Tokenised Financial Assets are Bringing New Opportunities to Industry Stakeholders

Arnaud Misset (Caceis) looks at the opportunities and risks with tokenised financial instruments and the roles that all industry stakeholders in Europe will play in this rapidly developing area.

Technology is driving major change in the financial services industry, bringing in new ways of creating, accessing, managing, distributing, and holding assets. Regulators and industry participants need to be proactive in this area both to take advantage of the opportunities and manage the associated risks.

Distributed Ledger Technology

The foundation for this digital revolution is Distributed Ledger Technology (DLT), with Blockchain being the best known DLT protocol. Every transaction is logged into a data block and then validated, with any subsequent transaction containing common elements, forming a link to the previous one. The validation mechanism and links make chains of data blocks nearly impossible to break, so Blockchain’s “shared record of truth” is considered tamper-proof.

Asset Tokenisation

Tokenisation involves the digital representation of physical assets on distributed ledgers, or the conversion and issuance of traditional asset classes in tokenised form. Tokenised assets can be stable coins (cryptocurrency pegged to a reference asset), securities tokens (representations of financial instruments or cash certificates), non-fungible tokens (NFTs - a digital identifier of ownership), or a central bank digital currency (CBDC – a digital currency with the same functions as a traditional currency).  The tokens are usually kept in a digital wallet with a public cryptographic key as the account number and a private key required to access the token.

Practical uses and considerations

Most of the world’s Central Banks are looking into using CBDCs as it offers huge potential operational efficiency gains. CBDCs would also help legitimise DLT and drive further adoption in the financial industry as so much more could then be handled “on chain”. Assets can be managed and exchanged globally in real time, facilitating areas from trade settlement to cash payments (DvP), and delivery of funds to recordkeeping. Today, cumbersome verification by a central entity is required for many such tasks but Blockchain’s decentralised nature changes that.

Private Equity and Real Estate

Even in the slow-moving, traditional paper-based, world of real estate and to an extent Private Equity, where processes like change of ownership and transactions are subject to costly delays, tokenisation can facilitate access and raise efficiency by converting real assets to tokens held on a Blockchain.

Other than these clear operational efficiency aspects, tokenisation can be employed to enhance the liquidity of illiquid financial instruments. Real estate investment locks away investor capital for long durations and is difficult to reconvert to cash quickly if required. In the form of a token, real estate investments can be traded around the clock on a global basis at current market values and without the need for a costly intermediary. Bonds is another area to which tokenisation can bring advantages in terms of liquidity, with potentially lower fees and quicker settlement times too. It is nevertheless important to note that all this is more a “perception of liquidity” as the underlying asset generally remains illiquid.

Fractional Ownership

Certain private markets such as private equity and real estate, effectively exclude retail investors through high minimum investment thresholds in traditional REITS and long-term capital lock-ups. These non-market-linked investments offer excellent portfolio diversification possibilities and asset tokenisation can play a role in helping retail investors gain access through the concept of fractional ownership. Like shares, tokens can represent a stake in a physical asset that would not normally be divisible. Multiple owners can invest in the asset, be it a large company or a small house for rent, and reduce their overall exposure to risk.

Benefits to fund managers

Tokenisation can play a role in improving and facilitating distribution of private assets in funds, by streamlining distribution on a cross-border basis and opening up the market for illiquid assets to a wider range of investors. The rapid and highly efficient rebalancing of open-ended funds’ portfolios possible with tokenised assets, enables managers to react to market changes or regulatory measures and remain in compliance with their investment policy’s illiquid asset exposure limits while making significant cost savings.

Regulatory landscape

There are exciting future opportunities for wider applications for this innovative technology but it must be accompanied by a robust regulatory framework. The European pilot regime for financial securities on Blockchain came into force on 23rd March 2023 as an EU-wide experiment lasting three years, with the possibility of another three-year extension. It allows for tokenised fund shares to be bought and sold on a secondary market, and removes obstacles while maintaining security and harmonisation of EU law, although not surprisingly, regulators are focused on consumer and investor protections, along with risk policies, procedures and controls.  We should also see the emergence of delivery versus payment on blockchain (DVP on chain) with an acceleration of the work of the European central banks at national level and of the Eurosystem on Eurodigital.

Regulation in Ireland

As for tokenised traditional assets, amendments to Irish MiFID Regulations on 23rd March 2023 defined a “financial instrument” as one listed in Schedule 1 to the Irish MiFID Regulations issued via DLT, potentially permitting Irish funds to invest in tokenised financial instruments. On 4th April 2023, the Central Bank of Ireland clarified its position on Irish-domiciled UCITS and AIFMD funds’ exposure to “digital assets”, specifically those based on an “intangible or non-traditional underlying” which means cryptocurriencies or NFTs but not tokenised traditional assets. Closed-ended QIAIFs, open-ended QIAIFs, with or without limited liquidity, can have indirect exposure to those digital assets subject to certain conditions. However, QIAIFs are not allowed direct exposure until the Central Bank is satisfied that depositary safe-keeping rules are met. UCITS and RIAIF funds, are permitted neither direct or indirect exposure.

Managers need a clear understanding of how regulators classify tokens to be sure that investors can hold and exchange digital assets in the same manner as traditional assets. This is where collaboration with a service provider is key to ensuring a favourable outcome for managers and investors.

The role of the Custodian

Custodians have an important role to play in the widespread adoption and creation of digital assets, harnessing their existing expertise to ensure digital asset security and efficient transactions. Safeguarding and controlling access to private keys to the underlying assets must offer the same level of security as for traditional assets, so building clearly defined access controls and procedures, will further strengthen the value of custodians. AML is also a key consideration, due to investors entering and exiting a structure. Depending on the type of issuer, we need to consider and ensure compliance with all related regulations. Practical aspects, such as corporate actions, must also be embedded into tokenised financial instruments. This can be achieved with ‘smart contracts’, (essentially programmes stored in the Blockchain) that run when predetermined conditions are met.

For such state-of-the-art technology, custodians need to develop a strong network of partners that can replicate what is done in the traditional space to digital assets.  Operationally, a custodian should designed specific processes and procedures to handle both traditional and digital assets at the same time with consolidated reports.

In a major development for CACEIS Bank in France, the AMF approved its Digital Asset Service Provider (DSAP) application, making it the only DASP allowed to offer digital asset custody services to third parties. As a DASP, CACEIS is closely involved in the development of the digital asset ecosystem, demonstrating our desire to be at the forefront of asset servicing innovation. As CACEIS is now authorised to handle any form of digital asset, the group will soon implement a custody service for private keys, and tokenised assets or fund units. Within the framework of the Markets in Crypto-Assets Regulation (MiCA), similar applications have been filed by CACEIS’ other European entities.

Conclusion

The financial services industry will have to grapple with the introduction of Blockchain technology over the coming years. It’s clear that the speed at which digital assets develop will largely depend on regulators and Central Banks’ creation of digital currencies. We will likely see institutional investors driving demand for digital assets as a recent internal survey showed some 40% of asset owners had a strategy involving tokenisation. Investor and manager education on digital assets is going to be key, especially for compliance, risk and other oversight functions, such as fund boards and pension scheme trustee boards.