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Potential Scenarios of DLT Developments in the Financial Industry

World Economic Forum Report on Digital Assets and Distributed Ledger Technology (DLT): Potential Scenarios for DLT Transformations Across Various Stages of Adoption and Application in the Financial Industry

World Economic Forum Report on Digital Assets, Distributed Ledger Technology, and the Capital Markets Outlook

Table of Contents

Distributed Ledger Technology (DLT), which has been around for over a decade, is now navigating various stages of adoption and application in the financial industry. Opinions about its potential in capital markets vary significantly:

Positive Outlook: DLT can revolutionize capital markets by simplifying financial operations, creating an intermediary-free system, and facilitating access for small businesses and retail investors.

Neutral Outlook: DLT is seen as merely a new tool that may enhance certain capital market processes without causing a revolutionary shift.

Negative Outlook: Due to challenges such as scalability, costs, alternative technologies, security, and regulatory issues, DLT may not achieve widespread adoption in capital markets.

The eventual outcome remains uncertain, as the future of DLT in capital markets depends on technological advancements, regulatory frameworks, and market participants’ acceptance. Despite these challenges, companies are significantly investing in this emerging technology, and regulators are increasingly inclined to support its integration. Some DLT-based products and services have reached commercialization, demonstrating the technology’s transformative market potential.

The 2016 “Future of Financial Infrastructure” Report by the World Economic Forum examined blockchain-driven transformations in the financial industry. While DLT has existed for years, its meaningful real-world applications have only recently begun to emerge, suggesting a paradigm shift in progress. Based on collaborative efforts among the Forum’s organizations and interviews with capital market experts, the findings aim to provide strategic insights to market leaders and regulators about the current status and future scenarios of DLT developments.

DLT in the Financial Industry

The popularity of distributed ledger technology

Several factors make the use of distributed ledger technology easier in financial institutions:

1. Interest in Digital Assets:

Rising demand for cryptocurrencies and digital assets.

New opportunities for financial institutions.

2. Growth in Related Markets:

Expansion of DLT-related markets like stablecoins.

Increasing DLT use in decentralized finance (DeFi).

3. Regulatory Facilitation:

Development of new DLT-specific regulations.

Enhanced transparency and oversight.

4. Technical Advancements:

Improved DLT infrastructure.

Enhanced speed, security, and efficiency.

5. Alignment with Capital Market Trends:

Growing competition.

Need for digitization in financial services.

These factors accelerate digital transformation across the capital markets ecosystem.

Challenges in Traditional Market Structures

Lack of a Unified Information Source: Each institution independently stores and processes transaction records, increasing complexity, errors, and costs.

Transaction Time Limitations: Processing and verification needs restrict trading timeframes.

Inefficient Balance Sheet Optimization: Limited liquidity and market inflexibility reduce operational efficiency and access to financing.

The table below outlines the impact of distributed ledger technology (DLT) in addressing operational inefficiencies and enabling better resource management within companies and markets:

The Impact of DLT in Addressing Operational Inefficiencies and Enabling Better Resource Management in Companies and Markets

DLT CapabilitiesEstablishing trust by providing universal and immediate access to a discretionary document for various stakeholders in a market or transaction.Automating and synchronizing business processes between independent legal entities (such as companies, banks, and investment funds) through the use of smart contracts.Facilitating asset transfers between independent legal entities within a more flexible timeframe.
Business BenefitsReducing the need for manual data editing, approval, and reconciliation.Minimizing human involvement, reducing risks, improving risk management, and lowering costs across various processes.Freeing up liquidity and improving financial management to enhance efficiency and increase flexibility.
Practical Example Based on DLTInnovation in Mortgage-backed Securities: Storing detailed information about mortgage loans on a centralized, intermediary-free blockchain.Platforms designed to manage the lifecycle of derivatives transactions after the trade execution. Goal: Enhancing efficiency, reducing risks, ensuring compliance with regulatory requirements, and improving transparency in financial activities.
Facilitating short-term lending (Intraday Repo)through tokenized collateralized repurchase agreements.

A “Repo,” short for “Repurchase Agreement,” is a form of short-term borrowing primarily used in government bonds.
The seller typically sells government bonds to investors overnight and agrees to repurchase them the next day or after a specified period at a slightly higher price.
This price difference reflects the interest rate paid for borrowing. Repos are used by financial institutions to manage short-term liquidity needs, with securities serving as collateral for the loan.

There are two main types of repo agreements:

Overnight Repo: The loan duration is one day, and the borrower agrees to repurchase the securities the next day.

Term Repo: The loan duration extends beyond one day, lasting for a predetermined number of days, weeks, or months, as agreed upon by both parties.

Repos play a critical role in financial markets by providing high liquidity and short-term financing. They also assist central banks in implementing monetary policy, as repos are used to control money supply and short-term interest rates.

What is Distributed Ledger Technology (DLT)?

Distributed Ledger Technology (DLT) is an immutable database that securely shares information among individuals or organizations. Unlike traditional systems, DLT uses a network of computers to store information instead of relying on a central authority. The goal of this technology (blockchain is an example) is to enhance transparency, security, and trust among all participants by ensuring that data remains consistent, accurate, and up-to-date.

The Four Core Elements of DLT:

1. Distributed Ledger and Peer-to-Peer Network:

Data representing assets or transactions is copied across every node in the network, ensuring resilience against unexpected events like cyberattacks and promoting transparency.

Information is stored on each network node.

Ensures transparency and resistance to cyberattacks.

2. Digital Signatures and Hash Functions:

Strong encryption prevents any alterations after data is published, ensuring resistance to tampering.

Robust cryptography to safeguard data integrity.

Digital signatures verify the authenticity of the data.

3. Consensus Algorithms:

A mechanism to validate foundational data and ensure all participants have a unified view of the information and network decisions. This eliminates the need for intermediaries in transactions.

Validates data and creates consensus among participants.

Removes the need for intermediaries.

4. Smart Contracts:

Automated agreements are written in computer code and are executed independently without intermediaries.

Automates contractual obligations.

Enhances efficiency and minimizes errors.

DLT
DLT

Unique technical features of distributed ledger:

Bringing significant financial benefits to capital markets.

DLT enables a shared, synchronized ledger, introducing unique technical benefits and significant financial advantages for capital markets. Its core functionalities include:

1. Validated, Shareable Data:

Multiple entities can access a unified, up-to-date, and immutable version of a shared ledger, eliminating the need for separate databases. Data consensus reduces manual reconciliation, minimizes disputes, and improves accessibility and accuracy throughout the financial system.

2. Tokenization:

A token represents an asset or unit of value created and managed on a distributed ledger. Tokens can signify cryptocurrencies, company shares, loyalty points, or even units of physical assets like gold or real estate. In finance, tokens enable investments, value transfers, or smart contract execution. Tokenization supports decentralized financial ecosystems (DeFi), allowing users to transact without traditional intermediaries like banks or insurance companies.

Key Advantages of Tokenization:

  1. Faster and cheaper asset transfers (enabled by 24/7 operation and removal of intermediaries).
  2. Division of assets into smaller units, enabling access for smaller investors.
  3. Increased liquidity in niche markets (specialized segments with fewer competitors and highly tailored offerings).

3. Smart Contracts:

These contracts automate the execution of market rules, transaction conditions, and regulatory compliance, reducing human intervention in settlement processes. They enable secure and fast processing, minimizing costs and errors. Key Benefits: Lower costs by automating repetitive processes. Optimize balance sheets by enabling quicker, more efficient allocation of liquidity and capital. Reduce complexity and risk by eliminating counterparty credit risks during settlement.

The Necessity of DLT for Achieving Business Goals

1. Secure Interactions Among Multiple Entities:

Pre-agreed business processes, rules, and exceptions facilitate interactions, while a reliable data source simplifies transactions among entities.

2. Shared Understanding Across Organizations

A unified data version improves transaction efficiency.

3. Challenges with Centralized Intermediaries:

DLT offers a more effective solution in markets without central intermediaries or where dependency on them poses issues (e.g., high costs or insufficient data validation). Although DLT isn’t universally applicable, it can yield significant commercial results under specific circumstances.

Can Smart Contracts Achieve Optimal Results Without Distributed Ledger Technology (DLT)?

This section examines the advantages and disadvantages of both approaches.

Smart Contracts with Distributed Ledger Technology

Synchronization:

DLT ensures that all parties have access to an up-to-date version of data, enabling a shared perspective.

Automation:

Smart contracts on DLT can execute automatically, ensuring coordination in workflows.

Challenges:

Implementing and managing a DLT system requires significant investment, and scalability can be an issue.

Smart Contracts Without Distributed Ledger Technology

Easier Implementation:

Leverages existing infrastructure, requiring less investment.

Suitable for Specific Use Cases:

Ideal for internal applications or trusted partner collaborations.

Challenges:

Relies on a trusted intermediary to ensure data integrity. Transitioning to a DLT-based system later can be complex. There is no one-size-fits-all solution. The choice depends on the specific needs of organizations. By assessing their requirements, investment capacity, ease of implementation, and awareness of challenges, organizations can make informed decisions:

  • For complex scenarios involving multiple parties and requiring full transparency, DLT is more suitable.
  • Smart contracts without DLT suffice for simpler or internal use cases. For example, the Hong Kong Stock Exchange (HKEX) is developing a solution using smart contracts without DLT to shorten the securities settlement process in China under the Northbound Stock Connect program.

Technology Stack and Selected Options

Technology Stack and Selected Options

Degree of Centralization in Distributed Ledger Systems

DLTs can limit individuals’ access to data and transaction approvals. While this may reduce some benefits of DLT, companies leverage these features to create permissioned, customized, and hierarchical systems for enhanced trust and control in capital markets.

Ledger UpdatePermissionless

Permissioned
Open to the public.

Only trusted entities can validate transactions.
Access to Use the LedgerPublic

Restricted
Anyone can review and perform transactions on the ledger.

Only trusted individuals can review and perform transactions.
Access to View the LedgerNon-hierarchical

Hierarchical
Anyone can maintain a complete copy of the ledger and view all its data.

Only certain individuals are allowed to maintain a full copy or view of all data, and some may only access specific portions of it.

Risks of Distributed Ledger Technology

Despite its advantages, DLT is a novel technology that introduces several risks.

1Legal and Regulatory RisksFragmented and incomplete oversight.
Lack of standardized regulatory guidelines.
Challenges with new legal requirements (e.g., smart contracts, finality of settlements).
2Implementation RisksManaging systemic changes across the ecosystem.
Potential issues with specific asset classes or simultaneous operations.
3Operational Management RisksLimited experience in validating and auditing smart contracts.
Challenges in enforcing data standards across networks.
Emergency management risks (e.g., software upgrades, urgent updates, hard fork issues).
4Technological RisksCybersecurity threats (e.g., 51% attacks).
Concerns about data privacy and security.
Interoperability and integration with other systems.
Uncertainty about long-term performance and reliability in production environments.

Complementary and Alternative Technologies

DLT is one of several emerging technologies transforming capital markets. Some technologies complement DLT, while others serve as alternatives:

12345
TechnologyCloud ComputingArtificial Intelligence & Machine LearningRobotic Process AutomationNext-Generation APIs
DefinitionThe quick availability of computing resources (such as computing power, storage, databases, and application software) without the need to manage supporting infrastructure. Typically, cloud computing offers a flexible method with pay-per-use options, minimizing upfront costs compared to traditional data centers.The use of advanced analytical methods, including the analysis of unstructured data, to create multidimensional predictive models that support or autonomously perform human decision-making.A productivity tool that uses predefined codes to automate repetitive tasks, including data entry and transformation. These codes mimic human performance to execute business processes in a limited and structured manner.An Application Programming Interface (API) is an interface that provides programming access to a service or data in a remote application or database. APIs that enable minimal and more efficient data transfer—part of microservices design patterns—along with new data exchange standards (such as ISO 2022), have renewed the appeal of APIs for financial institutions.
BenefitsReduced fees, lower costs, faster execution, reliability, global scalability, improved efficiency and performance, adaptable capacity and resourcesGreater automation, improved decision-making, and process optimizationIncreased automation of repetitive tasks, process optimizationIncreased integration of real-time data, greater automation, process optimization, and enhanced standardization
Key Market Applications/ Use CasesNetwork infrastructure services for big data analysis, software systems in human resources and sales.Enhancing pre-trade operations such as forecasting opportunities, evaluating mergers and acquisitions, generating trading signals, or providing customer services. Forecasting opportunities for corporate mergers and acquisitions, valuation features, generating trading signals, or delivering customer service.Focus on post-trade and support sectors, along with handling numerous repetitive tasks (such as payment processing and customer onboarding).Key market information, digital payments, innovative customer applications and experiences
Integration with DLTSimultaneous use of cloud services alongside distributed ledger technology presents an effective opportunity to accelerate development processes by leveraging pre-built infrastructures.Alternative product features enable the direct processing of complex tasks (such as reconciliation features). Improving data used for AI models.A potential alternative to replicate straight-through processing functionality for a limited set of tasks without human intervention.Modern APIs are now the primary tools for system integration, and they also enhance data sharing among institutions. The complementary capabilities of DLT rely on APIs for utilization.

Distributed Ledger Technology in Capital Markets: From Idea to Reality

After years of experimentation, financial institutions and technology providers have started implementing projects based on Distributed Ledger Technology (DLT). While a fully digital and global capital market based on DLT is still a distant goal, global forecasts suggest that DLT applications across a wide range of assets, business cases, and ecosystems will increasingly become a reality.

Examples of the Growth of DLT Applications (As of April 2021):

Operational Deployments

  • Securitization of blockchain-originated loans (active).
  • Issuance of private tokens on blockchain (active).
  • Corporate bond issuance (active).
  • Management and distribution of private funds (active).
  • One-day repo trades (active).

Planned Launches

  • Bilateral/Intracompany repos (coming soon): Bilateral repos are direct repurchase agreements between two parties without intermediaries. Intracompany repos occur between subsidiaries or affiliates within the same company.
  • International collateralization (coming soon).
  • Upgrading market platform and core infrastructure using DLT (coming soon).
  • Comprehensive digital infrastructure for capital markets provided by a central bank (coming soon).
  • Lifecycle management of securities/credit (coming soon).

Concept Stage

  • Corporate bond issuance process.
  • Public fund distribution
  • Public fund management

DLT is already being used for financial management activities, such as token issuance and corporate bond management. The primary focus remains expanding its use in public and private fund management, including asset distribution and derivatives. Most of these applications are still in development and are expected to launch soon.

Timeline of Technical and Functional Advancements in DLT for Capital Markets

Evolution of DLT Over Three Decades

1. Technical Advancements:

  • Foundational Concepts (1990s): Distributed computing, smart contracts, and cryptographic signatures laid the groundwork for DLT.
  • Emergence of Cryptocurrencies (2008): Bitcoin gained value and popularity, leading to the development of other platforms and technologies like stablecoins and multi-party financial structures.
  • Standardization and Advancements (2020): Efforts to improve compatibility and security through frameworks and technologies like MPC (Multi-Party Computation).

2. DLT Developments in Capital Markets:

  • Pilot Projects (2010s): Financial institutions and governments began testing and deploying DLT for securities settlement and trade finance.
  • Focus on Practical Applications (2020): Projects increasingly aimed at addressing real-world challenges.

Applications of Distributed Ledger Technology

Applications of Distributed Ledger Technology

Distributed ledger technology, through data encryption, process integration, automation with smart contracts, and creating a unified source of information across all mentioned markets, has helped reduce errors and costs while increasing the speed of transaction settlements. These processes lead to greater transparency, efficiency, and the development of innovative infrastructures, ultimately improving the performance of these markets.

Conclusion

Distributed ledger technology cannot perform miracles in capital markets, but leveraging its unique capabilities can help address many of the existing inefficiencies and major challenges in these markets. For example, providing a shared, reliable, and immutable data source eliminates the need for data validation by multiple entities. Additionally, smart contracts enable asset exchanges without the complexity and high credit risk.

In the coming years, we will likely witness increased digitization of markets, including the widespread adoption of distributed ledger technology. However, there is still no broad consensus across the market on fundamentally transforming all aspects of capital markets through distributed ledger technology.

Sources:

https://www.investopedia.com/terms/d/distributed-ledger-technology-dlt.asp

https://www3.weforum.org/maintenance/public.htm

https://media-publications.bcg.com/The-Future-of-Distributed-Ledger-Technology-in-Capital-Markets.pdf

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