The International Legal Framework for Intermediated and Digital Securities: The Necessary Interplay of Private and Regulatory Law in the Context of Client Asset Protection and Collateral

Investment securities come in different guises. Initially, they were primarily issued and held directly in the form of physical certificates or as entries on share registers. Subsequent technological developments facilitated the appearance of a system based on the immobilization of securities with central securities depositories and intermediation. In this setting, securities are represented by book entries in the systems of one or more financial intermediaries that operate between the issuer and investor. The latest form in which investment securities are now appearing is as digital (or crypto) securities, based on blockchain or distributed ledger or other, comparable technologies.

This contribution highlights some of the differences in the international legal framework for intermediated and digital securities, notably in the context of client asset protection and in that of collateral transactions.

Ideally, the same private and regulatory law rules should apply to investment securities whatever the guise in which they appear. Where there are no technological differences or other factors that dictate another approach, a level playing field should be ensured between non-intermediated, intermediated, and digital securities. This is reflected in the policy objective of ‘same activities, same risks, same regulation/regulatory outcomes’, formulated by the International Organization of Securities Commissions (IOSCO) in its Policy Recommendations for Crypto and Digital Asset Markets (‘IOSCO Recommendations’).

In the case of intermediated securities, the most important reference documents used in this contribution are the 2009 UNIDROIT Convention on Substantive Rules for Intermediated Securities (‘Geneva Securities Convention’), the 2013 Principles on Close-Out Netting (‘Close-Out Netting Principles’), the 2017 UNIDROIT Legislative Guide on Intermediated Securities, as well as a range of guidance documents issued by global regulatory standard setters in the wake of the global financial crisis of 2007 and onwards. In relation to digital assets, two international documents adopted in 2023 take centre stage: the UNIDROIT Principles on Digital Assets and Private Law (‘Digital Assets Principles’) and the IOSCO Recommendations referred to above.

Client asset protection

The global legal standards for intermediated securities suggest that account holders are best protected by imposing a combination of requirements on intermediaries, namely: to hold or have available sufficient securities, to allocate such securities to account holders (notably by way of segregation), and to follow loss-sharing rules should a shortfall nonetheless occur in the event of insolvency (Articles 24-26 of the Geneva Securities Convention; Legislative Guide on Intermediated Securities, paras 209-219, 264-266). More particularly, securities held by an intermediary for account holders should not be available for that intermediary’s other creditors, while an intermediary’s own securities of each description are allocated to its account holders in cases where insufficient securities are available to cover their claims (although this allocation rule is optional).

Likewise, the Digital Assets Principles set out the baseline rule that a digital asset maintained by a custodian for a client under a custody agreement is not available for the satisfaction of claims of the custodian’s other creditors (Principle 13(1)-(2)). In addition, although this rule is optional, a shortfall is first met by the custodian’s own digital assets of the same description (Principle 13(6)). However, Principle 10(4) deviates from the rules for intermediated securities in that it makes it possible to contract out of the protection mechanisms for custody agreements set out in Principle 13. This could leave investors with a mere contractual claim in the absence of regulatory protection mechanisms. This is especially worrisome given the exponential growth of retail investors in crypto and digital assets as referenced in the IOSCO Recommendations. Fortunately, IOSCO has filled this gap with segregation, information, and other requirements concerning client asset protection in Recommendations 12-16 and 18.

Collateral transactions

In our chapter ‘Financial Collateral: From Private to Regulatory Law Reform’ in Transnational Securities Law (OUP, 2022; 2nd edn), Matthias Haentjens, Guy Morton, and I argue that essentially three legal paradigms or ‘mindsets’ are relevant when structuring financial collateral transactions: (i) ‘ordinary’ private and insolvency law, (ii) the more liberal private and insolvency law approach reflected in Chapter V of the Geneva Securities Convention (which was directly inspired by EU Directive 2002/47/EC on financial collateral arrangements), and (iii) regulatory law which gained prominence after the global financial crisis.

The international legal framework regarding financial collateral transactions with intermediated securities reflects these three paradigms. Part VII of the Legislative Guide on Intermediated Securities concerning collateral transactions not only discusses private and insolvency law reform (mindset ii), but also refers to several post-global financial crisis regulatory guidance documents that qualify such reform (mindset iii; see especially paras 280-282). Among several other measures, this includes the introduction of a ‘regulatory stay’ to allow regulators some time to take appropriate action. Likewise, the Close-Out Netting Principles suggest private and insolvency law reform measures (mindset ii), while Principle 8 expressly references the regulatory constraints set out in the Financial Stability Board’s Key Principles of Effective Resolution Regimes for Financial Institutions (mindset iii). (For further detail, see Marcel Peeters, ‘On Close-out Netting’, in Transnational Securities Law (OUP, 2022).)

However, where international guidance as to the role of digital assets in collateral transactions is concerned, regulatory considerations are as yet few and far between. Unlike the Legislative Guide on Intermediated Securities and the Close-Out Netting Principles, Section V (‘Secured Transactions’) of the Digital Assets Principles contains none at all, instead largely echoing mindset ii. For example, the Commentary to Principle 17 deals with enforcement and the availability of close-out netting without mentioning any regulatory qualification such as a ‘regulatory stay’. The IOSCO Recommendations and a paper by the International Swaps and Derivatives Association likewise provide no guidance on the regulatory treatment of financial collateral transactions involving digital assets.

This begs the question of how this gap should be filled. Is the general regulatory framework for financial collateral that was developed primarily with intermediated securities in mind sufficient? Or is specific international regulatory guidance needed regarding collateral transactions involving digital assets? In any case, private and regulatory law reform ideally go hand in hand. For example, the UK Law Commission’s Digital Assets: Final Report (June 2023) recommends the development of a statutory legal framework for the entering into, operation and enforcement of collateral arrangements involving certain crypto assets (para 8.158) and the alignment of such a framework with the regulatory environment (para 8.159(3)). Such an approach contributes to the creation of a level playing field between intermediated and digital securities, as well as safe and robust financial markets.

Concluding remark

The distinction between private law and regulatory law may not always be clear-cut. When work on the Digital Assets Principles first got underway, Luc Thévenoz rightly noted that ‘certain points dealt with as part of regulatory law were in fact points of private law’ and underscored the need to ‘take a broad approach and go beyond labels such as “private law” or “regulatory law” to look instead at the merits’ (Summary Report of the First Session, UNIDROIT 2021 – Study LXXXII – W.G.1 – Doc. 4, para 11). Systems with merit include those that ensure the protection of client assets and envisage an adequate framework for financial collateral transactions. Where private law does not ensure such goals, or does so only in part, regulation has an important role to play.

Thomas Keijser is Senior Researcher at the Radboud Business Law Institute of Radboud University, the Netherlands.