What fund managers need to know about tokenisation

Looking back on the key developments in 2022, it is clear that whether you have concerns about innovation, regulation, or changing stakeholder roles, tokenised funds are set to transform the investment management industry and that change is coming fast, by Daron Pearce, the founder and CEO of Daron Pearce Associates.

Private market investment firms

Hamilton Lane and Partners Group have already launched tokenised funds. Digital Funds recently filed to launch a tokenised S&P 500 EW Index Fund and Abrdn plans to launch a tokenised fund.

The Investment Association (IA) is lobbying for the approval of blockchain based funds. This is no surprise given that increasing investor demand for tokenised funds coincides with a time when the funds industry is seeking to boost its competitiveness in a rapidly evolving global market.

Chris Cummings, IA Chief Executive argues that, “Greater innovation will boost the overall competitiveness of the UK funds industry and improve the cost, efficiency and quality of the investment experience.”

Nadine Chakar, until recently head of digital assets at State Street views tokenisation as a more fundamental shift, quite simply that it will “… change everything that we do.”

In this context, it is key that fund managers understand:

• How today’s investors have changed

• What the pace of change might look like

• The benefits and challenges of tokenised funds

• How to manage industry scepticism

The bottom line is that fund managers need to recognise and begin to influence those factors shaping end investor preferences, as well as the necessary investment architecture. This will enable them to lay strong foundations for their future success.

Investors have changed Fund management operating models can be highly complex, structured around a web of intermediary relationships which stand between the fund manufacturer and the end investor. These models, perhaps designed to mitigate investment risks, have resulted in an inaccessible market that multiplies transactions and increases costs for the end investor. Such an inefficient model was immediately challenged by the blockchain vision of a peer-to-peer distributed ledger which removes multiple intermediary layers, supporting a simpler and arguably more effective model for fund governance and distribution.

But this wholesale disruption of the traditional market is not simply down to innovations in technology. In a report earlier this year, the IA identified three societal factors driving the adoption of tokenisation in the UK fund industry:

1. A gradual shift from ‘deference’ to ‘reference’ which could challenge the role of fund managers and see them facing increased competition to remain relevant.

2. Hostility from millennials towards the traditional roles of capitalism: This creates opportunities for alternative or new disruptors— especially since millennials are set to inherit over £5.5 trillion in the next 20 to 30 years.

3. New variations on the traditional understanding of investment driven by the pandemic, specifically an increase of direct investing by Gen Z (18-23), the rise of ‘amateur’ traders, alternative investing, and influencer advocated investment strategies.

Fund tokenisation is being driven by the persistent pressures of economic disruption, customer expectations, and a drive towards investment democratisation. Fund managers need to reconsider investor objectives or risk being left behind in an increasingly fast paced industry.

The pace of change

While it is true that shifts in societal attitudes towards investment are key to the disruption of fund management, the future of tokenised funds depends on the level of technological change that the industry adopts in response to these changes.

There continues to be an increase in the pace of the move towards tokenised funds. For example, On September 13 2022, Securitize, a leading digital assets securities firm, announced the launch of a fund tokenizing an interest in KRR’s Health Care Strategic Growth Fund II (“HCSG II”) on the Avalanche public blockchain.

John Wu, President of Ava Labs, which is part of the strategic partnership, explained that “Financial markets demand innovation, and over the last two years we’ve seen dramatic leaps forward in the evolution of real-world assets moving onchain and delivering on the promise of breakthrough technology for institutions.”

To open up funds to a new audience of investors, leading investment firms need to form a technology strategy for fund management. But what could this vision of the future look like?

Once again, The IA has identified three possible scenarios for change:

1. Business-as-usual enhancement: This is a more efficient version of today’s funds, which enables improved speed, scale and efficiency with new technologies. tokenisation is used to enable fund shares and underlying assets classes to be traded.

2. Innovative evolution: This scenario uses technology to change the nature of the key stakeholders and the investment opportunity set. It supports more tailored portfolios through investor preferences and broader market access.

3. Transformative change: Technology changes the relationship between the customer and their portfolio, so risk and return can be tailored at stock and securities level, instead of fund level. The role of the investment manager is changed as customers exercise greater control.

Whether tokenised funds will become a more efficient version of existing funds – a T share class for example – or a completely new concept depends in part on the level of participation that consumers demand.

The benefits of tokenised funds

The market opportunities for tokenisation could be game-changing for an industry that suffers from low margins and high competition.

Some industry experts see tokenisation as an opportunity for a better system that works for investors and fund managers with tokenised funds delivering greater transparency, improvements in data and analytics and perhaps most importantly instant atomic settlement.

It’s no surprise then that fund managers are already thinking about the possibilities. In 2022 Token City found that 73% of fund managers identified private equity assets and 65% pointed to hedge fund assets as most likely to be the first to see significant levels of tokenisation.

The impact on investors can only be positive, especially as there is fundamentally no difference between investing in a tokenised fund and a ‘traditional’ fund. The investor simply holds tokens in a digital wallet via an App on their phone.

So, what are the expected benefits driving the expectations of different industry stakeholders?

The key proposition for fund managers is:

• Instantaneous settlements with appropriate payment methods

• Immutable transaction records for quality reporting

• Reduced risk with less intermediaries involved

The benefits for investors include:

• Democratized investment through lower lot sizes or partial ownership of assets

• Increased access to private markets currently only accessible to institutions

• Improved accessibility with realtime digital access

Regulators will have the ability to:

• Track the movement of tokens in realtime to ensure the integrity of data

• Encode investor’s rights, legal responsibilities and limitations, and ownership records into funds

• Use smart contracts to automatically notify of regulation breaches While these benefits lay the groundwork for the creation of a financial system that revolutionises how investment funds work, the challenge is to realise the benefits for all parties.

The challenges of tokenised funds

Change will always be uncomfortable, but tokenised funds fundamentally challenge the way that existing financial systems work.

That said, in a recent address, Mairead McGuinness, the European Commissioner for Financial Stability reminded her audience at the Banque de France conference that “regulation and innovation are not in conflict.”

The desire for change is clear. So, what are the challenges that fund managers need to overcome?

• Regulation prevents change: Existing regulation supports the current financial model, so international rules and regulations are needed to enable cross-border funds

• Systems constrain interoperability: There is a risk of creating siloed assets that don’t communicate with each other and limit the traceability of transactions

• Blockchain technology is immature: Modernising and updating the existing financial infrastructure will occupy budgets and resources in difficult economic times

• Complex stakeholders make consensus slow: Change depends on the collaborative efforts of investors, asset owners, banks, regulators, industry associations and global financial markets

• Limited investor knowledge: Investors need to be equipped with the knowledge to make informed choices when new products become available

• An evolution of existing roles: Tokenised funds cut out intermediaries, so traditional institutions will need to adapt to new competition in the market

It is critical to the growth of the industry that different stakeholders work together to enable new products and solutions, especially when these challenges could be an opportunity to future-proof UK investment funds.

How to manage industry scepticism

Tokenisation still raises mixed views from established fund managers.

Catherine Valega, a wealth consultant at Green Bee Advisory says, “Retail investors will often skip the more boring financial planning tasks— emergency funds, insurance, maxing out retirement contributions—and jump right into these investments.”

Securitize CEO Carlos Domingo takes a different view: “Tokenization has the potential to address many of the biggest challenges for individual investors seeking to participate in private market investing by enabling technological and product innovations that were not possible before.”

So, what are the tokenisation skeptics worried about and how can we address their concerns?

The most common objections to tokenisation are:

• The technology is not ready for mainstream adoption: Fund managers are often concerned that digital accounts can be manipulated or that the blockchain can be altered. Organizations can mitigate these risks by monitoring the development of the technology and establishing robust risk management strategies that include governance and security.

• Infrastructure needs to evolve to support tokenisation: As new tokenised funds emerge, legacy players will need to evolve their issuance, risk and compliance, and identity management to innovate their offerings. Funds that take advantage of partnerships with new tokenisation platforms will be able to accelerate their infrastructure maturity.

• The pace of innovation makes the future of funds hard to predict: The future landscape is hard to predict, specifically in terms of the role of traditional funds and the speed of change. Organizations will need to adapt to demands for new functionality and improved user experience as value propositions evolve with technological innovations.

It is evident that tokenisation has the potential to transform today’s financial infrastructure. The pace and depth of change depends on the ability of fund managers to confront industry skepticism and to offer solutions that resolve the challenges of tokenisation.

How to reinvent funds for tokenisation

It is evident that, to reinvent funds for tokenisation, we need to let go of traditional ideas of fund management in favour of the democratization of investment.

However, a difficulty for fund managers is that traditional operational and regulatory structures need to be changed to support tokenised funds.

A 2021 report by Roland Berger identified a four-step approach to preparing for the shift towards tokenisation:

1. Evaluate the implications of tokenisation: Fund managers should evaluate the potential impact of tokenisation on their business model and assess the relevant risks and opportunities

2. Define your target position: Decide whether you want to be a frontrunner or follower and draw up scenarios for development and score them against their value, feasibility and cost

3. Develop a capabilities roadmap: Map the capabilities that you need to achieve your target position in terms of technology, business model, and regulation

4. Think about implementation: Start to develop your in-house skills and either build a user interface or partner with technology vendors

In addition to developing an internal strategy, fund managers need to develop broader industry relationships that help them to:

• Push for an established framework for tokenised funds to operate in the UK

• Address the need for regulation that adapts quickly to emerging developments

• Enable transparent digital information and disclosure to investors

This will help the industry to protect the UK’s position as a cutting-edge financial centre focused on supporting new developments.

Conclusion

There’s no mystery as to why customers want increased customisation and participation and greater control over their portfolios. With no end to technological innovation in sight, the need for financial institutions to reduce complexity, cost, and improve accessibility has never been greater. The industry’s ability to modernise investment funds will rest on their understanding of the challenges and opportunities that underpin the global adoption of tokenisation.