How Do You Know You Own Your Stocks? You Dont. So who has the ledger?

Bruce Fenton

(Part 3 of 4: The Present, How Value is Tracked and Settled)

Blockchains and the counter-intuitive world of trusted third parties: How global ledgers for stocks and other securities work today.

Key to understanding ledgers is knowing where the current ledger is which says you own your stock. Many assume the issuer has the database, reality is more complex.

Continued from Part 2 VOC: The First Publicly Traded Security & The Rise of Global Markets

Pen & paper wasn’t scalable in markets as they grew. While trade of equities, bonds and other securities demanded more volume and settlement capabilities, the best and brightest of the captial markets came up with increasingly innovative solutions to scale the markets and settlement systems to demand.

This led to a layered and distributed network and created a vast complex system governing how global securities interact with each other, the markets and global money.

Some doubt the effectiveness of using blockchains for securities settlement. What is the purpose of a token? Why not use a database? Often what is being solved for is misunderstood.

Understanding the problem means first understanding how the ledgers work today. For example, contrary to what many think it’s NOT your issuer (like Apple) who keeps track of the ledger of who owns shares That’s done by the complex settlement system we will cover here.

Volume for US and Global Equity (and other securities) markets is massive and has always increased as technical capabilities increased.

First its key to realize how large and complicated these markets are. Volume is significant. This isn’t a science experiment or theoretical idea like so much in the “blockchain world”. These are real markets, they are huge and they have a lot of money at stake. The best technical minds have worked on solutions for years and made significant improvements. Its a mistake to assume that either the current system is backwards or that its easily fixed by either existing technology or a blockchain.

Key to the current system is the master ledgers run by DTCC, Euroclear and a complex network of custodians, brokers, transfer agents and other parties with their own distributed ledgers

So back to the example: If you own Apple stock…how do you know you really own it? You trust a custodian of a broker…but how do you know they have the stock? Most people simply trust in “the system” and figure that if Charles Schwab says they have it, they do. But how does Schwab know they really have those shares? Do they have a list or certification from Apple? Nope. That couldn’t work as Apple doesn’t have the database of shareholders and doesn’t have a way to update it.

If you hold shares in Apple or another public company, they don’t have a database with your name and holdings. It would be impossible to update and maintain. Today’s public companies who want to contact shareholders hire consultants who interact with the trusted 3rd party ledger holders then they use snail mail to contact shareholders.

Brokers likewise don’t share ledgers with each other OR the securities issuer. Each entity has its own ledger but this is not a master ledger which can prevent double spends. So how do they manage it? They trust 3rd parties like DTCC & Euroclear.

The various parties involved have different trust and sharing parameters with each party they deal with, this requires use of trusted third parties
Each firm has its own customer list and ownership ledgers — they report this to trusted third parties who then share what is needed with counterparties

Since brokers don’t trust each other with their ledger and the issuer doesn’t have the ledger, who does? It used to be handled by a combination of bearer assets and internal ledgers. Brokers would settle up at the end of the day and have bicycle messengers deliver the net shares at the end of the day.

By the late 1960s it became consolidated with trusted 3rd parties. This change is a whole fascinating story in itself, the stock markets closed early and faced massive problems due to capacity issues.

The settlement of securities caused scaling issues: it used to be settled by messengers delivering physical shares. As soon as databases, digital technology and secure means of message transfer came along, the participants in this market embraced it.

Even with massive growth and the advent of computers the system could not effectively track real ownership as scaling issues increased. By 1996 Wall St gave up even trying tot track individual ownership and put all ownership of stocks in one name: Cede & Co.

This is so amazing that it’s worth repeating: In 1996 all the major participants on Wall Street agreed to take all the stock in all the companies and put it in legal ownership of one company. We then built systems around this which give custodians and then brokers claims on those shares…with customers of the brokers having a claim on those claims.

Yes this all sounds crazy. But this is the only way markets have been able to work at the scale they have.

There are only a handful of trusted third parties who handle all the public securities on earth.

The system works similarly in various jurisdictions Japan (right) and other systems cooperate heavily with the DTCC & Euroclear
This chart shows the landscape of clearing and settlement layers as of what appears to be the early 2000s
The lawsuit showing that Dole Foods and its administrators had differing numbers of shares from what legitmate public stockholders also held

The system doesn’t exist so much because of regulatory pressure and it certainly doesn’t exist because of lack of will or because of incompetence on behalf of those executing it — this complex system exists simply because it’s the only way that the world has been able to figure out how to accomplish what needs to be done.

The advent of distributive ledger technology created with Bitcoin has the potential to change this.

Drawbacks of the Current System

The current system has drawbacks — but not the drawbacks you might think, especially if you are coming from a Bitcoin/crypto angle. The issues are not about trust because, as mentioned, the issuer is already trusted — the issue is about how ledgers work and how we move things of value around the world because of the way those ledgers work.

Crypto people in some cases are fortunate enough to only understand the way the world should works: they understand crypto: you take your Bitcoin or token from Kraken and you move it to Coinbase regardless of jurisdiction regardless or name on the account and you do it pretty much within a matter of hours. You can also remove it from the exchange, switch wallets, take custody yourself, print it to duplicate copies of paper, place it on hardware, move it to another jurisdiction, transfer it to different entities etc. For any ERC20 token you could do this today. For something that is actually a security there is no technical reason that this could not work for something like a stock of a real company. There are indeed some regulatory challenges but most of today’s issues and limitations on current systems are technical and operational and many regulations are becoming easier to comply with through the creation of the Jobs Act and other initiatives.

So these methods of raising capital and managing stock offerings exist and the technology to issue tokens using distributed ledgers exist. The merging of these worlds has begun and in my opinion will continue until much of the current system is radically changed.

Remember nothing until Bitcoin was able to move like this because nothing, until Bitcoin, had a ledger which worked the same way Bitcoin’s does.

It’s all about the ledger.

As mentioned, there are drawbacks of the old system.

When you trust layers of complex third parties to run your ledger it becomes slow and prone to failure. For example, when Dole Foods was acquired, the company thought they had 36 million shares outstanding but 49 million shares worth of claims came in.

Bloomberg explains it well here: You don’t own your shares. You own a claim on a claim to these shares.

The fault of the Dole Foods situation was likely caused by the complex systems rather than what might be expected
In another relatively modern example of how the centralized systems work, securities were nearly destroyed during hurricane Sandy. This may seem antiquated but digital systems also offer surprising points of failure

There are other issues with trust of a centralized third party and the centralized systems related to this. Since these parties actually hold the securities there are physical and technical risks. Millions of shares were nearly destroyed by Hurricane Sandy for example.

Logistics. Examining ledgers and how they work is all about getting into the details of how the logistics work in current systems.

It took a year and a half of specialists in secure rooms with water vacuums and dryers to recover the shares.

The value: over $1 trillion This may seem antiquated but DTCC is actually technically advanced — they do what is possible based on how the ledgers work. The current system is amazing. The technical sophistication of DTCC and related entities and what they are able to accomplish daily is a stunning technical achievement.

Distributed ledgers can make the system work much, much better.

In the next article we will cover specifics of how a decentralized, blockchain distributed ledger May be able to solve many of the issues faced today.