08 October 2020

Technology blueprint for the financial world

Distributed Ledger Technology replaces old structures

Opening the banking system and creating a peer-to-peer structure: distributed ledger technology (DLT) may disrupt and replace the hierarchical structures in the world of financial transactions. The interview with Nils Löhndorf, Netcetera’s Managing Director Financial Technology, by Kurt Schmid, Marketing and Innovation Director Secure Digital Payments at Netcetera, explains the nature and advantages of asset tokens and distributed ledgers.

What is a distributed ledger? And what are its benefits compared to other technologies?

Traditionally, large centralized proprietary banking systems or stock exchanges clear financial transactions by relying on large scale systemic institutions and central securities depositories or CSDs. Used for example in a blockchain setting, these hierarchical structures can now be replaced by distributed ledgers. “Opening up the entire ecosystem” and “creating a peer-to-peer structure”, as Nils puts it, who has studied token technology for the past 6 years. Block chain-based transactions are ordered within blocks and then distributed to every party within the network – in real-time and with all the data involved on the spot, as a “single source of truth”, according to Nils. The network then approves the transaction, the block is added to the network and the transaction is completed.

But what exactly is such a token in DLT?

Existing tokens, representing value, are mostly utility tokens such as banknotes, shares or postal stamps. In the blockchain-based DLT network, tokens – basically pieces of computer code – represent or incorporate those real-world assets. In other words: an asset token is an encrypted unit of account in the DLT network, where it can be programmed with all the necessary data and transaction rules to comply with regulations. Hence it is secure and transparent at the same time. Tokens are economical and fast, providing lots of options for liquidity for the partners within a DLT network.

How is an asset token generated and where is it stored? And if you deal with shares, do you need a token each for every traded share?

You take digital assets, such as shares or real assets, such as real estate, and move them to the blockchain. That means a “smart contract” is written in code, representing the ownership rights and the conditions and regulations of the deal – not necessarily one contract per share, but one contract per intended transaction. The actual generation of a token stack is ideally done by a bank – with the help of experts as intermediary such as Netcetera, who know how to use the technology to the users' advantage.

What are the benefits of DLT compared to other technologies?

DLT is a network and non-hierarchical, based on a single source of truth. Its inter-operability – the ability to exchange and make use of information – supports the exchange of smart tokens. It can work on any system and uses the internet to store and distribute the data. It is not bound to proprietary systems and can be verified at any point of the transaction. It is an open standard in the true sense of the word and hence the smart contracts' design can be custom-made to comply with all the desired rules and regulations in every market.

What are STOs (Secure Token Offerings) and are they similar to ICOs (Initial Coin Offerings)?

An ICO is basically a utility token – for example like a ticket to a movie theatre that is not even yet constructed. The people behind an ICO collect funds and promise their investors: You get 15% discount on the first movie tickets sold here in two years time! This might work for an investor, or not – if that cinema is not built, you cannot claim those movie tickets. In other words: If the issuer is not successful, the investors are left behind. In contrast, a STO is asset based – say on equity or a piece of real estate – and there are redeemable rights attached to those assets. Dealings in STO are governed by the regulators to be secure. Existing assets can be tokenized through an STO so that they qualify as transferable securities under MiFID. The newly published eWPHG in Germany now under legislative review aims to govern the issuing and trading of secure tokens, like similar initiatives by FINMA in Switzerland which are currently being implemented, amongst others.  Also, there is the technical component: The protocols in STO enable the issuer and the intermediaries to programme a comprehensive smart contract which is regulated and hence potentially enforceable by law as the legislation in different countries adapt to the proposals mentioned above.

Typically, there are restrictions for trading shares in the by-laws. How can this be implemented using DLT?

An US-based company wants to make its shares tradable in Europe to increase its liquidity. STO's advantages play out nicely in this example: The company can encode all the necessary regulations into the smart contract, for example excluding all US investors for reasons of compliance. Additionally, it can white- and black-list potential accounts, certain buyers and sellers, define a required time-in-wallet, limit number of tokens in wallets and so on.

How does such a “token wallet” work? And what is the role of a custodian?

The secure base of block chain is encryption. Public and private key information is stored in a digital wallet and is then related to the owner and his tokens. Equity tokens alone, though, do not ensure rights of ownership, as we have seen for example in crypto currencies disappearing by the millions when crypto exchanges went bust and private keys were lost. You need custodians to make it safe. In the traditional world, banks act as custodian of ownership rights and see this as one of their principal tasks. We now have a need for digital custodians and indeed, we see a lot of custody start-ups providing encryption and storage for those digital assets. This need would be “a good opportunity for issuers and banks to become digital custodians”, reckons Nils. In the future of digital assets , “if you want to  own the client relationship you need to own the custody ”.

Can you give us some examples of banks that already are live with such services?

The World Bank raised a two-year bond marking the first time that investors have supported the World Bank's development activities into a transaction fully managed by block chain technology.

Societe Generale issued covered bonds worth 100 million euro as security token, registered on the Ethereum blockchain and rated AAA by Moody's and Fitch.

Sperbank conducted the first commercial block chain transaction in Russia, issuing MTS in the value of 750 billion Ruble with six months smart contracts.

If you want to learn more or have questions not covered here, please feel free to get in touch. Or watch the webinar on DLT "How to monetize distributed ledger technologies (DLT) based asset tokens as issuer?":

 

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