For mainstream financial institutions, the true value of crypto innovations appears to lie in the underlying technology, rather than the crypto-assets themselves. More specifically, it is likely to be in permissioned chains which eliminate many of the inefficiencies presented by legacy settlement systems.
What is DLT?
Distributed ledger technology (DLT) – or blockchain, as it is more commonly known – was made famous by Satoshi Nakamoto’s 2008 whitepaper describing a peer-to-peer version of electronic cash. It is a digital system for recording the transaction of assets that uses cryptography to store information securely and immutably in multiple places simultaneously. Unlike traditional databases, distributed ledgers have no central data store or administrative functionality. DLT is the technology that underpins all assets in the crypto-universe – unbacked crypto-assets, stablecoins and central bank digital currencies (CBDCs).
DLT comes in two forms – either decentralised and permission-less (e.g. Ethereum, Bitcoin) or centralised and permissioned (e.g. JP Morgan’s Onyx). Whereas permission-less DLT allows any user to add nodes to the network, a permissioned infrastructure has a ‘gatekeeper’ who limits access to pre-authorised users.
Regulatory Context
While global regulators have been highly vocal in their concerns around crypto-assets, they have shown encouragement and enthusiasm for the underlying DLT infrastructure. In fact, many regulators have been working with industry stakeholders to develop pilot projects and sandbox initiatives to test and trial the technology.
UK regulators have been actively reviewing DLT for several years, seeing “regulation as an enabler of positive innovation as well as a means of containing undue risk”. Feedback from the FCA’s 2017 Discussion Paper culminated in HM Treasury’s (HMT’s) January 2021 call for evidence (CfE) on wholesale market uses of DLT. The CfE described how, as part of the FCA’s Regulatory Sandbox programme, firms have successfully and compliantly issued equities, bonds and structured products on the Ethereum blockchain.
In September 2021, SIX Digital Exchange (SDX) received regulatory approval from the Swiss Financial Market Supervisory Authority (FINMA) to operate a stock exchange and central securities depository for digital assets in Switzerland. This authorisation enabled SDX to go live with a fully regulated, integrated trading, settlement, and custody infrastructure based on DLT for digital securities. With these licenses, SDX can now offer the highest Swiss standards of oversight and regulation.
In November 2021, the Bank for International Settlements (BIS) and Hong Kong Monetary Authority (HKMA) concluded Project Genesis which saw the building of prototype digital platforms enabling green bond issuance. The first prototype simulates the lifecycle of a typical bond on a permissioned DLT platform, including origination, subscription, settlement and secondary trading. The second prototype tests the same procedures using a public permission-less blockchain infrastructure. It also streamlines investor onboarding and facilitates the direct payment and settlement between the issuer and investor.
In December 2021, European Union (EU) ambassadors endorsed the provisional political agreement between Council and Parliament on a DLT pilot regime (part of the 2020 Digital Finance Package). Similar to a sandbox approach, this pilot will allow for experimentation within a safe environment and will provide evidence for a potential subsequent permanent regime. The agreement proposes that existing Multilateral Trading Facilities (MTF) and Central Securities Depositories (CSD) be authorised as DLT equivalents.
What are the benefits?
The representation of assets on distributed ledgers can deliver many benefits.
DLT’s smart contracts allow for the codification of stakeholders’ rights, obligations and ownership and produce a single source of truth. As a result, the need for bilateral reconciliation is eliminated, along with many other inefficiencies encountered in legacy systems:
- Near instant settlement eliminates data silos and the processing gap between front and back office functions, therefore increasing the speed of settlement, especially across borders
- Near instant settlement also materially reduces settlement risk and the associated cash buffers firms are required to hold, freeing up capital to be used elsewhere
- Having one immutable version of each client record reduces frictions experienced in client onboarding and creates the potential for vastly improved relationship management processes
DLT could also enable an unprecedented level of transparency for both consumers and regulators. Retail investors would have the ability to continuously track coupon payments (as seen with Project Genesis), while regulators would have real-time access to ledgers, enabling them to monitor risks more effectively.
What are the challenges?
Despite the benefits, DLT simultaneously presents new challenges.
Although it eliminates certain types of risks, it introduces a new risk based on counterparty issuance. This is because each trade relationship involving a new blockchain requires its own ‘token’, with its own bespoke credit risk.
The creation of multiple alternative ledgers could also cause greater fragmentation within the existing ecosystem if there is insufficient interoperability. Based on their initial choices, users could find themselves locked into a specific infrastructure and unable to transact across competitors.
Transitioning from complex and embedded legacy systems onto DLT infrastructure will be a delicate and complex process, involving increased effort and expense. Market participants would likely be required to complete their functions on legacy systems while simultaneously testing DLT, to avoid disrupting critical daily processes and to ensure that markets continue to operate seamlessly.
And finally, some versions of the technology can be extremely energy-consumptive and may not sit comfortably alongside the ESG agenda.
To permission or not to permission
The benefits and challenges are exacerbated depending on whether DLT infrastructure is permissioned or permission-less.
Permissioned structures can be faster and more scalable than their permission-less counterparts. This is because the latter’s high level of decentralisation means only a limited number of transactions can be authenticated at a given time. Permissioned structures are also less energy-consumptive, as they are not consensus-based and operate more like traditional servers. Finally, permissioned structures allow gatekeepers to build in governance structures and dictate their preferred level of transparency and centralisation. This is a flexibility which is potentially better suited to the commercial and regulated landscape.
However, permissioned structures pose a greater risk of market fragmentation if there is a proliferation of smaller closed ledgers that are not interoperable.
What does this mean for firms?
For mainstream financial services firms, the future is likely to involve a permissioned DLT network where all participants are known to one another.
Evidence of this is already being seen among high-profile global banks – several of which are banding together to participate in private blockchain networks for the execution of activities such as foreign exchange settlement and trading repurchase agreements.
However, not everyone will be a winner. Such moves would cut out the FMI entities that currently settle trillions of dollars’ worth of global currency deals on behalf of banking clients. And the stock lending business could be mortally impacted by instant settlement.
These developments show that, contrary to previous opinion, crypto technology does not look set to disintermediate all legacy institutions. There will be winners and losers based on the role that each plays in the ecosystem and how quickly they establish themselves on an interoperable structure. Therefore, in order to future-proof business models, firms should continue to experiment in the permissioned DLT space, taking advantage of regulatory initiatives and support such as the UK’s FMI sandbox and the EU’s Pilot DLT Regime.
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