Token Tech: The Evolution and Architectures of Distributed Ledgers

Distributed ledger technology (DLT) is an essential ingredient for creating digital assets through tokenisation. Most commonly implemented as a blockchain (a cryptographically linked list of records that Is duplicated and synchronised across a number of network nodes), DLTs securely record and store digital tokens that represent specific assets.

Tokenisation is regarded as a sweet spot application for DLTs given their security capabilities (while technically not immutable, it is extremely difficult to change or delete a record hosted on a DLT without it being detected), their automatic record synchronisation to provide a single source of truth, and support for programmable tokens and smart contracts.

Recently, the focus of DLT innovation and deployment has been on performance, scalability and open-ness. Just as business use of internet technologies began with closed intranets, so the first uses of DLT by businesses – and especially in the privacy-oriented financial vertical – was to implement private, permissioned networks. Private DLTs are generally limited in terms of the number of nodes deployed, and each node needs to be operated by a known, pre-authorised entity.

Note: private, permissioned DLTs in use in the financial markets include R3’s Corda and Hyperledger Fabric.

While private DLTs offer security and consistent performance they are best suited when supporting well defined and credentialed business ecosystems, such as a syndicated loan alliance or a specialised trading consortia. As such, growing private DLT ecosystems can be challenging and time consuming.

By contrast, public DLT networks have spawned many decentralised finance (DeFi) markets that are open to any entity with an internet connection and a digital asset wallet. Historically, they have attracted risk-tolerant individuals, crypto hedge funds and operators of crypto treasuries seeking high yields. The ‘all welcome’ nature of DeFi often results in sizeable ecosystems and liquidity to match. The downside is that the integrity of participants is unknown, and public DLT transactions are generally visible to all.

Note: For popular public DLT’s deployed by financial institutions, check out Ethereum, Solana and Stellar for starters.

While public DLTs generally come with higher risks, the potential rewards are also attractive to institutional finance players. As a result, institutions have leveraged technologies to add elements of regulatory compliance and transaction privacy to public DLTs. For compliance, seeking out higher quality counterparties that are open to passing KYC and AML certifications is one option, as is embedding auto-compliance logic into the code of tokens. When it comes to privacy, techniques such as zero knowledge proofs and multi-party encryption are often investigated.

As a result of employing these quality mechanisms, public, permissioned DLTs have emerged and are finding favour among institutional investors who are adept at balancing the somewhat higher risk of an open market with significantly higher rewards.

Note: For providers of public, permissioned DLTs, explore the Canton and Hedera Hashgraph DLTs.

Institutions looking to deploy DLT solutions in support of tokenisation therefore face a wide choice of architectures to choose from, a decision driven by determining what kinds of digital asset markets and applications they intend to engage with combined with risk tolerance determinations and the regulatory regime in which they operate.

For sure, choosing a DLT for tokenisation is not only one of the first steps that an institution needs to make, but it’s one of the most time consuming in terms of research.

Token Tech is a regular series that dives into the technologies that underpin the tokenisation and digital assets rails that are powering Wall Street 2.0.