Dematerialisation of securities in the UK: what it means and why it matters.
Written by Sam Tyfield, Partner at Shoosmiths
Dematerialisation is the process of converting physical securities, such as share certificates or bonds, into electronic form. This means that investors no longer need to hold or transfer paper documents to prove their ownership of securities. Instead, they can use a digital ledger or a central securities depository (CSD) to record and manage their holdings. Why is the UK moving towards dematerialisation?
The UK government has announced its intention to dematerialise all securities issued by UK companies and traded on UK markets by 2025. This is part of its wider plan to modernise the UK's financial infrastructure and align it with international standards. The main benefits of dematerialisation are:
· it reduces the risk of fraud, theft, loss or damage of physical securities
· it lowers the cost and complexity of issuing, trading and settling securities transactions
· it improves the efficiency and transparency of the securities market and the corporate governance of issuers
· it enables faster and easier access to capital and liquidity for issuers and investors.
Opinion that change is necessary, has been broadly positive (including Helen Thomas in the FT opining that we should “kill off the City’s old-fashioned paper fetish once and for all”). Opinions vary on how to achieve this.
What are the challenges and opportunities of dematerialisation?
Dematerialisation is a complex and ambitious project that requires the collaboration and coordination of various stakeholders, including issuers, investors, intermediaries, regulators and infrastructure providers. Some of the key challenges and opportunities are:
· Depending on the method by which dematerialisation is achieves, it could require the adoption of new technologies and systems, such as distributed ledger technology (DLT) or blockchain, that can support the digital representation and transfer of securities.
· It involves the harmonisation of legal and regulatory frameworks, such as the definition and recognition of securities, the rights and obligations of owners and issuers and the rules and standards for disclosure and reporting.
· It likely will involve a significant shift away from individuals holding shares in their own names.
· It creates new opportunities for innovation and competition in the securities market, such as the emergence of new types of securities, platforms and services and the potential for cross-border integration and interoperability.
Source: Calling All Investors
The interim report by Sir Douglas Flint, published in July 2023, outlines potential recommendations and invites industry feedback for implementing the digitisation of certified shareholdings. The aim is to enhance communication between issuers and ultimate beneficial owners of issued share capital, empowering retail shareholders to exercise their voting rights effectively. In the next phase, after reviewing feedback, the taskforce plan to delve into practical steps and establish a timeline for implementation. The report sets out four models for dematerialisation:
1. A digital version of the current system, where a digital registry is established which mirrors the current registry (in effect creating two (identical) registries.
2. Ensuring that it becomes easier to become a member of CREST, so that each individual shareholder may hold the dematerialised shares in their own name (this is not regarded as a viable option (see page 13).
3. Mandate that all certified shares are moved to a securities depository (and held by a single nominee) (this is the report’s preferred option) (the Third Model).
4. The introduction of a DLT-based securities holding, trading and settlement framework (the Fourth Model).
TheCityUK, amongst other industry bodies, set out its recommendations in response to the report and these included:
1. The share registry system should be reformed in a way that encourages competition and leverages the UK’s advantages as a pioneer in Open Banking, aligning with upcoming changes in financial data exchange and digital ID.
2. Using fewer physical materials and more digital technology should keep the benefits of the UK’s securities holding model, which includes the use of pooled accounts for nominees, while using technology to enable authorised access to the final owners of the securities where possible.
3. Keeping it simple; they do not want a situation where six different shares that are dematerialised lead to six different portals and passwords, as this will be hard for those who are less familiar with new technologies.
4. It is essential to establish market-entry criteria and other contractual obligations and outcomes for each nominee.
5. The Government should guide a public communication campaign to help retail investors and small businesses in the digital transition, with strong cooperation between public authorities and financial sector firms and issuers who have contact with these stakeholder groups.
6. The UK should seize the chance to update its methods in this area and the Digitisation Taskforce should collect data on the expenses (real or imagined) of keeping things as they are.
7. Having a clear vision of the final outcome will allow the industry to start investing in a transition to less material use and the proposed updated architecture.
8. Any proposed model should respect the rights of shareholders, especially those of retail certificated holders who may have a different status as ‘name-on-register’ shareholders in the future. In the next phase of the consultation, it will be crucial to learn in detail the specific rights that retail shareholders want to use under a new system, and how to best enable them in the context of modernisation.
Others in the industry were quick to criticise the report on its use of language, lack of (a) statistical data, (b) concern for individual shareholder rights and (c) consideration of the Swedish model of custody accounts, and had seen the content of it as an ‘erosion of freedom’. While the report’s preferred option is the Third Model, ultimately, the long-term view is that technological advances should enable a more fundamental reshaping of the market infrastructure and that we should be working towards (a version of) the Fourth Model. The difficulty in the short-to-medium-term is that even the Third Model will require material legislative and contractual engagement using technologies and processes which are well-known and well-used. Moving straight to a new paradigm of the Fourth Model with so many unknowns at this stage is impractical, no matter how attractive the result of the model may be. In terms of settling the architecture and framework necessary to implement the Fourth Model, the issues faced are obvious from the nascent developments being welcomed in the digital assets sector, including the proposed launch of a “central clearing counterparty” for digital assets, the launch of a “sandbox” for digital financial markets infrastructure and the concerns around collateral mobility and capital efficiency in the crypto asset markets. Financial markets infrastructure is developing in the digital assets markets but until it has a track-record and/or the regulations are finalised and/or existing English common law concepts which can accommodate the unique aspects of digital assets are the subject of positive jurisprudence, unfortunately we are left with turning to traditional concepts and frameworks to provide a solution.
Dematerialisation, the transition from physical to electronic securities, prompts profound questions about the future of securities ownership and trading. What motivates the UK government's ambitious push towards dematerialisation, and what challenges does this transition pose? How do different dematerialisation models, such as digital registries and blockchain integration, reshape market infrastructure and impact individual shareholders? Amidst these changes, how can regulators ensure the protection of shareholder rights and market integrity? Furthermore, what role do emerging technologies like blockchain play in facilitating this transition and what are the implications for market transparency and accessibility? As the financial landscape evolves, what steps should be taken to address concerns about data privacy, cybersecurity and regulatory compliance in a dematerialised securities market?