonds have no idea that some other entity owns their assets. Their misapprehension is understandable. Even many brokers are unaware of Cede & Co.'s existence, Long said.
"This thing is so critical. It's at the center of the economy. And no one knows about it."
"From time immemorial, your broker held your shares," said Patrick Byrne, the founder and longtime chief executive of the online retailer Overstock, who has studied this issue with singular intensity.
The current system, by contrast, has its origins in the great "paper blizzard" of 1970, a crisis afflicting the back offices of New York brokerage firms. In those days, paper certificates changed hands when trades were made, and couriers rode around the city with burlap sacks full of stocks. Transfer agents kept everybody honest.
During the 1960s, however, trading volume on the New York Stock Exchange more than quadrupled, and securities firms found it impossible to settle transactions and get the paper out quickly enough.
"If things get logjammed badly enough, it ripples out and people don't know who owns what," Byrne said.
The NYSE did its best to help firms catch up, switching to a four-day week with abbreviated market hours, but it was no use. As a result of the crisis, more than 100 brokerages were forced into bankruptcy or were swallowed up by stronger rivals.
The following year, the Securities and Exchange Commission held a conference to discuss possible solutions. One was to go fully electronic, "dematerializing" the stock. That would have required getting all 50 states to change their laws to allow uncertificated shares. Most financial firms were in favor of this option, but they didn't think it could be implemented quickly enough. (The available technology was also a limiting factor.)
And so the other proposal won the day, in which paper certificates would be "immobilized" in a central depository. Interests in the securities — claims against the depository, the registered owner — would be traded, not the securities themselves.
Either solution would have meant radically changing the system — eliminating the need to deliver physical shares — but only dematerialization would have allowed stockholders to retain full ownership of their stocks and bonds.
The development of the present system proceeded gradually, by a series of milestones — which Byrne calls a "road to perdition" — but the final step was a 1994 amendment to the Uniform Commercial Code, enshrining the system of indirect securities ownership in the law of all 50 states.
It should be noted that this system is far superior to having a bunch of couriers schlep bundles of paper all over town. "There's no doubt that the current system is better than the system in place in 1977. It's because of this system that we have highly efficient capital markets," Santori said. "By and large, they are much more efficient than they were in the Seventies, and it's thanks largely to this system. But it brings problems of its own."
One of these is related to a practice called "rehypothecation," in which, as Long has written, "market players re-use their securities as collateral over, and over, and over again, multiple times a day, to create credit. Multiple parties' financial statements therefore report that they own the very same asset at the same time."
In the so-called repo market, hedge funds and banks and broker-dealers post collateral to one another — predominantly Treasury bonds and mortgage-backed securities. Where things get tricky is that firms are allowed to re-post to another party collateral they have received — so Bank A posts to Bank B and B posts to C and C posts to D, creating "collateral chains" of unknown length. The counterparty exposure is tough to track.
"At a systemic level, it creates double-counting in the records," Long said.
As a regulator, said Santori, "you can't tell what's being traded and re-traded and how many times. … You have no transparency into the system. There are of course reporting requirements, and regulators can engage in auditing, but none of that is done in real time. And none of it is ultimately verifiable."
Drawing on the research of International Monetary Fund economist Manmohan Singh, Long estimates that only one in three parties who think they own a U.S. Treasury bond actually does.
"There could be many times more people than the number of chairs," said Byrne, "and you never know when the music is going to stop."
The case for transforming this system is not only a practical but a philosophical and even a moral one, driven by the imperative to restore property rights to their true owners. But as long as financial firms continue to benefit from rehypothecation and slow settlement times, they have no incentive to change. "You can't change this in the markets," Santori said. "You have to change it in the law."
Since 2015, his firm has been working to do just that. It is preparing an amendment for the state of Delaware that would update its version of the UCC to create a new type of security — distributed-ledger shares.
These shares "would be born, they would live, they would die all on a blockchain," said Santori. They would be cryptographically authenticated by the state of Delaware. And they would not merely be representations of securities; they would be the securities themselves.
Delaware's technology partner in this initiative — announced at a blockchain conference in May 2016 — is Symbiont, a smart-contracts startup that has taken aim at capital markets.
Mark Smith, Symbiont's CEO, describes these "smart securities" as impossible to forge, duplicate or subdivide into more pieces than has been authorized. They will make it clear who owns what and enable fast trades while keeping ownership in the hands of the actual owners.
"The DTC is really a share-registry system," Smith said. "They're responsible for maintaining who the ultimate IOU holders are. But with a distributed ledger, you now have the ultimate share registry. There is no longer a need to cede your ownership to Cede & Co. to get the electronic benefit."
The Depository Trust & Clearing Corp., the parent company of the DTC, did not respond to a request for comment for this story. The DTCC itself has shown interest in blockchain technology in the past six months. Its executives have spoken at blockchain conferences and have joined the advisory boards of Coin Center and the Chamber of Digital Commerce, two tech advocacy groups in Washington. In March, the DTCC hosted a "blockchain symposium" for finance professionals in New York.
If state law is amended in 2017, as expected, companies incorporated in Delaware will have the option to issue their shares on Symbiont's blockchain rather than using the DTC system. More than half of publicly traded American companies and 66% of the Fortune 500 are incorporated in Delaware. If this initiative is only the first step toward making blockchain securities universal for American companies, it would be a very big step.
It remains to be seen, however, whether any companies will choose to abandon the devil they know for this alternative system. And while Symbiont has already gotten smart contracts running on its blockchain, it has yet to create any securities. Another smart-contracts platform, Ethereum, has recently become embroiled in controversy over the spectacular failure of its flagship contract and the resulting bifurcation of its blockchain into two competing systems.
Smith said he isn't worried. At the governor's request, the Delaware Bar Association will be proposing the amendment to the state legislature, which has enacted close to 100% of recommended amendments to the UCC. So he has every confidence that blockchain securities will be fully legal starting next year.
"The governor has signed off on this," Smith said. "The secretary of state has signed off on this. This is a done deal. There's no going back."