How Tokenisation Could Redefine How the Funds Industry Operates

Introduction

Tokenisation, the process of converting an asset or the ownership rights of an asset to a digital form using blockchain technology, has gained significant traction throughout the financial services industry. In the rapidly evolving world of finance, the advent of Distributed Ledger Technology (DLT) and tokenisation is poised to revolutionise the funds industry. This article explores the transformative potential of tokenisation, its impacts on various stakeholders, and the associated benefits and risks.

The Technological Backbone: Distributed Ledger Technology (DLT)

DLT, the technological backbone of tokenisation, represents a paradigm shift in data management. It offers a decentralised model that enhances security and relinquishes the need for a central authority. DLT allows updates to be independently recorded by each node in a network, with the integrity of these updates safeguarded by a consensus mechanism. This groundbreaking technology forms the foundation of blockchains and offers unprecedented levels of transparency, significantly reduces the need for reconciliations, and enhances the reliability of data. However, it’s important to note that DLT is not without its challenges, including the complexity of the technology, scalability issues, and regulatory concerns.

DLT’s decentralised model is a significant departure from traditional data management systems, which rely on a central authority to maintain and update the database. This decentralisation enhances security by eliminating a single point of failure and allows for greater transparency as all nodes in the network maintain a copy of the shared database. This transparency is further enhanced by the consensus mechanism, which ensures that all updates are agreed upon by the majority of nodes before they are recorded. This ensures a single version of truth across the network, reducing the potential for discrepancies and conflicts in the data.

Impacts for Investors

Tokenisation has the power to reduce minimum investment thresholds by fractionalising assets, a process that divides high-value assets into smaller, tradable units. This concept, while not new, is being revolutionised by blockchain technology. In the past, retail investors encountered significant limitations when attempting to invest in private assets. These constraints stemmed from factors such as high minimum investment thresholds and limited asset liquidity.. Fractionalising assets reduces these barriers, and with the increased efficiencies that fund tokenisation can lead to, it is likely that private asset funds will be more accessible to a wider cohort of investors, including retail investors.

Tokenisation also streamlines the process of fund ownership and trading. Investors can buy, sell, and transfer tokens more efficiently due to the digital nature of the blockchain. This increased efficiency can lead to faster transaction times, lower transaction costs, and greater market liquidity. Furthermore, the transparency provided by blockchain technology can enhance investor confidence, as it allows for greater visibility into the fund’s operations and performance.

Impacts for Investment Managers

Fund liquidity continues to be one of the most significant risk areas for funds, particularly for those investing in real-world assets. Tokenisation can increase a fund’s liquidity by fractionalising  lumpy assets into numerous tokens, thus widening the scope of potential investors and reducing the cumbersome nature of selling these assets.

The increased liquidity provided by tokenisation can also reduce the risk of price manipulation, as it allows for a larger number of participants in the market. This can lead to more accurate price discovery and a more efficient allocation of resources. Furthermore, the ability to fractionalise assets can allow for greater diversification within a fund’s portfolio, as it allows for the inclusion of a wider range of assets.

Impacts for Delegates

By tokenising the shares/units of a fund, there may also be administrative benefits that could improve the subscription and redemption process for investors. The smart contracts that will be the basis of ownership for the investment can have built-in procedures that can be triggered once certain procedures are met. This will allow for a more automated documentation process.

The ownership of a token can also be used to validate voting rights, thus allowing the investor to directly participate in the voting process. This streamlined voting process would reduce the need for intermediaries, as the vote is executed automatically through the smart contract.

Tokenisation offers a unified truth source for all fund service providers, eliminating reconciliation needs, reducing delays from sequential processing, and automating workflows like dividend payments and token holder communication.

Benefits of Tokenisation

Reduced Complexity and Costs

Tokenisation can significantly reduce the complexity and costs associated with traditional fund management. With all parties having a single ledger, there is a decrease in the need for trade confirmations and reconciliations between back offices after the trade has occurred. This can lead to substantial cost savings and operational efficiencies.

Democratisation of Markets

Tokenisation can democratise markets by lowering minimum investment requirements. This provides greater opportunities to a wider range of investors, particularly retail investors who have traditionally been limited in their ability to invest in private assets.

Growth Opportunities for Transfer Agents and Fund Administrators

The process of tokenisation could provide transfer agents and fund administrators with opportunities to grow their market shares. Their revenues and profits could grow through cost efficiencies due to more automated processes.

Increased Liquidity

Tokenisation can increase a fund’s liquidity by fractionalising large scale assets into tokens. This widens the scope of potential investors and reduces the cumbersome nature of selling high-value assets.

More Diversified Portfolios

The ability to fractionalise assets can allow for greater diversification within a fund’s portfolio, as it allows for the inclusion of a wider range of assets.

Risks of Tokenisation

Potential Unsettled Transactions

Tokenisation does not remove the potential risk of transactions not being settled by one party. This risk needs to be effectively managed during the post-trade process.

Increased Operational and Legal Risks

In the short term, there may be a rise in both operational and legal risks. Even though the risks have been diminished in account-based settlement systems that are well established, a move to new processes and platforms and a transition to tokenised assets would result in those risks reappearing.

Cybersecurity Threats

As an emerging technology, tokenisation faces significant cybersecurity threats. Without the implementation of robust systems, the tokenised assets could potentially be compromised by malicious actors.

Regulatory Risks

The lack of regulatory frameworks present an increased regulatory risk as firms within the fund industry would be unsure about the risk controls they should be implementing for the purpose of compliance. There shall be regulatory developments to ensure adoption of tokenised assets and a framework and confines for asset companies to work within.

Conclusion

Tokenisation is an emerging technology that holds immense potential to transform the funds industry. However, it also brings new challenges and risks that need to be addressed. As we continue to explore and expand its applications, it is crucial to develop robust systems and regulatory frameworks to ensure the secure and efficient implementation of this revolutionary technology. The journey towards tokenisation has begun, and it promises to be an exciting one, filled with opportunities and challenges alike.