Blockchain for pensions: How distributed ledger technology can aid digital transformation

16 November 2023

You cannot live and breathe digital transformation in the pensions and investments market, as Dunstan Thomas do, without exploring the potential merits of distributed ledger technology.

Distributed Ledger Technology

Distributed ledger technology (often referred to as DLT or blockchain) is a key enabler of faster, and potentially more secure digital trading and record keeping. The “distributed” nature of transaction records, and the fact that the data is secured using sophisticated cryptography within the blockchain, assures this.

In the asset management world, managers are already using distributed ledger technology as the infrastructure on which to create innovative new digital, “tokenised” investment offerings. Tokenisation in finance refers to the issuance of securities as native digital assets, which means that they can be recorded, moved and stored on the blockchain in a transparent way. Simply put, a token is a wrapper that encapsulates value and/or data.

Distributed ledger technology therefore broadens market opportunities for smaller blocks of assets, improves data transparency, as well as having the potential to bring greater liquidity to niche markets. All blockchain data is encrypted to ensure immutability and trust of a ledger is maintained within an ecosystem — be it private or public.

Tokenising of assets

If you apply the idea of tokenisation to assets in funds, you could potentially offer bite-sized chunks of funds that were previously limited to institutional investors — investing in private equity-backed businesses, for example. This has the potential to bring many more investors into markets that hitherto have been the preserve of institutional money only. More investors normally bring greater liquidity.

The blockchain can also be used to move money in and out of these digital assets rapidly and cost-effectively. It is no surprise that Abrdn recently tokenised one of its flagship funds — the Aberdeen Standard Liquidity fund, which is a sterling-denominated money market fund with £15.7bn of assets. Abrdn worked with the digital securities exchange Archax — which it bought in 2022 — to complete the tokenisation work.

But how might distributed ledger technology be applied to digitisation challenges that the pensions world is addressing right now? DLT is particularly well suited to applications that demand tight data security, identification management and security, as well as those enhancing operational efficiency and streamlining regulatory compliance and reporting.

Streamlining client onboarding

So, DLT could logically be applied to the challenge of client onboarding, particularly to elements of onboarding associated with authenticating that you are who you say you are online. DLT’s architecture is ideally suited for authenticating new customers. You might share data about yourself with the relevant DLT. That personal data is then able to check the data against multiple third-party sources to verify that data and identity.

Preventing Pensions Fraud

Distributed Ledger Technology could then be used to prevent fraud and pension scams by blocking unauthorised access to policies and preventing data modification, which might be a prelude to attempted access to accounts. Access and adding to data records can only be done by authorised parties, which you as the data owner must authorise.

The distributed ledger then verifies that any change or transaction is correct. A complete and accurate record of the history of all transactions and data changes is assured by using a chain of blocks that stores the hash of the previous block, making it impossible to alter or delete any record. Records can only be added to as new activity takes place.

Reducing slow pension transfer times

Our industry is dogged by regular complaints of slow pension transfers, often accompanied by unhelpful accusations that the current fund holder is deliberately slowing things down to enjoy their ad valorem fees for a little longer. Various organisations, including Origo and the Financial Conduct Authority, measure average transfer times and find that they have stuck stubbornly at around two weeks. This could be another area where DLT could make a quantum leap and drive us to markedly shorter transfer times.

It would be great if we could drive transfer times down from days to hours or even minutes. Maybe a transfer could be fully completed, and money allocated at the destination — all within the duration of a client visit?

Smart contracts and Collective Defined Contribution schemes

The strength of distributed ledger technology in identification and authentication can be carried through automatic creation of what is often referred to as “smart contracts”. These are ideal for financial decisions linked to recovery periods, deficits or surpluses, which can be automated using DLT as the technology backbone.

There has been some discussion already about applying DLT to help eliminate the possibility of over-consumption of collective defined contribution pension funds today, at the expenses of future beneficiaries who need to rely on their share of a CDC at some point long in the future.

So potentially, DLT offers a route to automating decision-making that ensures intra-generational fairness — a key concern for this new breed of occupational pension scheme that has just gone live.

24/7 Clearing and settlement

DLT is also being applied in the world of banking for 24/7 clearing and settlement. For example, Citibank is already using DLT to allow both its institutional and corporate customers to turn cash into digital tokens, thereby making it easier to move money around the world at times when traditional financial markets are closed.

The current UK practice that funds are valued once a day seems rather dated now. It was around 50 years ago that unit-linked pensions and savings took the market by storm. While daily pricing is fine for small regular contributions, it is not great for large sums if the market moves between the time the client decides on a course of action and the fund’s valuation point. DLT offers help in moving transactions much closer to the time of the actual investment decision.

The largest financial messaging system in the world, Swift, has teamed up with Chainlink, which offers middleware that connects blockchain-based smart contracts with external data such as share prices. Chainlink enables non-blockchain enterprises to securely connect with blockchain platforms.

Together, Swift and Chainlink have built a credible proof of concept with the power to scale tokenisation. This proof of concept had collaboration from more than a dozen major financial institutions, including Australia and New Zealand Banking Group, Depository Trust & Clearing Corporation, and Lloyds Banking Group.

It successfully demonstrated the transfer of tokenised assets in multiple cases. Transfers were completed between two wallets on a single DLT network (Ethereum), between two wallets on different DLT networks (Ethereum and Avalanche), and from a public DLT network to a private network (Ethereum and Quorum). This experiment shows that financial institutions can build on existing back-end systems — minimising the level of investment needed — to transact across public and private blockchains and leverage the Swift global messaging network.

It has the potential to enable parties to trade and settle directly with each other within minutes, and at low cost. Customers will benefit not only in terms of access to higher growth assets, but also the ability to move seamlessly between assets and providers without incurring heavy transaction fees, and with much smaller times out of the market.

It is this sort of technology that will enable new mobile trading and banking apps to offer the “man on the street” a small piece of an asset class that was, until very recently, the preserve of the institutions alone. Providing data security and investment guidance is there, this can only help stimulate more of us to save for a rainy day and eventually enable a more comfortable retirement.

Application of distributed ledger technology based tools offers providers and platforms alike the ability to expand investment options for pension savers in line with the chancellor’s “Mansion House compact” goal. It also offers the potential to increase the efficiency of digital-only services for customers, as well as offering the potential for strong authentication, swifter onboarding and transacting.

For providers and platforms, its record-keeping strengths are also well suited to supporting regulatory compliance demands, which will only increase as more digital token-based investment products are authorised by regulators and reach the advice market.

In addition to all the benefits discussed above, the revolutionary potential of DLT is that it makes the end investor the owner of his or her own data. They will be able to give financial service providers access to appropriate personal data as required, rather than the other way round.

The investor is in control and can deal with multiple financial service providers in a radically more flexible and efficient manner, creating plenty of new options as the consumer is more empowered.

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