Shredding paper: 3 tips for dematerialisation
When George Clooney and his gang of thieves in the movie 'Ocean’s Twelve' set out to steal the world’s oldest stock certificate – issued in 1606 by the Dutch East India Company – luckily it was only a movie. Yet in reality the risk of theft is actually far worse, with millions of euros worth of paper securities reported lost or stolen around the world every year.
Reducing the risk of theft, forgery and other types of fraud is only part of the reason why financial markets are moving away from issuing and holding securities in physical form. Another major reason is that physical securities are very inefficient to process and bring higher costs for issuers and end investors alike.
In Europe, dematerialisation is seen as a necessary step in the direction of greater financial harmonisation. All EU Member States are required to fully dematerialise their physical securities by 2020. While the end goal has been set from the top down, individual Member States can choose how they arrive at this point. Given that local laws differ from country to country, this flexible approach to dematerialisation makes sense. And, indeed, there are more ways than one to reach this objective. In Belgium, for example, the civil code was amended to make it illegal to issue bearer securities; while in the Netherlands, the Dutch Securities Giro Act (i.e. the law governing Euroclear Nederland) was amended to make bearer securities ineligible in the Giro deposit system, effectively reaching the same conclusion.
The lack of a one-size-fits-all solution, however, doesn’t mean that countries yet to dematerialise can’t learn from the experiences of those that have. On the contrary, as we’ve found in ESES, there are lessons that can be applied from one country to the next to make the dematerialisation journey smoother.
Lesson 1: Apply the ‘polluter pays’ principle
Since the costs associated with maintaining and processing physical securities are shared along the entire chain of intermediaries, issuers and agents may not see the immediate need to dematerialise their securities. Where voluntary dematerialisation is applied, increasing the cost of issuing physical securities (i.e. the ‘polluter pays’ principle) puts the incentive to change with the parties that have the power to do so.
At the peak in 2001, Euroclear Nederland held over 7 million physical securities in its vaults. That’s when a voluntary shift to paperless issuing began in the Netherlands, but it wasn’t until 2008 that the ‘polluter pays’ principle was applied. To mitigate the costs for issuers and agents, Euroclear Nederland offered a free destruction period in which over one million paper certificates were presented for destruction. By 2011, the number of physical securities in the Netherlands was down by 95% from the 2001 level. However, the remaining 5% continued to require a significantly disproportionate amount of costs and resources when compared to the electronic securities in book-entry form.
Under a combination of increased market pressure, legal pressure, and higher costs, the last issuers presented their securities for dematerialisation in 2012.
Lesson 2: Introduce shareholder identification laws
While the administrative burden of dematerialising securities falls primarily on issuers, there is a silver lining when shareholder (and bondholder) identification laws are introduced. French legislators successfully applied this method in 1987, following dematerialisation there in 1984, and it has served as a model for the Netherlands.
Shareholder identification laws, such as the recent Corporate Governance Act which came into effect on 1 July 2013 in the Netherlands, increase transparency and strengthen the link between issuers and their investors. They require professional intermediaries to provide details about shareholders and their stake in the company – essential information for companies to effectively communicate with their shareholders, for example, ahead of the annual general meeting.
Shareholder identification laws ‘externalise’ the benefits of dematerialisation for issuers by bringing shareholders out of the shadows. From a corporate governance point of view, this transparency is paramount for maintaining investor relations and safeguarding against dangerous groups that could use their anonymity to garner decision-making power in the company.
Lesson 3: Centralise securities monitoring
Without a physical representation, the integrity of a security is no longer a given. This is one of the consequences of dematerialisation and different countries have tackled the issue of monitoring the integrity of electronic securities differently – with varying outcomes.
In the Netherlands, the responsibility lies with issuers themselves to maintain and monitor the integrity of their securities. In practice, the work is carried out by law firms, administrative firms, agent banks and issuers themselves, resulting in fragmented market practices and overly complicated reconciliation, given that the information required is difficult to obtain.
Legislators in France and Belgium, meanwhile, have centralised this role at the CSD level. Euroclear France and Euroclear Belgium (the CSDs for France and Belgium, respectively) are the Tête de pyramide of the securities processing chain and hold the key to monitoring the integrity of securities on their books. Given their expertise in reconciliation and existing infrastructures to hold securities, CSDs are a natural choice to perform this service and mutualise the benefits market-wide.
Euroclear on the paperless trail
Dematerialisation in the markets where Euroclear is the CSD:
||31 December 2015
||In line with CSD-R
||In line with CSD-R