In this post I explore how legal title to publicly listed shares works in Hong Kong, the USA, and Singapore. Then I relate this to tokens recorded on blockchains.
I learnt something interesting on Monday when the Hong Kong Securities and Futures Commission published a consultation paper on paperless securities. (Disclosure: I am a member of the SFC’s FinTech advisory committee though I am not an expert in share ownership). They say, with my emphasis:
Hong Kong law currently still requires the use of paper documents to evidence and transfer legal title to certain securities, including in particular shares. Because of this limitation, as well as other practical business and operational considerations, most investors in listed securities hold and transfer their securities through the Central Clearing and Settlement System (CCASS) where the securities are “immobilised” and held under the name of a single nominee (i.e. HKSCC Nominees Limited, HKSCCNOMS).
However, this also means that investors only hold and transfer the beneficial interest in the securities, and not legal title to them. In other words, the securities are not held in the name of the investor concerned.
Being only beneficial owners, investors holding securities through CCASS have no direct relationship with the issuer. In the context of shares, this also means they are not conferred shareholder rights under the law. They must instead rely on the registered owner (i.e. HKSCC-NOMS), and any intermediating entities in between, to exercise these rights on their behalf (such as any voting rights), and to pass on any entitlements (such as dividends, bonuses, etc) to them.
This reminded me of something I read in Matt Levine’s Money Stuff a few years ago. He discusses the situation for the majority of publicly listed shares in the USA in a piece entitled “Banks Forgot Who Was Supposed to Own Dell Shares“:
Nobody owns stock. What you own is an entitlement to stock held for you by your broker. But your broker doesn’t own the stock either. What your broker owns is an entitlement to stock held for it by Cede & Co., which is a nominee of the Depository Trust Company, which is a company that is in the business of owning everyone’s stock for them. This system sounds convoluted but actually makes it easy to keep track of things: If I sell stock to you, I don’t have to courier over a paper share certificate, or call up the company and have it change its shareholder register. Our brokers just change some electronic entries at their DTC accounts and everything is cool.
He also quotes an opinion submitted to the court of Chancery of the state of Delaware, USA which provides the historical background:
DTC’s place in the ownership structure results from the federal response to a paperwork crisis on Wall Street during the late 1960s and early 1970s. Increased trading volume in the securities markets overwhelmed the back offices of brokerage firms and the capabilities of transfer agents. No one could cope with the burdens of documenting stock trades using paper certificates. The markets were forced to declare trading holidays so administrators could catch up. With trading volumes continuing to climb, it was obvious that reform was needed. Congress directed the SEC to evaluate alternatives that would facilitate trading.
After studying the issue, the SEC adopted a national policy of share immobilization. To carry out its policy, the SEC placed a new entity—the depository institution—at the bottom the ownership chain. DTC emerged as the only domestic depository. Over 800 custodial banks and brokers are participating members of DTC and maintain accounts with that institution. DTC holds shares on their behalf in fungible bulk, meaning that none of the shares are issued in the names of DTC‘s participants. Instead, all of the shares are issued in the name of Cede. Through a Fast Automated Securities Transfer account (the “FAST Account”), DTC uses an electronic book entry system to track the number of shares of stock that each participant holds.
By adding DTC to the bottom of the ownership chain, the SEC eliminated the need for the overwhelming majority of legal transfers. Before share immobilization, custodial banks and brokers held shares through their own nominees, so new certificates had to be issued frequently when shares traded. With share immobilization, legal title remains with Cede. No new certificates are required.
What’s the situation in Singapore? It’s a little better. According to insideINVEST, normal people can open accounts at the Central Depository (CDP). The CDP keeps track of the list of owners of shares traded on the SGX, the stock exchange in Singapore. Those with accounts at the CDP have legal title to their shares, though many people still nominate their broker to have legal title. Usually this is because brokers like this control over their clients’ assets, and so offer trading discounts to incentivise this behaviour. In short, in Singapore there doesn’t seem to be a single company that has legal title to all the shares, unlike USA and Hong Kong.
Nominees all the way down
Today, the ownership of legal title plus conferring of rights to beneficiaries via a chain (ahem) of commercial agreements between nominated custodians seems to be a “hack” rather than a target end state. You’d think you’d never design a system to have to work like this, yet we are here because the world evolves organically. Processes, such as the payment of dividends, are initiated by the issuer of the share, and can take a long time to reach the ultimate beneficial owner of the share. Parties in the middle need to be relied upon, and they don’t work for free.
At the same time, sometimes the chains need to be there; some level of complexity is necessary or desired.
For example perhaps a citizen or entity of one country may not be allowed to directly own a piece of a company in a different country. So an opportunity opens up for an enterprising middleman who can buy the share and confer the benefits to a party who really wants it.
Or perhaps for financial privacy, someone may not want to let the world know that they have a relationship (financial or otherwise) to a certain company or companies. Or a hedge fund may not want to signal to the market what exposures they have.
And we want to reduce the temptation for a fund manager to run away with his client’s assets under management, hence the separation of custody from the asset management (though there are more elegant solutions for this in a tokenised world).
We have optionality
So chains of parties who confer rights up the chain can be useful. More generally, is it useful to have the optionality of having these intermediaries.
We have learnt that with tokens recorded on blockchains, beneficial owners can now have the choice to hold tokens (as a direct link to the issuing company) on their own behalf, without necessarily needing a chain of custodians to pass through beneficial ownership rights, causing commercial drag and latency lags.
So the tokenisation of agreements, whether those agreements are regarded as financial securities or not, and whether these are recorded on public blockchains or not, is a fascinating area for research and development for this year and beyond. I recently wrote about tokens lowering the barriers to innovation. Here’s something else I wrote about token maximalism and why it can be beneficial not to need to rely on private sector systemically important third parties to execute your wishes for you.