While the institutional adoption of blockchain technology has proceeded more slowly than many predicted a decade ago, the market continues to evolve in exciting and unexpected ways.
When we began our journey at R3, we believed that the path to institutional adoption of distributed ledger technology would involve a single, global network. This network would follow the Ethereum model, but would also be specifically designed for regulated financial markets, providing a platform for the issuance and exchange of all types of tokenised assets, enabling faster settlement and the automation of business processes. We believed that such a network would remove the complexity and friction that had developed out of financial markets’ reliance on outdated legacy systems.
As we began to work with capital markets participants, solving for their business use cases, our vision for the market changed. We came to understand that a single-network solution would not be able to address the regulatory requirements of global capital markets, nor would it provide the level of sovereignty that central banks, financial service firms and other market participants must demonstrate in order to comply with them.
We now firmly believe that, rather than a single network or unified ledger solution, the digital markets of the future will require a heterogeneous ecosystem, or a ‘network of networks’. Competition and collaboration have always been key to building more efficient markets, and we believe these two forces will continue to drive innovation in this space.
No one-size-fits-all model
Discussions surrounding public-versus-private and open-versus-permissioned networks, while important, have acted as somewhat of a red herring in the industry. The question is not so much which model of DLT is best overall for financial markets, but rather which model best addresses the requirements of specific use cases.
We see many potential uses and benefits of public permissionless networks in financial markets, such as in the distribution of tokenised funds and other assets, but they also have limitations. This is because they are, by their very nature, both transparent and censorship-resistant. Anyone with an internet connection is theoretically able to connect to and transact on them, typically pseudonymously. While this poses a challenge to institutions that must comply with know-your-customer and anti-money laundering requirements, there have been successful use cases, such as ABN AMRO’s use of a permissionless network to issue tokenised corporate bonds.
In contrast, permissioned ledgers – whether public or private – are managed by designated entities, providing a level of control over who can access them and what requirements they must meet. What these networks give up in decentralisation, they make up for in enhanced privacy, scalability and data control. Our substantial experience serving regulated financial market participants has taught us that most firms want a significant degree of control over their technology stack, including over who can access the network and which data are available to which participants. While providing this level of control typically requires a permissioned model, that does not mean that is all the ecosystem has room for. This is where the crucial topic of interoperability arises.
Interoperability
Take for example a regulated financial institution that wants to build a solution for a tokenised money market fund. This firm may find that, while a permissioned network is necessary for regulatory compliance, its clients would like to be able to purchase shares using a digital currency issued on a public blockchain, such as a stablecoin. As such, the firm’s permissioned network must be able to transact with the public blockchains that house clients’ digital currencies. This is not only necessary to prevent the siloing of assets, but also to bolster liquidity on these new platforms.
Similarly, because these DLT networks will coexist and be used alongside traditional infrastructure for some time yet, emerging DLT infrastructure will need to interoperate with firms’ existing non-DLT systems and current books and records applications. As such, R3’s interoperability effort is focused on ensuring that our networks can interoperate with whichever networks our clients require.
Our work with SIX Digital Exchange has illustrated the versatility of DLT and the successful coexistence of permissionless and permissioned networks. SDX is the world’s first fully regulated digital exchange and central securities depository, enabling traders, broker-dealers, custodian and other banks to access digital assets. SDX’s CSD provides secure custody and eliminates the need for institutions to manage their private keys for ledger-based securities. These digital assets can be custodied alongside traditional assets, such as listed shares, exchange-traded funds and structured products, allowing investors to use their existing bank security deposit accounts. Additionally, issuers can benefit by attracting investors who do not wish to maintain public blockchain custody solutions for
their private securities.
In January 2023, SDX released the first native digital bond by the city of Lugano, Switzerland to be admitted in the central bank’s eligible collateral basket. In partnership with Aktionariat, they went on to demonstrate that shares issued on the Ethereum blockchain could be transformed from public ledger-based securities into intermediated, bankable securities on a regulated, permissioned platform. Collaborations like this underscore the pivotal role blockchain interoperability plays in setting a new standard for innovation in regulated markets, by facilitating custody and improving the transferability of digital securities for private company investors.
In another great example of the value of interoperability, June 2024 saw the completion of the first end-to-end test of a cross-chain repurchase trade settlement by Fnality and HQLAX. The two parties completed a fully automated, successful atomic settlement via smart contract across the Ethereum-based Fnality Payment System and the Corda-based HQLAX Digital Collateral Registry. These use cases illustrate that the blockchains firms choose to invest in and build on now do not need to be treated as risky bets on the type of network that will win out in the long run. Market participants should choose the right tool for their problem today, and the providers of DLT technology should remain committed to developing interoperability solutions that preserve the ability of these networks to connect to and interact with one another in the future.
The path forward
When DLT first emerged as a solution for financial market infrastructure, there was a fear that this model would disintermediate incumbent FMIs. Instead, incumbents like SIX Group, and the many Tier 1 institutions that have supported R3 throughout our journey, have become pioneers in this space. Rather than disintermediating FMIs, DLT has become a tool through which they are improving their own operations and capabilities in order to meet the needs of an evolving market and better serve their clients now and in the future.
Encouraging more participants to join industry initiatives will be crucial to realising the full utility of this technology and to accelerating industry adoption. While greater regulatory clarity will be needed before traditional institutions are fully comfortable integrating DLT systems into their everyday workflows, collaborations between industry groups and regulators are underway globally.
R3 believes that a heterogeneous DLT landscape is the future of digital capital markets. Achieving this vision will require interoperability between an ecosystem of diverse DLTs that have a range of characteristics, applications and participants. With assets and currencies coexisting on multiple different networks, solutions that enable cross-ledger transactions are essential to realising the opportunities of digital finance and the full utility of this technology.
Kate Karimson is Chief Commercial Officer at R3.
This article featured in OMFIF’s Digital assets 2024 report.
