Proponents of blockchain technology are slowly convincing the world that traditional securities often face numerous challenges such as lack of transparency, intermediary risks, poor efficiency, and more, due to a reliance on outdated methods. However, the implementation of Distributed Ledger Technology (DLT), particularly blockchain, offers a promising solution.
In a recent research report by digital securities specialists Tokeny, a close look was taken at how the legal framework in countries like Luxembourg allows for the use of DLT in maintaining securities registers. Below, we highlight some of the key points in this report including the potential of blockchain and DLT, and their ability to enhance transparency, efficiency, and compliance in securities registers.
Enhancing Transparency and Efficiency
DLT and blockchain technology, with its tamper-proof distributed ledger, have the potential to greatly improve transparency and efficiency in securities registers. By leveraging it, real-time monitoring of ownership can be achieved. This means reducing the occurrence of errors and fraud.
Additionally, such technologies eliminate the need for intermediaries, streamlining processes and reducing costs as a result. Meanwhile, decentralization and the ability to structure custom smart contracts means that blockchains can foster interoperability across markets and jurisdictions, facilitating enhanced liquidity and market access.
Addressing Legal Considerations
The legal framework in Luxembourg supports the use of DLT and blockchain in maintaining registers of dematerialized and intermediated securities. While bearer securities, which are physical certificates, cannot leverage such technology due to their tangible nature, there is ongoing debate regarding the classification of security tokens as digital bearer securities. However, dematerialized securities, represented by book entries, can effectively utilize blockchains based on the ‘Blockchain Laws' enacted in Luxembourg.
To ensure legal certainty in capital markets, it is essential to establish clear legal reasoning and achieve consensus among legal practitioners. Tokeny notes that Blockchain Laws I, II, and III provide valuable guidance and recognition of DLT for the keeping, transferring, and issuance of intermediated and dematerialized securities.
Tokenization and Smart Contracts
Blockchain technology enables tokenization – a process that involves representing assets on a blockchain. This process holds significant potential for securities registers, as it allows for the creation of real-time investor registries and eliminates the need for data reconciliation by third parties. Tokenization also boosts security by leveraging the immutable nature of blockchain-based records.
Additionally, self-executing contracts with predefined rules and conditions, known as ‘smart contracts', can automate various aspects of the securities lifecycle. By utilizing smart contracts, compliance with laws and regulations can be ensured, resulting in increased efficiency and transparency of securities registers.
On-Chain Identity Verification
On-chain identity verification is another critical component of leveraging DLT in securities registers. Per Tokeny, this process involves leveraging ‘decentralized identifiers (DID) and anonymous verifiable credentials' to provide individuals with control over their digital identity, without the need for reliance on third-party authorities; this process is also known as ‘whitelisting'.
This decentralized identity system allows individuals to manage their identities using cryptographic keys and smart contracts, with the blockchain serving as a tamper-resistant ledger to verify the authenticity of identity information. By linking decentralized identities to blockchain addresses, a cryptographic connection can be established between tokenized assets and their real-world owners. This connection enhances privacy, security, and user control. On-chain identity grants individuals self-sovereignty, enabling them to manage their identity, access permissions to credentials, and linked wallets.
Permissioned Token Solutions and Interoperability
To ensure the security and compliance of transactions, permissioned token solutions play a crucial role. These solutions enable control over token transfers, ensuring that unauthorized transfers are prevented. Furthermore, interoperability mechanisms are vital for achieving seamless interaction between legacy systems and blockchain networks. Middleware and API gateways often act as intermediaries, facilitating communication and data exchange between the two systems, ensuring compatibility and smooth interaction between different protocols and data formats.
Interoperability is particularly significant for securities registers, as it ensures the accurate transfer and recording of ownership information when transitioning from legacy systems to blockchain networks. By ensuring interoperability, securities registers can fully benefit from the aforementioned advantages on offer (transparency, security, and efficiency) by blockchain technology.
Overcoming Challenges and Seizing Opportunities
Despite its potential, the adoption of blockchain technology in the financial industry is not without challenges. Tokeny lists the following as a few key examples of what these challenges look like.
- Strategic allocation of capital
- Mass adoption
- Lack of pressure to adopt blockchain
Tokeny believes that to overcome these challenges, education initiatives are essential to increase awareness among market participants about the benefits and potential applications of blockchain technology. Collaboration among stakeholders, including technology providers, regulators, and financial institutions, is also crucial for driving standardization, innovation, and the integration of blockchain technology into existing financial systems.
Asset Tokenization and Sustainable Finance
Asset tokenization presents a significant opportunity for alternative asset management industries to expand their range of products and services. Tokenization allows for fractionalizing assets, providing liquidity, and reaching new investor types. Tokeny notes that in the current market environment which touts rising interest rates and falling asset prices, tokenization can offer a solution by enabling fractional sales of fund units to investors strapped for cash. This benefits existing investors by providing liquidity and also enables a new generation of investors – which Tokeny says is ‘digital native' – to access alternative investment products.
Within Luxembourg, embracing DLT and asset tokenization also aligns with the country's focus on sustainability in finance. DLT enables the integration of sustainability factors into financial transactions, allowing for more transparent and reliable access to Environmental, Social, and Governance (ESG)-related information. Tokenization facilitates the customization of investments based on individual investor preferences and values, attracting a broader range of investors interested in sustainable finance opportunities. By utilizing DLT for sustainability-driven finance, Luxembourg can foster a more conscious and ESG-focused finance industry, contributing to global sustainability goals.
The above points are just a few ways in which DLT and blockchain technologies are being utilized by forward-thinking nations like Luxembourg, in an attempt to streamline participation in capital markets. Tokeny has done well to highlight many of the potential advantages and challenges associated with adopting this technology. By embracing DLT and asset tokenization, forward-thinking nations can position themselves as leaders in the digital transformation of traditional finance, all the while contributing to sustainability goals and fostering a more inclusive and ESG-driven financial ecosystem.
To learn more about the role DLT and blockchain can play, make sure to check out the full report by Tokeny HERE.