Distributed Ledger Technology Use Cases in Asset Management

A ‘Golden Source’ for Trust and Audit

Nov 14, 2023

Introduction

The integration of distributed ledger technology (“DLT”) into asset management will usher in a wave of innovation, transforming the way various asset classes can be tracked, traded, and managed. This technology, commonly known as blockchain, offers enhanced transparency, trust, auditability, and efficiency in handling different types of asset data, particularly in situations where multiple counterparties and intermediaries are involved. The adoption and implementation of this technology will unleash a diverse range of use cases of distributed ledger technology in asset management across equities, debt, private equity, venture capital, wealth management, and non-financial assets.

DLT simplifies asset management by creating a shared ledger of asset data with immutable and auditable records. This allows robust verification and audit of data stored on chain or supplied from off-chain sources. As distributed ledgers are append-only databases, they allow for a permanent record of ownership and all changes to ownership since issuance, which aids in reconciliation, audit, and compliance with securities law.

Smart contracts add programmability to DLT, and support automation of many aspects of asset management, including payments, disbursements, trading, purchase, redemption, etc. Smart contracts can also work with non-ownership data, such as shareholder votes, corporate actions, regulatory reporting, and the like.

DLT brings transparency, liquidity, and efficiency to the traditionally opaque private equity and venture capital industries. By providing a verifiable and immutable history, DLT ensures that all parties work from the same golden source of data. DLT transforms wealth management with transparent and auditable records of investment, widening the scope of possible services to meet growing client demands.

DLT extends beyond financial assets to include non-financial assets like real estate, manufacturing equipment, carbon credits, art, and collectibles. Tokenization facilitates authentication, fraud protection, and chain-of-custody tracking, making high-value assets more accessible to a broader range of investors. Auditable ownership records on DLT help to ensure regulatory compliance and adherence to reporting standards.

Vertalo’s distributed ledger technology consists of Vertalo Securities Protocol (“VSP”), and an API-based architecture. As an SEC-registered transfer agent, Vertalo leverages its platform to address a wide range of use cases in multiple asset classes. VSP facilitates DLT use cases in asset management across two dimensions; the need for a transfer agent, and the spectrum of blockchain capabilities. Vertalo is purpose-built for this type of flexibility, as each asset class and user profile will have different requirements.

Distributed Ledger Overview

Distributed ledgers provide the foundation for issuing, exchanging, and tracking digital representations of ownership and other data with immutable records. In the context of contemporary blockchains, this has taken several forms, from transactional cryptocurrencies to non-fungible tokens to proof of existence for off-chain data. These immutable records support a wide range of use cases in finance and asset management.

DLT confers numerous advantages to traditional capital markets infrastructure. At its core, DLT is simply an append-only database that is shared as a network among its participants, which allows for high fidelity record keeping. Many DLT networks also offer smart contract capabilities, which allow for tokenization as well as automated or conditioned transaction types. Smart contracts can mimic traditional exchange models, lending models, and other representations of traditional financial services and products.

This activity can occur on highly decentralized public networks, or can be adapted to private or permissioned networks. The factors that determine the choice of chain are jurisdictional regulation and user demand. The benefits of using distributed ledgers for recording ownership and transactions remain unchanged, however the benefits could be further optimized given the use case.

Transparency: DLT offers an immutable and auditable record of any data stored on chain, including ownership, transactions, and signatures for off-chain data. Common access to these data ledgers on chain reduces the need for intermediaries and eases the process of synchronization among multiple parties. Each on-chain record is visible to all ledger users, and each can see changes in real-time. Further, ledger data can be shared with regulators, auditors, and other approved 3rd party compliance partners.

Auditability: The cryptographic nature of DLT ensures that records are immutable and history is preserved. This immutable history supports robust audits, and creates trust in the reliability of the data. Cryptographic signatures combined with out-of-band data exchange extend auditability to data passed through off-chain means. Any member of the network can verify data based on the immutable records read on-chain.

Efficiency: Automated data verification based on data stored on-chain reduces the complexity and increases the efficiency of data sharing among network participants. Verifying off-chain data using on-chain cryptographic proofs streamlines processes that rely on trusted data synchronization, such as settlement, clearing and settlement of trades, reconciliation, asset management operations, and audits of large data sets, reducing administrative complexities and costs.

Liquidity: DLT integrates well with digital securities technology (SEE VSP WHITEPAPER), enhancing API-based data exchange (SEE API WHITEPAPER) with an immutable audit trail for trading data. The fractional ownership made possible by digital securities, where bid size and increment are smaller, benefit the most from the increased efficiency of data synchronization and audit.

Decentralized Finance (DeFi): Smart contracts that represent ownership on-chain can implement lending, borrowing, and derivatives programmatically. This emerging area of development can bring new efficiencies to real-world assets represented in tokenized form.

Distributed ledger technology is revolutionizing asset management across various asset classes. From equities and debt to private equity, venture capital, wealth management, and non-financial assets, DLT is enhancing transparency, auditability, efficiency, and liquidity.

Asset Management Industry Background

The Asset Management (“AM”) Industry is a large and diverse market, encompassing a range of asset classes, investment strategies, and customer profiles. With an estimated $115T in AUM as of FY’22, the AM industry represents an integral part of the global economy. In this context, asset managers are facing new challenges with global uncertainty, rising interest rates, market volatility, expanding regulatory regimes, and heightened operating costs. Asset managers are faced with a growing cost-income ratio, with the greatest impacts felt among smaller asset managers. While this sets the stage for consolidation in the industry, large firms must increasingly invest in technology solutions for better investment outcomes and stronger profitability profiles.

A regulatory picture that is ever increasing in scope and cost drives much of the Operating Expenditure (“OpEx”) in the AM industry. Additionally, fee pressure and growing complexity in both portfolio construction and client demands present additional challenges. Asset Managers are increasingly looking to novel technology to innovate and address these pressures, including growing expenditure on third-party technology solutions.

With regards to DLT, AM firms are seeking to capitalize on the benefits of integrating chains into their data-management platforms, to gain efficiency and also enhance functionality, while remaining compliant with applicable regulations. In response to growing customer demand, institutions are testing a wide range of applications of DLT across numerous asset classes and operating activities. As DLT continues to mature, asset managers have an opportunity to embrace and leverage this technology to reshape the future of asset management.

DLT Use Cases In Asset Management

Distributed ledger technology provides numerous advantages in several categories in the AM industry. The immutable append-only nature of distributed ledgers represents a step forward in verifying transactions, while providing significant advantages in auditability. With the addition of smart contracts, which serve as the basis for tokenization and automated transactions, asset managers can enhance their offerings without driving significant marginal operating costs.

The fundamental difference between tokenized assets and their traditional counterparts lies in how ownership is 'represented.' Conventional assets rely on systems controlled by specific issuers, transfer agents, broker dealers, and custodians, often resulting in fragmented processes that require third-party intermediaries and costly manual reconciliation and remediation. This hinders efficiency, interoperability, and the potential for innovation. In contrast, tokenization leverages public or private distributed ledgers to create a shared source of ownership data, eliminating fragmentation and simplifying synchronization across all ledger users. As a result, efficiency is heightened, interoperability improves, and the environment for innovation becomes more favorable.

Similar uses of DLT apply to non-ownership data in asset management. The DLT provides a common basis for verification and audit of data shared among parties responsible for different aspects of asset management.

There exists a range of applications for DLT in AM, each leveraging various aspects of DLT functionality. Using DLT to store ownership data or non-ownership data, the evolution in asset-management infrastructure will drive efficiencies across a broad range of AM activities.

Shareholder Ledger Management

Perhaps the most foundational level of asset management begins at the capitalization table. The record of asset ownership is the most fundamental element of Asset Management - who owns what and how much of it. Great strides have been made by AM firms in recent decades to digitize these asset ownership records to do away with the paper-based, friction-laden processes of the past. However, inefficiencies still abound with inconsistent data formatting and structure across different systems, both between internal departments and among third parties the AM firms must work with, such as custodians, fund administrators, and transfer agents.

As an ownership ledger, DLT allows multiple parties to verify the data independently, thereby enhancing trust and efficiency in cap table management across all parties. In addition, DLT provides a shared data structure and format, and a common point of reference for transactions that affect the cap table ownership records. This golden source of truth reduces risks and liabilities associated with cap table management, and provides opportunity for automation to reduce administrative costs.

Equities

Distributed Ledger Technology streamlines the administration of equities by establishing an immutable, decentralized, permanent ledger that records ownership and transactions, building on cap table management features. DLT supports on-chain payment mechanisms. Combining DLT payments with DLT cap table management allows fully programmatic settlement of equities, thereby shortening settlement periods (typically several days for traditional equities) and reducing the associated counterparty risk. Further, these technologies can support automated dividend disbursement while maintaining the verifiability and auditability for all parties..

Smart contracts can automate data management for both ownership and non-ownership data. Stock splits, shareholder voting, and recording of other corporate actions can be automated through smart contracts on a DLT platform, making these processes more transparent and auditable

DLT can similarly simplify regulatory compliance by maintaining an immutable record of all transactions. This immutable history makes audits more straightforward and ensures greater transparency in reporting. Additionally, real-time trade surveillance can be conducted more broadly on a DLT platform, helping to identify and prevent market manipulation, insider trading, and other types of fraud. DLT can also help asset managers create more transparent and easily-auditable investment products, such as tokenized funds that can be traded on secondary markets.

Debt

In debt markets, DLT offers enhancements for bond issuance, trading, and oversight. The transparency and auditability benefits of using DLTs for equities apply equally to debt instruments, where multiple parties contribute to origination, trading on the secondary market, handling interest disbursements, and regulatory compliance. These benefits can lead to lower operational expenses and increased liquidity within debt trading ecosystems.

Trading in the secondary debt markets often lacks transparency, making it difficult to establish fair value for debt instruments. The visibility from DLT enables more transparent pricing and trade verification, allowing asset management firms to more appropriately mark their debt portfolios to market in order to better anticipate valuation swings in uncertain interest rate periods.

Smart contracts on a DLT platform can automate interest payments on debt instruments that otherwise require manual processing and verification, ensuring timely and accurate interest payments to bondholders.

The transparency offered by DLT can provide better data for risk assessment. This can result in more accurate pricing and lower risk premiums, reducing the overall cost of borrowing.

Private Equity & Venture

Through its immutable history of ownership and investment, Distributed Ledger Technology offers a reliable and secure method for monitoring ownership percentages, streamlining the capital-formation journey, and improving communication with investors in the context of private equity or venture capital. Using DLT to record ownership of interest in a fund lets smart contracts automate manual processes, such as onboarding, capital calls, distributions, redemptions, and reporting.

Wealth Management

DLT can apply in the field of wealth management through its provision of a clear, verifiable history of investment portfolios. Both financial advisors and investors benefit from transparent insights into asset distribution, portfolio performance, risk assessments, and regulatory reporting. Wealth managers that use DLT-compatible technology may also gain access to a wider range of investable asset classes, including tokenized assets and cryptocurrencies. This allows wealth managers to meet the evolving needs of clients without significantly increasing administrative costs.

The transparency of DLT can support more fully informed decision-making, both for wealth managers and their clients. The immutable nature of DLT makes it well-suited for compliance with increasingly stringent financial regulations. Everything from customer onboarding to transaction history can be securely and transparently logged, streamlining the auditing process, and helping wealth managers to better assess risk and adapt investment strategies accordingly. This can result in better asset allocation and potentially higher returns.

As client demand for exposure in a widening range of asset classes grows, tokenizing assets like real estate, art, or other illiquid investments can make them more accessible to a broader range of investors. By turning these assets into tradable tokens on a DLT-based platform, wealth managers can offer new investment opportunities to their clients. Smart contracts on DLT can automate the creation and management of customized financial products. This reduces the administrative burden and allows wealth managers to bring a greater variety of options to their markets.

Real Estate

The benefits of DLT extend beyond financial assets to include non-financial assets like real estate. Often seen as an opaque and cumbersome traditional market, real estate stands to gain much from the transparency, efficiency, and automation that DLT offers.

Much of the cumbersome nature of the real estate market stems from due diligence in title transfer. Recording on DLT the history of titles, liens, easements, encumbrances, restrictions, covenants, property condition reports, zoning regulations, and so on makes them part of a permanent and verifiable record, making subsequent diligence less arduous and more efficient. The fact that properties go through repeated diligence makes this a high-return benefit.

Tokenization of real estate data can be extended to include not just ownership information, but also leasing and occupant information. Recording leasing and occupancy data on the blockchain can provide additional benefits including automation of payments or disbursements as with debt instruments.

Other Non-financial Assets

In industries like agriculture, manufacturing, equipment leasing, and pharmaceuticals, DLT can trace the entire lifecycle of a product. This verifiable chain of custody reduces risk by making it easier to identify counterfeits or compromised goods and easier to ensure authenticity and proper handling. DLT can also serve as a verifiable and immutable registry for copyrights, patents, and trademarks. In the leasing of large equipment such as aircraft, medical equipment, ships, and more, putting leasing data including ownership records, lessee records, payment schedules, and location of the equipment ensures accuracy in the tracking of these assets and the leases associated with them by asset management firms, avoiding costly efforts like data reconciliation and payment collections. As these assets are frequently purchased, sold, and collateralized, the benefits of DLT in equity and fixed income assets apply equally to these cases.

DLT can track the production, transfer, and retirement of renewable energy credits in a transparent way. This can encourage sustainable practices by ensuring that credits are only counted once and are allocated accurately.

Authenticators of high-end products like fine art and luxury goods can use DLT to record findings and history. Each product can have unique, immutable records that demonstrate its provenance and ownership.

Decentralized Finance

Decentralized finance (“DeFi”) is an emerging area of DLT in finance that employs smart contracts to provide traditional financial products and services. While DeFi to date has largely consisted of unregulated, permissionless, and globally accessible platforms, the same technology can be adapted to permissioned environments or private networks that allow participants to maintain regulatory compliance. DeFi smart contracts implement protocols for lending, borrowing, trading, automated portfolio management, payments, dividends, derivatives, and peer to peer asset transfers.

An emerging subsector in DeFi is the Real World Asset (“RWA”) category, which allows for issuers and asset managers to use their tokenized assets as collateral in lending markets, create decentralized exchange markets for assets, generate income on their assets, or gain exposure to a wide range of investment opportunities. The integration of DLT enables asset managers to take advantage of these opportunities and efficiencies with minimal marginal cost to operations and administration.

Conclusion

Many strides have been made in order to improve markets and operational processes and expenses in the asset management space through digitization efforts of assets and transactions. These markets and processes can be and are being further improved through the introduction and integration of DLT. DLT provides a single, immutable source of truth - the proverbial ‘golden source’ - when it comes to the data of securities, real world assets, and non-financial assets to increase the reliability and accessibility of these records and to decrease friction and OpEx. Reductions in verification and reconciliation have proven downstream effects in cost savings for asset management firms in their asset servicing, structured product, and portfolio management business units.