Blockchain beyond crypto: How financial institutions are using DLT

Key Takeaways

• Distributed ledger technology (DLT) in finance is touted as the ‘next big thing’ in the shift from paper-based transactions to digital financial and monetary systems.
• Capital markets and financial institutions are slowly switching to DLT from traditional systems, drawn by its enhanced security, transparency, and efficiency.
• While the move to DLT is not without challenges and risks, innovative advances on DLT systems – such as tokenization – make investing more accessible and flexible.

The financial world is witnessing a new wave of transformation, driven by distributed ledger technology (DLT). A decentralized system of managing data, DLT can accelerate processes such as settlement, collateral management, and data reconciliation, fundamentally changing how the entire financial system operates.

This blog explores what DLT is, its key advantages and disadvantages, and how it is transforming the financial ecosystem.

What is DLT?

DLT in finance allows businesses to record, share, and store data across a network of computers, eliminating the need for traditional databases with a centralized ledger. The system is highly secure since the data is spread out and there is no single point to breach. To tamper with data, hackers need to hack into most or all the computers in the network.

Blockchain versus DLT? People often get confused between DLT and blockchain, but they are not the same. DLT is a broad term that refers to various technologies, including blockchain. Some other DLT systems include Directed Acyclic Graph (DAG), Hashgraph, and Holochain.

DLT is best known as the underlying enabler of cryptocurrencies such as Bitcoin and Ether, but its use goes beyond crypto. In capital markets, DLT can issue new securities directly on a digital platform, tokenize assets, and create Central Bank Digital Currencies (CBDCs). Implementing DLT in capital markets could be the natural next step in the ongoing shift from paper-based to digital systems, both in finance and in how money is used.

How is DLT transforming the financial ecosystem?

One key advantage of DLT is its strong security. A BCG report illustrates how securely the technology works, exemplifying it with a blockchain operation.

In blockchain, information is stored in secure ‘blocks’ that are chained together using a cryptographic signature called a hash. Once a particular block is approved, validated, and added to the ledger, it can no longer be changed. Any new updates are added as new entries that are visible to everyone. All parties can see exactly what changes were made and when. This makes the system fully transparent, where all parties work with the same information. This set-up also means that there is no need for reconciliations, matching, or other data processing steps.

A Deloitte report notes that DLT can tackle some of the most expensive and time-intensive challenges in financial markets by eliminating redundancies, automating reconciliation processes, and minimizing operational risks.

DLT can also issue smart contracts and automatic digital instructions that are executed when pre-determined conditions are met. “The integration of smart contracts and automated processes within clearing and settlement activities is projected to generate global infrastructure operational cost savings of approximately USD 15–20 billion annually (including US, Europe, and the main markets),” the Deloitte report states.

Capital markets and financial institutions are slowly switching to DLT from traditional systems, drawn by its enhanced security, transparency, and efficiency. DLT simplifies the complex structures of business operations and makes it easier for custodians, issuers, investors, and intermediaries to work together. It allows them to share information instantly, reducing reliance on manual processes.

Advantages of DLT systems

• One of DLT’s main benefits is that it is decentralized. Since no single entity controls the system, it is more resistant to censorship, fraud, and other forms of abuse.
• Due to its decentralized nature, anyone with an internet connection can access the available data, making the system more inclusive.
• DLT is built on cryptographic technology that makes the system secure, significantly reducing the chances of hacking and other forms of cyber attack.
• All transactions, data, and their changes are visible to all stakeholders, creating a more open and transparent ecosystem.
• DLT automates tasks and eliminates intermediaries, boosting efficiency; it also reduces costs and enhances user experience.

Challenges linked to DLT

• DLT eliminates several risks, but it also introduces new ones based on counterparty issuance. For example, every new transaction involving a new blockchain requires its unique ‘token’, each carrying its own distinct credit risk.
• The creation of multiple alternative ledgers could cause greater fragmentation within the existing ecosystem, especially where interoperability is lacking. Based on their initial choices, users may become too comfortable with a particular infrastructure, limiting their ability to transact with other platforms.
• Moving from complex legacy systems to DLT infrastructure is a delicate and costly process. Also, to ensure smooth daily operations, market participants need to keep the legacy systems running while testing DLT in parallel, at least initially. This could raise prices.
• Some versions of the technology can be energy-intensive and may not be compatible with the ESG agenda.
• DLT has no regulatory framework yet, making it difficult for market participants to know if they are on the right path.

How is tokenization opening new opportunities?

Tokenization is adding another layer of innovation to DLT systems. Features like instant collateral mobility, continuous global access, and integration across asset classes are setting standards for tomorrow’s financial services. In the coming days, all assets – stocks, bonds, and more – will exist and be transacted on a unified ledger, making markets more efficient, accessible, and innovative.

Here are some use cases for the tokenization of assets:

• As financial markets move towards T+1 and T+0, asset tokenization can play a game-changing role as it offers instant settlements.
• Tokenization creates new opportunities by making historically illiquid and difficult-to-trade assets, such as real estate, more accessible, and functional. In real estate, tokenization allows for fractional ownership, where more investors can invest in smaller amounts. This aspect also makes buying and selling easier on secondary markets, improving liquidity, the Deloitte report points out.
• In money market funds (MMFs), tokenization enables real-time liquidity through intraday repos. Traditionally, MMFs use overnight repos (short-term loans that last 24 hours), which don’t always match the borrower’s actual needs, forcing borrowers to incur costs for unused time. Tokenization facilitates secure, immediate transactions, allowing settlements within minutes or hours as needed, thus avoiding additional costs.
• Tokenization can also be applied to many other types of assets, such as bonds, stocks, ETFs, loans, and even precious metals.

However, existing regulatory frameworks and infrastructure within capital markets are not ready for this shift. Still, tokenization is pushing innovation forward in the financial world, helping make investing more accessible and flexible.

Conclusion

DLT and tokenization have the potential to transform the financial world significantly. But it’s important to recognize that this transformation is not merely about adopting a new technology. Conversely, it requires a fundamental shift in how financial transactions are designed, executed, and managed.