Fund tokenization has the potential to revolutionize traditional funds by making them more liquid, more accessible, and more efficient.
What is fund tokenization?
Fund tokenization is created by a piece of computer code, a file, a digital contract on a blockchain that produces a digital token to represent a unit of ownership in a fund, record its regulatory status and transaction history, and the asset characteristics of the fund’s underlying assets.
The digital token will be stored at an address on a computer network, and the investor will receive a pair of keys: a public key and a corresponding private key. The investor’s public key will be linked to their network address and can be thought of as akin to an IBAN for a bank account. Their private key, similar to the PIN number of a bank account, will be secured in a digital wallet.
For decades, paper records of asset ownership and transactions were dematerialized and stored electronically, leading to the question: How is a token in a tokenized fund different from a dematerialized paper record of asset ownership?
Dematerialized paper records are held in a centralized database managed by a trusted party. In contrast, tokens are held on a blockchain, which forms part of a decentralized ledger technology (DLT). The blockchain is decentralized, meaning each node of the DLT maintains a synchronized ledger of all token transactions across all the nodes of the network.
It is easier to own and transfer tokenized funds because the rules governing these two activities are embedded in software code, thereby reducing the dependence on certain intermediaries.
To date, investing in private debt, private equity, infrastructure, and real estate has been largely restricted to institutional investors whether by regulation, large minimum investment amounts, requirements for long lock up periods, absence of any realistic secondary market, limited liquidity, or other barriers to investment.
How does one tokenize an investment fund?
The first step in tokenizing a fund is to choose the jurisdiction of issue, taking into account the legal and regulatory framework.
Thereafter, funds need to consider the following:
1. The choice of blockchain network: This entails deciding between a private or a public blockchain, considering ownership of the data infrastructure, and determining whether a permissionless or a permissioned blockchain is more suitable for the use case.
2. Governance of the blockchain: Particularly in relation to the handling of forks as these have serious legal and tax consequences for investors in the fund.
3. Characteristics of public blockchains, such as the Bitcoin peer-to-peer network:
a. Pseudo anonymous in terms of the identity of holders of bitcoin, the number of bitcoin at an address on the network, and transactions made by the holder of the private key to that address on the Bitcoin network,
b. Censorship resistant in that no single entity or group can easily manipulate or block transactions, control the supply of bitcoin, or prevent users from participating in the network,
c. Transparency, and
d. Reliance on probabilistic settlement.
By contrast with public blockchains, a tokenized fund requires:
(i) Identification of unit holders for KYC-AML-CFT purposes;
(ii) Compliance to provide access to the blockchain for financial services regulators and auditors;
(iii) Confidentiality in relation to the identity, number of holdings, and transactions carried out by the holder of the private key to an address on the network;
(iv) Deterministic finality as investors cannot accept an investment fund in which their purchase of tokens representing units in the fund has only a high probability of settlement but lacks an absolute guarantee.
Settlement finality is usually achieved by ensuring that both the buyer and seller involved in a token transaction acknowledge the finality of the transaction.
4. The characteristics of the tokens representing the units in the fund, e.g., any lock-up period, any investor qualification rules, such as professional investors only, jurisdiction of residence of investors, and division of assets with traditionally high minimum investment amounts into smaller and more affordable tranches.
5. The extent of any secondary market trading in the tokens and choice of a suitable trading venue.
6. The choice of entity to provide the tokenization service.
7. The information to be encoded in the token, such as the private placement memorandum and compliance requirements for the transfer of tokens.
8. Choice of authorized and regulated service providers that can collectively work together to deliver services to a tokenized fund.
9. Decision regarding whether a custodian will hold the private keys to the investors’ tokens, if investors will hold their own private keys, or if investors will have a choice in how they hold their private keys.
10. How investors will interact with the tokens and underlying blockchain, e.g., via a smart phone app linked to their bank account.
11. Oracles1 required to provide real-world data to the blockchain, for example, updates on the state of assets with limited useful life that depreciate in value over time, updates to footfall in relation to retail outlets in a real estate fund, or to the price of gold in a physical gold fund.
12. Writing the code for the relevant smart contracts for the tokens to pay dividends to the token holders or permit the transfer of ownership of a token assuming such code is not embedded in the base layer of the blockchain.
Once these matters have been resolved and the offering documents have been approved by the relevant regulators, tokens may be issued to new subscribing investors.
Thereafter, tokens can be listed on any agreed trade execution venue to create a secondary market in the tokens, thereby increasing the liquidity of the tokenized fund.
What are the benefits of tokenization?
Benefits for investors:
1. Fractionalization of ownership of units in a UCITS or AIF allows funds, that traditionally have had high minimum initial investment amounts, can be offered in more affordable tranches, expanding the potential market for funds investing in sectors like private debt and private equity. This allows investors to diversify their portfolios and gain exposure to a wider range of assets while enhancing liquidity.
2. Secondary market trading of tokenized fund units among existing unit holders in the fund which creates a more liquid secondary market for the fund tokens, thereby widening the attraction of traditionally less liquid funds.
3. Appealing to a generation of technology-savvy investors who transact their banking and investments via smart phone and expect 24/7 service.
4. Increased transparency of certain underlying investments such as real estate AIFs.
Benefits for asset managers:
1. Tokenization allows asset managers to create more diversified portfolios with both tokenized traditional funds and crypto-assets, all of which could be held by an investor within a single digital wallet.
2. Lower operating costs for a UCITS or AIF once the entire workflow has been digitized.
Benefits for service providers:
1. The blockchain provides a shared single source of truth for all fund service providers eliminating the need for constant reconciliation, removing the delays caused by sequential processing by fund service providers, and automating workflow processes such as payment of dividends or profits and communicating with token holders. Reconciliation reduction does not preclude continuing regulatory requirements for data and asset integrity oversight by certain service providers.
2. Settlement of trades in the tokens is faster.
3. The blockchain provides an auditable trail of transaction history and ownership records.
What are some of the biggest challenges in tokenizing assets?
Tokenization lacks a fully developed and comprehensive legal and regulatory framework. However, jurisdictions like Singapore, France, Germany, and the United Kingdom are making significant strides in the development of a comprehensive legal framework for tokenization.
As tokenization is a “new technology,” it requires significant investigation, internal reviews, and board approval by organizations all of which take time.
KYC-AML-CFT may also need to extend to the payment of “gas” fees2 to entities staking crypto-assets in a proof of stake consensus mechanism on the blockchain employed for tokenization.
Are tokenized units in AIF and UCITS funds regarded as crypto-assets for regulatory purposes?
In the EU, tokenized units in AIF and UCITS funds are regarded as financial instruments under MiFID rather than crypto-assets under the forthcoming EU MiCA Regulation.
How might fund tokenization change the shape of private equity, private debt, infrastructure, and real estate funds?
From a regulator’s perspective, tokenization has the potential to reduce information asymmetries. At the 2023 Managed Fund Association’s global summit in Paris, regulators noted a lack of visibility of concentration risks, liquidity risks, and synthetic leverage risks3 in private funds which might potentially alert regulators to links to other parts of the financial sector.
Fund tokenization can provide clear information regarding the issuer of the token, the asset characteristics of a fund, and details of the buyer, seller, and price at which transactions are executed thereby reducing information asymmetries and potentially improving the price discovery mechanism.
Is tokenization suited to cross border distribution?
Conceptually, tokenization is very suited to cross border distribution. The EU regulatory framework for the distribution of units in AIF and UCITS funds is particularly suited to the cross-border distribution of tokenized funds.
However, the regulations and the legal status of tokens in a tokenized fund vary across international jurisdictions potentially hampering their global cross border distribution.
Have any asset management firms tokenized funds or other assets?
At time of writing, the author is aware of four investment management firms that have reported tokenized funds or assets. Table A below summarizes details of their tokenization of assets.
Table A
Asset Management Firm | Type of Asset or Fund Tokenized | Brief Details |
|---|---|---|
Apollo | Digital Mortgage Loans | Provenance blockchain with Figure Lending LLC, a fintech company, to facilitate the origination and transfer of digital mortgage loans using blockchain technology. |
Franklin Templeton | US Government Money Fund | Polygon blockchain enables the fund to be compatible with the Ethereum blockchain. |
Hamilton Lane | Global Private Assets Fund | The minimum investment size was reduced from US$125,000 to US$10,000. Tokens are listed on ADDX, a digital securities exchange in Asia. |
KKR | Private Equity Fund | The minimum investment amount was reduced, and Securitize, a digital asset securities firm, was used to issue, manage, and trade the digital securities on the Avalanche blockchain. A trading system for the tokens may be offered at a later stage. |
What are the management challenges in tokenizing funds?
To get the maximum benefits from tokenization, an organization must add the new and disruptive technology of blockchain to its existing IT infrastructure which requires the digitization of the entire workflow.
The management challenges include:
- The coordination of the legacy and new blockchain technology.
- Differences in culture between the operators of the legacy technology and those of the new blockchain technology.
- The transition to tokenized funds presents a somewhat all-or-nothing scenario where incorporating a small number of the tokenized benefits can hinder efficiency improvements. To achieve cost savings and revenue growth, it is necessary to fully digitize the workflow surrounding and within the blockchain technology.
For the best customer experience, the infrastructures of different blockchain venues and pools of liquidity for units in funds must interact seamlessly with one another and with centralized systems linked to blockchain networks. Standards of interoperability need to be negotiated within the industry to deliver this high level of customer service and gain the network effects that increase the attraction of adoption for other players.
1Blockchains are typically designed to operate in a self-contained manner, with limited access to external information. Oracles bridge this information gap by fetching real-world data from trusted external sources and making it available on the blockchain.
2Gas fees refer to the cost associated with executing transactions or smart contracts on a blockchain network. Gas fees are primarily associated with blockchain platforms that utilize a mechanism called "gas" to allocate computational resources and prevent network abuse.
3 Particularly in relation to uncleared bilateral derivatives.
Conclusion
While fund tokenization is not without its management, legal, and regulatory challenges, it has the potential to transform the shape of private asset funds and resolve the concerns of regulators regarding such assets.
There are significant benefits in terms of lower costs and higher revenues for service providers and asset managers. Investors find the ability to diversify their portfolios and enhance the liquidity of their investments very appealing.
A number of major players in public and private markets are starting to successfully tokenize funds or other assets.
