US T+2: Getting Rid of Paper Stock Certificates

Will the US finally go paperless?

When it comes to issuing certificates that evidence share ownership, that is.

This is the hope of Depository Trust & Clearing Corp. (DTCC), transfer agents and other industry participants, now that a two-day settlement cycle could be just around the corner for the US.

For more than a year they have been working with the New York Stock Exchange and Nasdaq to craft a proposed rule change they intend to file soon with the US Securities and Exchange Commission. The new rule would eliminate the option of issuing physical share certificates for new companies that intend to be listed on one of the exchanges, say DTCC officials and transfer agents speaking at a recent luncheon event in New York hosted by the trade group Securities Transfer Association (STA). Hired by issuers, transfer agents serve as administrative recordkeepers for registered shareholders.

The rule filing, now being drafted by the exchanges’ legal counsels, would mean that investors in newly listed companies would have proof of ownership of their shares in one of two ways only — either through their brokerage accounts or on the records of the issuer company or its transfer agent. If owned through the investor’s brokerage account, the shares would be registered at DTCC in “street name” — that is, the name of the broker dealer. Investors in companies that participate in the Direct Registration System  (DRS) of Depository Trust Company (DTC) would receive a statement of ownership from the company or its transfer agent. As the US’ national securities depository, DTC is a subsidiary of DTCC.

The industry effort to eliminate physical certificates has been spearheaded by the Dematerialization Cross-Stakeholder Forum, a working group established in 2013 by DTCC and SIFMA that includes DTCC members, exchanges, transfer agents, trade associations and regulators. The group is working in parallel with other subgroups to achieve a two-day settlement cycle (T+2) in the US for equities, corporate and municipal bonds and unit investment trusts.”T+2 could take place sometime in 2017,” predicts Jon Ciciola, director of settlement and asset services at DTCC. “Without an SEC mandate, any change is voluntary and requires industry consensus.” Most European markets are already ahead of the curve, having migrated to T+2 from T+3 in October 2014 at the behest of European regulators.

Leading the T+2 charge is an industry steering committee headed by the Securities Industry and Financial Markets Association (SIFMA) and the Washington, D.C. mutual fund trade group Investment Company Institute. About 600 executives in 17 subworking groups are now reporting to an Industry Working Group (IWG) that in turn reports to the steering committee. The findings of the subworking groups, appearing in a white paper prepared with the help of global consultancy PwC, are set to be published in mid-May, says Ciciola.

Dematerialization is just one among the 34 required changes that have so far been identified if T+2 is ever to take hold in the US. Accepted practice in many European and Asian markets, dematerialization is a blanket term that refers to the process of replacing paper certificates representing ownership of shares of US equities with book-entry securities — aka those held in electronic form. With the US government securities market completely dematerialized and the municipal market nearly so, only equities are lagging.

T+2 and Paper Don’t Mix

Transfer agents tell FinOps Report that it is virtually impossible to settle an equity transaction in two days if the shares are held in physical certificates. With book-entry dematerialized equities, shareholders can instruct their brokers to electronically move shares from the issuer’s transfer agent to the broker in preparation for settlement — a process generally completed within 24 hours to 48 hours — just in time for T+2. By contrast, shareholders owning physical certificates have to mail them to DTC for deposit in their brokerage account, then have DTC deliver the certificates to the transfer agent to validate they are still legit. Transfer agents would ultimately have to approve the transfer of the name of the account to DTC’s nominee name of Cede & Co. The entire convoluted process could easily take over a week to complete.

Doing away with certificates would also ease the need for investors to replace stolen, lost or damaged ones and ease DTCC’s operating burden of storing them. As evidenced during Hurricane Sandy, even the best-designed infrastructures are fallible. About one million certificates had to be either cleaned or replaced when water seeped through the DTCC’s vaults in its basement at 55 Water Street in lower Manhattan.

Granted, the new move toward complete dematerialization isn’t the first time the US has tackled the issue of physical certificates, but it will certainly go a long way. The US has been reducing the number of certificates in circulation over the past few years as more securities are issued without certificates and issuers are taking advantage of DTC’s DRS. Launched in 1996, DRS allows investors to register their shares with the issuers in book-entry form without needing to hold a physical certificate. Of the 8,000 issues eligible for DRS, only about 380 are still offering certificates, by DTCC’s estimates.

“Most issuers have been in favor of eliminating certificates but some are still dragging their heels waiting to see how the new rules come out,” says Kathryn Sevcik, senior vice president of Wells Fargo Shareowner Services in Mendota Heights, Minnesota. “Transfer agents, SIFMA and DTCC are encouraging them to become 100 percent dematerialized.”

In 2008, the NYSE and Nasdaq did require listed companies to include their shares in the DTC’s DRS, but there were loopholes. Issuers could be DRS eligible but not participating which meant that all investors got share certificates automatically. Or investors could be DRS eligible and participating, which meant that shareholders would only get a certificate if they requested one; otherwise they would get a DRS statement. A third category of issuers is DRS eligible and participating and 100 percent dematerialized, meaning no certificates would be issued under any circumstances.

Thus, the 2008 initiative by NYSE and Nasdaq failed to eliminate certificates altogether even though the effort undoubtedly helped. Reportedly NYSE and Nasdaq officials didn’t force the issue with all listed firms, because they feared alienating some whose investors were gung-ho about holding share certificates. Since then, far more shareholders have become willing to accept statements.

The anticipated rule change would require new issuers listing on the NYSE and Nasdaq to participate in DRS and become fully dematerialized so they could not issue any certificates. Transfer agents of those firms would also be required to join DTC’s Fast Automated Securities Transfer program. Contrary to the wishes of transfer agents, NYSE officials say they currently have no plans to file for another rule change requiring existing companies listed on the NYSE to dematerialize their shares.

What’s Next

Listed companies are just the tip of the iceberg in the types of firms DTCC and transfer agents want to include in the DRS program. Next up are restricted shares and over-the-counter and small microcap securities. However, those types of securities are far harder to corral into the program.

In the case of restricted shares, DTCC would allow transfer agents to record all of their investors’ information about their assets on their books while broker-dealers would control the accounts and underlying shares for the purpose of monitoring the restriction window. Many transfer agents can operationally issue shares in book-entry positions identifying the restrictions and block any transfers until restrictions are lifted. However, broker-dealers reject this scenario, because they are worried about not being able to reflect the shares on their books and allow investors to use the shares as collateral. They want to ensure “good control” which means that they have the same access to the securities as if they were held at their firms’ offices. Although DTCC says it is working to solve the problem, transfer agents tell FinOps that to date the volume of restricted shares issued is so low that it may be cost-prohibitive to make any changes.

Over-the-counter and small microcap companies are also difficult to include in DRS because they often have problems qualifying for DTC’s settlement services in the first place. DTC has not hesitated to “freeze” some shares from its settlement process, because it claimed that issuers didn’t meet its eligibility requirements.

The good news for issuers and transfer agents: they will likely face far less difficulty than other industry sectors in moving to a T+2 timetable. “We can get ready in several months at a minimal cost,” says Sevcik. “Dematerialization aside, issuers will likely have to review their materials for direct purchase or dividend reinvestment plans to see if they mention a T+3 settlement cycle. If so they will need to amend their plan documents. The technology impact will be greater for broker-dealers.”