Digitizing the City: How the UK's financial system is scrapping paper

The UK government has set out its stand to supercharge London’s position as a global financial centre through a combination of modernization and reform. From enhancing shareholder democracy to digitizing shares, the UK has been handed a once-in-a-generation opportunity to strengthen its competitiveness as a capital-raising centre. Technology is the key, and millions of investors could benefit alongside the companies in which they invest.

Work is already in progress to attract future IPOs, with the 2021 UK Listings Review, chaired by Lord Hill, setting out a series of recommended reforms that are progressively being implemented. The 2022 UK Secondary Capital Raising Review, led by Mark Austin, is a key component in this mission.

It looked into improving further capital-raising processes for publicly traded companies in the UK. This included investigating the role of technology to transform how individual shareholders receive relevant information from the companies in which they invest and participate in the latter’s secondary capital raisings.

The government has appointed Sir Douglas Flint, chairman of asset manager abrdn, to lead a Digitisation Taskforce to eradicate paper-based processes in the securities settlement infrastructure for capital markets and make improvements to the UK’s shareholding framework. This includes enhancing widening retail investor participation in capital markets and enhancing shareholder democracy.

This move has the potential to positively affect millions of UK investors, their advisers and the companies raising capital, and forms part of a wider conversation about the digitization of markets globally. For many market participants, change is long overdue, but close industry collaboration between the financial ecosystem and government will be essential in delivering on the benefits of greater efficiency, transparency and economy.

The Digitisation Taskforce must prioritize and maintain operational resilience while enhancing existing processes – ultimately to save time and money, and make it much easier for people who own securities assets to manage them.

To take one example in the UK, a small but significant minority of shares that have not been digitized has posed a challenge for years because finding, moving and validating physical certificates takes time and resources, and risks them going astray. Moreover, the continued existence of such certificates requires companies, investors and their intermediaries to operate and fund separate and duplicative issuance, settlement and communications processes for digitized and paper-based shareholdings.

Industry and capital market stakeholders, under the chairmanship of Sir Douglas, are tasked with digitizing these certificates, which will allow companies to issue new securities in dematerialized form only and transform existing paper shares into fully electronic holdings.

In several Nordic countries, individual investors already hold digital “beneficial owner” accounts directly at their Central Securities Depository (CSD) – an enabler that not only supports innovation in flourishing fintech scenes in Sweden and Finland, but also levels of retail share investment are nearly four times as much. According to the OECD, shares represent 10.9% of household assets in the United Kingdom compared to 39.9% in Sweden – thanks in part to the popular tax-advantaged Investment Savings Account (or Investeringssparkonto – ISK).

Digitizing certificates is a means to protect and extend shareholder rights and, through the Austin review recommendations, empower individual investors to participate in corporate governance and secondary capital raisings.

The companies that issue shares will play a critical role in facilitating digitization and will themselves stand to benefit, including from communication and processing efficiencies and a lower cost of capital. The terms of reference for the Digitisation Taskforce cover not only the eradication of paper certificates, but also the potential digitization of arrangements for holding and settling shares and for communicating and exercising shareholder rights.

The work to underpin digitization dovetails with the objectives of open finance by exposing a wider range of financial products and services to the transformative impact of third-party data-sharing. In Singapore, investors are able to see a single dashboard of their shareholdings through the CSD. Innovative, accepted financial data exchange across different financial products and institutions is also progressively being rolled out.

Digitization also aligns with many of the debates taking place amongst securities markets stakeholders on the future market architecture – all of which will impact investors by potentially reducing costs in the financial system. These include technology like distributed ledger and central bank digital currency.

As the CEO of BNY Mellon put it recently: “Over the past two centuries, the world has seen many generations of financial technologies. Digital ledger representations of traditional assets such as cash, bonds and equities could be an important progression, as the original computer ledgers and real-time payments were from paper before them. This can lead to improvements in accuracy of record-keeping, easier handling of certain asset types and speedier, more efficient settlement.”

There has been much discussion of the potential for new technology, such as digital ledger representations of assets like bonds and equities. The tokenized bonds and central bank digital currencies being explored across all of the major financial jurisdictions are already well underway to harness the benefits of this new technology.

The UK minister for financial services, Andrew Griffith MP, has reaffirmed the UK’s commitment to positive transformation through technology with regulation, identifying opportunities in fiat-backed stable coins and the application of technology in the traditional payments system in particular.

The UK government has legislated for an FMI Sandbox in the Financial Services and Markets Bill. An FMI Sandbox allows financial market infrastructures and other designated persons to test and adopt new technologies and practices by temporarily disapplying, modifying or even applying certain legislation for specific purposes. This can include experiments in combining trading and settlement on a distributed ledger.

In addition, the government is exploring accelerating securities settlement cycles, with the settlement cycle for equities poised to move to T+1 in the United States. Equity markets in the UK operate on the basis that the exchange of cash for securities happens two days after the trade (i.e. T+2). For the gilt market, it’s one day.

The current technology that underpins the UK’s CREST settlement system enables real-time delivery-vs.-payment settlement already. However, this would require market participants in the system to be pre-funded, in contrast with current market convention wherein settlement cycles provide time for participants to arrange financing and position their securities to ensure settlement.

If we have learned anything from the past few decades, it is that, well designed and managed, further digitization of the UK’s markets can be positively transformational – for shareholder democracy, capital-raising, overall efficiency and future innovation.

As the UK’s Central Securities Depository, we have committed to a modernization programme, with a significant investment to gradually rebuild and upgrade in parallel with the Bank of England’s renewal of its Real Time Gross Settlement (RTGS) system and the government’s drive to modernise the UK’s capital markets.

We will be working with the wider ecosystem to explore how we can best employ legacy and new technology including the settlement of digital securities against digital cash, to inter alia support the UK ambitions for a Digital Gilt and the full digitization of paper share certificates.

Change in markets of this magnitude requires careful consideration to ensure it does not compromise security, resilience and the end users’ experience; consultation and cooperation will remain vital to this evolution.

It calls for a planned, informed and coordinated approach to ensure all parties have the support they need. By sticking closely to this model of collaboration, digitization will be a win-win for investors and issuers – and, crucially, help cement the UK’s position as an innovator on the world’s financial stage.