The Role of DLT in Supporting Emerging Markets through Foreign Direct Investment (FDI)
Poorly functioning judicial systems and unfamiliar business cultures impact the willingness of foreign capital to enter emerging markets.
While Europe and North America currently have rock bottom interest rates that return (in real terms) negative yields for some large asset classes, the potential gains in emerging markets are substantial and compelling for yield-hungry investors.
The first two decades of the 21st century have seen massive wealth creation in China and the Indian sub-continent. Some emerging market territories are now home to the highest concentration of billionaires and high net-worth individuals in the world. Anyone with an alternative asset investment strategy can see what an attractive investment opportunity such emerging markets present.
However, these investments often carry risks not found in the investors’ home markets: will a grievance be resolved fairly and efficiently? Will local business partners diligently execute upon what has been agreed? Quantifying these risks is challenging for asset managers, as is executing upon a post-investment management strategy that effectively handles the unique challenges of a specific emerging market.
The global financial crash of 2007/8 left an entire generation of asset and financial managers nervous of making deals in emerging markets. In one example of how judicial inefficiencies intertwine with local business cultures, the use of dollar denominated debt by Indian corporates became far more expensive (in their primary revenue currency) and defaults began soon after the 2008 crash. US and UK based asset managers found that, due to local judicial particularities, they were unable sue defaulting debtors unless they had originally purchased the debt via a specific type of Indian subsidiary (which few had). Once this emerged, defaults rose as firms that may have otherwise been able to honour commitments (even at great expense) broke covenants out of convenience.
Without a system to level the field, many have learned that the ease of avoiding such challenges outweighs the possible gains that can be had. While some research in this area points to the fact that the judicial and business culture risk is acceptable to firms that have made FDI in emerging markets (in this case specifically, Bangladesh), data are lacking when it comes to a quantification of how much FDI would have been deployed if not for these challenges.
Due to the COVID-19 pandemic, global FDI collapsed in 2020, falling by 42% to an estimated $859 billion, from $1.5 trillion in 2019. Even at today’s reduced rate, if 2.5% if of the total deployed capital was shadowed by potential investments that narrowly didn’t occur due to these concerns, it would mean an additional $21 billion could have found productive use emerging markets (and $38 billion in 2019). Emerging market investments furthermore often spark virtuous cycles of local demographic improvement. FDI funded projects aid the creation of a middle class with greater spending power and an insistence on better governance, regulation and public services.
A goal for Hunit is to aid the arrival of FDI in emerging markets. Hunit’s approach using Distributed Ledger (blockchain or DLT) based legal agreements is intended to increase the confidence of investors and result in an increase in new investments landing – capital which previously might have stayed in that tranche of ‘almost’ investments that didn’t occur.
Hunit’s technology platform allows for self-executing, legally binding smart contracts to become key infrastructure within a business relationship, helping to assure that the parties meet their obligations and guiding the execution of an agreement’s lifecycle. This in turn provides greater transparency and improved compliance by the agreement’s parties. Furthermore, Hunit’s Covenant Engine allows agreements to contain pre-planned and pre-permissioned remedies that are released if certain types of breaches occur – allowing many or most of the types of grievances that would have resulted in a court case can be resolved quickly, cheaply and predictably.
Digitalised agreements also offer novel way of handling equity ownership in regions that often have poorly functioning capital markets. By using DLT based smart shareholder agreements and equity shares, business owners and entrepreneurs can syndicate ownership effectively to access capital and find more viable exit options.
Moreover, the ways companies are run would be transformed in line with the added benefits of automated execution and reporting. The outcomes of poor business acumen are predictable and certain. When the consequences for missed reporting, or late submissions of investment documents are pre-agreed, businesses are incentivised to be better.
Without digitalised and automated contracts, FDI will remain a high-risk exercise. The decentralisation which DLT can usher in would bring better efficiency, and more opportunity to market participants. This levels the playing field (or at least makes it more level), opening the door for greater deployment of FDI in emerging markets.