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The Case For The Dematerialization Of Physical Securities

Monday, March 22, 2021

How going digital enables shareholders and creates efficiencies

Written by Katie Sevcik, EVP, Chief Operations Officer, at EQ, who has more than 30 years of experience in the securities industry, including transfer agent services.

The Depository Trust & Clearing Corporation (DTCC) makes a compelling case for dematerialization (DEMAT) in their recent white paper, “From Physical to Digital: Advancing the Dematerialization of Physical Securities.”

As a transfer agent, EQ plays an important role to encourage going 100% certificate-less.

The current situation – what needs to go digital?

There are still a lot of physical stock certificates in existence that were issued many years ago. Shareholders who have stock certificates need to deposit them first into an electronic book-entry position, such as direct registration, direct stock purchase plan or dividend reinvestment plan before they can do any trades. They are out of the market until they do so.

A lot of extra time and expense is involved in certificate destruction that we don’t have with uncertificated shares.

Transfer agents, brokers and the Depository Trust Company (DTC) all need to do vault audits with certificates — which require high levels of security. When these certificates are returned by the shareholder for a transaction, there are tight controls around the process.

A lot of extra time and expense is involved in certificate destruction that we don’t have with uncertificated shares.

I'm all for dematerialization. The good news is that, today, we rarely issue physical stock certificates. The Direct Registration System (DRS) has enabled efficient portability and permitted shareholders to do more types of transactions using online portals.

What about microcaps?

The microcap market is a bit different. To be eligible for direct registration with today’s regulations, you need to be part of a securities depository’s system in order to allow for portability. Currently in the U.S., it is the DTC that has the DRS and the issuer must be DTC eligible, as well as DRS eligible, to participate.

However, plan shares (such as employee plan, dividend reinvestment or direct purchase) can be in book-entry without eligibility at the DTC (DTC is a subsidiary of the DTCC). If you are a pink sheet securities issuer, or have securities that are traded over the counter and not DTC eligible, DRS is not an option. The industry will be looking at this to become fully dematerialized.

This leaves us with the challenge of how to get the over-the-counter securities into a type and format to dematerialize and be portable.

The challenge – how to get over the final hurdle

I agree with the DTC in their white paper, From Physical to Digital: Advancing the Dematerialization of Physical Securities, that in order to be able to expand, we don't want to issue physical certificates.

Even though we default to book entry, we and DTCC both want to go 100% dematerialized. Let's just go that extra mile and eliminate the physical certificate.

We issue shares from a stock split in DRS book entry. Some companies have elected to go 100% dematerialized; therefore, we no longer issue physical certificates for these companies. The majority of the DRS-eligible companies default to book-entry and only provide a physical stock certificate if the shareholder comes back and requests it.

We do see this request at times, particularly at the end of the year. For example, when someone wants to give gifts to their grandchildren, he or she may want a physical stock certificate for each grandchild. This is a generational preference: Older generations are used to physical stock certificates while their children and grandchildren are not. Once we issue them, it's not long before those certificates come back in for us to put them into book entry.

Even though we default to book entry, we and DTCC both want to go 100% dematerialized. Let's just go that extra mile and eliminate the physical certificate.

Take consumer banking for example: The bulk of loans and transactions are now going electronic and they are closing down hundreds of branches. Across the financial industry, people are getting used to dematerialization.

The solution – supporting issuers and brokers

Transfer agents can help by getting in front of the issuers that allow a stock certificate to be created and encourage full dematerialization.

On behalf of our issuers, we need to support the industry and try to encourage regulation change — to allow all companies to get dematerialized.

There are, however, challenges with restricted stock certificates on the broker side.

We can issue restricted shares in book entry. We have the capability of doing that today, but we find that the brokers are not able to hold DRS restricted shares, as DRS is not considered a good holding location by regulation. They need to have control over the shares so that the shareholder must go to them in order to do a transaction.

The brokers will need to come together on this. Agents are waiting and ready to move forward.

The future is electronic – and we’re almost there

There are ways other segments of the financial industry, like mutual funds, have utilized this process and fully dematerialized successfully.

All industries are going electronic. It's just a matter of time.

Like the DTCC, we are committed to doing our part — and working with the issuers to achieve 100% dematerialization.

A personal interest in dematerialization

When I worked on the broker and mutual fund side, that's when I realized there's so much more you can do to help investors and shareholders in a dematerialized, paper-free world. The efficiencies were realized immediately when I led a team that emptied out affiliate offices’ vaults of certificates, sending the certificates to the DTC.

One of my very first assignments when I joined the transfer agent side of the securities industry was looking at dematerialization. I flew out to the DTC to attend the cross stakeholders’ DRS committee meeting.

This is when they were looking at the first phase of direct registration and the DRS. The committee consisted of representatives from DTCC’s Product and General Counsel, transfer agents, brokers, SEC Trading and Markets and issuers. They were talking about how we could get this done — and I could see that each participant had their own interpretation of implementation.

Because when it comes to operations, it’s critical that all key participants in the industry are following similar best practices, or it will be chaos.

I had just come from the mutual fund industry. We built DTCC’s National Securities Clearing Corporation (NSCC) Defined Contribution Clearing System for funds, employers and employees — a system that the whole industry used. To ensure all flowed smoothly, we put together various scenarios to develop working guidelines. Because when it comes to operations, it’s critical that all key participants in the industry are following similar best practices, or it will be chaos.

You can’t have one transfer agent processing it one way, and the other transfer agent another way. At the meeting, I suggested that we follow a similar process, and the next thing I knew, I became the chairperson of the industry committee, assigned with writing all the guidelines for DRS dematerialization.

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