Why is the dematerialization of physical securities so important?
The industry demonstrated extreme resilience and agility throughout the extraordinary events of the COVID-19 pandemic in March and April, managing unprecedented volatility and transaction volumes even as we coped with the uncertainties and challenges of working remotely.
Processing physical securities, however, was a distraction from an otherwise resilient response by the industry to the pandemic. Physical processing personnel were unable to be on premises at their jobs to handle certificates, stamp and sign documents, receive checks and process paper. The result was no physical processing and no access to the vaults – or at best, access with extremely limited personnel and elongated processing timeframes.
Cashless and contactless commerce has accelerated and has reshaped every aspect of consumer behavior today, and physical securities processing is no different. This is a very small piece of the industry’s business, and quite simply, the costs and risks incurred by supporting physical securities are no longer acceptable.
The complete dematerialization of physical securities will contribute to a more cost-effective, efficient, transparent, secure, competitive and resilient marketplace.
The movement to transition away from physical certificates to electronic records goes back to the paperwork crisis in the 1960s. Why is this still an issue today?
Sixty years ago, the exchanges had to cease trading on Wednesdays, shorten trading hours on other days, and extend settlement by a day to T+5 just to give a reprieve to deal with the backlog of physical securities. The industry’s solution was to pool securities in a central location – immobilization in the vaults of a newly-created company, The Depository Trust Company (DTC) – followed by minimizing certificate movements by replacing paper certificates with electronic records, a process known as dematerialization.
Currently, most U.S. securities, including municipal and corporate bonds, U.S. government and mortgage-backed securities, commercial paper and mutual funds are offered only in dematerialized form. However, for certain asset classes, including some that are dematerialized, it is still possible for an investor to obtain physical certificates. Obtaining a physical certificate reintroduces the multiple handling touchpoints between transfer agents, beneficial owners, financial intermediaries, and DTC. Without question, dematerialization is a complex industrywide challenge and there always has been business and operational hurdles that will need to be overcome.
What are the risks and costs of physical securities processing?
The risks and costs associated with physical securities processing include everything from manual processing and delays in issuances and deliveries, to loss, theft, and natural disasters. Consider the enormous vault recovery efforts after Hurricane Sandy. And consider the COVID-19 pandemic – an extraordinary disruption that economies and governments around the world are still navigating. The industry had to quickly implement various workaround solutions for limited physical processing and created some stop-gap solutions, but even now, more than 6 months later, our industry is still not back to a pre-pandemic “business as usual” for physical securities processing.
In terms of costs, the economies of scale for physical securities processing have been completely reversed over the past several years. The costs to support physical certificate processing remain fixed, even as the number of transactions declines. Physical securities are very small piece of the business, yet the amount of effort required to support them is significantly disproportionate to their value.
What will it take to achieve dematerialization?
The plan that we’ve proposed in this white paper is very much a two-pronged approach – first, cease the issuance of certificated securities and automate manual touchpoints, and next, gradually eliminate the existing inventory of physical securities in the industry’s vaults. Both approaches are equally important; both must be addressed.
We know it can be done. Across Europe, Asia-Pacific, Africa and Latin America, other countries have stopped issuing physical certificates altogether. We are hopeful that working with the exchanges to amend listing requirements will be a significant step to end the creation of new physical certificates.
Dealing with the existing inventory will be more challenging. We have already reduced the inventory in DTCC’s vaults by a third over the past 8 years, and today, less than 1% of assets we service – valued at approximately $780 billion dollars – are still in physical form. With concerted effort and the help of the transfer agent community, we believe a realistic target in the next three years would be the full dematerialization of 98%+ of all physical stock certificates.
How can stakeholders get involved?
This white paper is intended to serve as a roadmap toward dematerialization. We are building consensus on critical next steps and engagement, much in the way the industry worked together cooperatively to successfully implement T+2 settlement in 2017.
This is not just a DTCC issue, physical securities held in vaults of banks and firms across the industry must also be addressed, and we cannot do this alone. The success of our plan depends very much on the partnership of all stakeholders, including banks, brokers/dealers, transfer agents, issuers, regulators, industry associations, and exchanges. It will require new business practices, changes in technology platforms, shifts in the legal landscape, and will require the support from regulators.