Why the DTCC Token Securities are a 'Half Innovation'

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1. Launch of DTCC Tokenization Service

On October 28, the Depository Trust & Clearing Corporation (DTCC) in the United States launched its tokenization service. Until now, the news had only indicated that DTCC was preparing for tokenization, but now it has truly become a reality.

The background for the launch of DTCC's tokenization service is related to the No-Action Letter issued by the U.S. Securities and Exchange Commission (SEC) to DTCC last December. The SEC stated that it would not impose sanctions if DTCC operated a limited securities tokenization service while adhering to the following conditions.

Restrictions on Tokenized Securities: Tokenization is only permitted for Russell 1000 index constituents, U.S. Treasury securities, and ETFs tracking major indices.

No Collateral/Settlement Value Assigned: While tokenized securities can be used as collateral, the existing DTCC system does not recognize the value of those tokens.

Holding/Transfer Conditions: Tokenized securities can only be transferred between wallets registered with DTC.

DTCC Authority: DTCC retains the authority to forcibly retrieve or transfer tokens due to loss, theft, or incorrect transfers.

Duration: The initial service will apply for three years from the actual launch date.

The fact that DTCC, a key player in the U.S. securities market, has actually launched a securities tokenization service is very encouraging news for the blockchain industry. However, looking at the contents of the SEC's No-Action Letter, it raises questions about whether tokenization can truly provide significant value compared to the existing financial system.

2. What Changes?

The process of how DTCC's tokenization service, DTS, operates is as follows:

• Participating institutions register their digital wallets with DTS.

• Participating institutions apply for token conversion for the securities held in their existing DTC accounts.

• DTC performs the necessary verification and control procedures.

• The rights to the securities are transferred from the participating institution's account to the DTC digital integrated account.

• Tokens corresponding to the transferred securities rights are issued and delivered to the participating institution's digital wallet.

• In summary, financial institutions can issue rights to the securities they hold as tokens on-chain.

The purpose of securities tokenization through DTS is not to actively trade in the stock market but to focus on collateral transfers between financial institutions, with the following improvements expected:

Operating Hours: While token conversion applications for DTS are only available on weekdays from 2 AM to 6 PM, already converted security tokens can be transferred/traded 24/7. This is a significant advancement compared to the existing DTC system, which only allows collateral transfers/trading based on business days.

Time Required: Collateral transfers using security tokens can be executed almost in real-time on the blockchain.

Smart Contracts: Tokenized securities can automate compliance, distribution, etc., through smart contracts on the blockchain.

3. What Does Not Change?

There are many things that remain unchanged.

Rights of Securities: Tokenized securities through DTS retain the same ownership, economic rights, and investor protections as existing securities.

Custody of Underlying Securities: DTC continues to hold/manage the underlying securities as before.

Securities Registration Name: The name agent Cede & Co. of DTC remains unchanged.

Official Record Management Entity: The existing DTC system manages official records.

Securities Identification Number: The same CUSIP is maintained.

Financial Market Structure: The relationships within the existing system, including DTC, broker-dealers, issuers, custodians, and beneficial owners, are maintained.

Dividend/Interest Payment Method: Payments are processed in fiat currency through the existing financial system, not through on-chain stablecoins.

Regulatory Compliance: Existing compliance measures such as KYC and AML are maintained.

The fact that the rights and CUSIP of existing securities remain the same is certainly a positive factor as it prevents liquidity fragmentation. On the other hand, the continued use of the existing DTC system for official record management and the maintenance of the existing financial market structure suggest that there are no significant improvements in terms of efficiency and scalability.

Interestingly, even though DTS uses blockchain, it does not automatically support DvP (Delivery versus Payment). One of the biggest advantages of blockchain is the ability to process the transfer of securities/payments atomically between buyers and sellers through consensus and smart contracts.

Thus, it would be natural to expect that DTS would support DvP, but this is not the case.

As stated in the SEC's No-Action Letter, DTS is designed as a Free of Value (FOV) service. In other words, the transfer of securities itself is not coupled with payment. DTS only performs tokenization and does not manage the cash payment obligations associated with the transfer of securities, nor does it have the function to finalize payments. Therefore, participating institutions must complete DvP transactions through separate systems such as stablecoins or digital cash.

4. Future Implications

The entry of DTCC, a key player in the existing securities market, into the tokenization industry carries significant implications. The mere fact that it has broken away from the outdated traditional rails used for decades and introduced blockchain as the next-generation financial rail raises expectations for the role of blockchain in future financial rails.

However, looking at the details of the recently launched DTS, there does not seem to be as much change as expected. Tokenization is only possible under limited conditions centered around the existing securities system, and its utility currently stops at an efficient collateral transfer level without operational time constraints.

This appears to have less utility compared to other securities tokenization projects that have recently gained significant attention in the on-chain ecosystem. In the Issuer-Sponsored model, a highly efficient tokenization method has become possible by completely rethinking the existing DTCC system, while the Linked Security model, although it cannot be provided to investors in compliance with U.S. securities laws, offers very high accessibility and usability to other investors.

The hopeful aspect is that the plans for DTS do not end here. According to the roadmap announced by DTS, various improvements remain, including 1) support for additional networks such as Stellar and Arc beyond Besu and Canton, 2) expansion of the types of securities that can be offered, 3) enhanced security for institutions, 4) expanded corporate action processing capabilities, 5) integration of existing DTC ledgers with on-chain securities holding records, and 6) expansion of payment functionalities.

The launch of DTCC's DTS is just the beginning. The giant of the financial market has only just cautiously stepped onto a new continent. While the immediate changes may be limited, this small step could eventually lead to an era where tokenized securities become mainstream in the financial market.

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