Investment funds are very liquid products by design, so why look at their tokenization? This article considers the true benefits of tokenizing funds.

Freepik

The move to tokenization of specific asset classes is accelerating and there are various initiatives and real-world products that aim to arrive at a digitally-native future for financial services.

These cover a range of assets, like certificates, private equity, and debt, as well as investment funds, whether traditional or alternative. With regards to investment funds, in the US for example, a newly-created digital manager is launching a tokenized ETF and a tokenized fund that tracks an S&P 500 index. Going back further, there is also the Franklin Templeton money market fund launched one year ago. This is not to mention the numerous projects for real estate and alternative assets tokenization.

Such products aim at maintaining the shareholders’ register via DLT or blockchain-integrated systems and the goal of their creators is to grow more products that are fully blockchain-based and use the model of “full issuance on blockchain”. In this case, shares of a fund – backed by hard assets – exist as native digital assets on a blockchain from the outset.

These are early days of course for full issuance products. Often, parallel systems linked to traditional methods are currently run for compliance reasons, meaning that the transfer agent’s book entry record is determinative. But the objective is clear: the intention is to have mass adoption of tokenized products that can be bought, sold, transferred, pledged, and so on twenty-four hours a day at very low costs and to increase volumes and liquidity. Additionally, a future aim of such funds is to enable investors to trade peer-to-peer directly on a blockchain or a digital secondary market.

However, while this vision of mass distribution and investor engagement is extremely important and certainly going to happen, is it really worth it for products that are liquid by design?

The foundations for a new model

What is needed right now is a renewed focus and understanding of the benefits that tokenization can bring to efficiency throughout the fund industry.

In the US, the tokenization revolution started from a typical viewpoint of efficient markets and targets the mass market approach. This is perfectly logical and in line with the development of the capital market. US stock markets are extremely liquid, transparent, and efficient.

"Re-engineering the core of fund distribution creates efficiency for existing actors in existing networks, resulting in cost reductions and real gains in operations"

On the other hand, in Europe, fund distribution actors with their intermediated business and operating models – built up over many years – are trying to find solutions to two main problems: reduce operating costs and increase market penetration and size. However, under the current complex system with its many redundancies, this is extremely difficult. There are barriers for investors to access products efficiently and these make investment funds costly for investors and those running back and front office operations. This has created the need to have intermediaries that aggregate masses in order to share costs, to some extent.

This is not to say that mass adoption is being ignored but what is being done is the re-engineering of the core of fund distribution. So, in Europe creating efficiency for existing actors in existing networks, resulting in cost reductions and real gains in operations, can be considered the foundation stone of future success and wider adoption.

Core efficiency is key

DLT-based fund distribution is clearly the way to go: it enables a decentralized and shared infrastructure amongst the distribution chain’s participants for reducing costly barriers arising from operational inefficiencies. Nevertheless, it should be remembered that the ultimate reason for a shift to DLT as the core infrastructure is not only cost reduction and operational efficiency but also better distribution for all, especially for end investors.

It is the concentration on the core that allows an infrastructure to be responsive and able to provide solutions to the widest possible range of actors and the widest variety of business and operating models. The infrastructure that enables DLT-based order processing must be able to do the same for tokenized full issuance.

So what are the efficiencies produced by a DLT infrastructure? Firstly, it creates a real flow of data and information throughout a network. For fund distribution, a question that often arises in discussions around the use of DLT is: “That’s all very well, but why not just do the same via the databases that we have now?”

Looking at the level of architecture, suppose that you are an asset manager operating in a network of fifty or so actors each with its own data centers, which is often the case in investment fund distribution. These actors need to be able to communicate with one another to varying degrees. They can do this either directly through messages or a central database can be put in the middle of all of them. The central database would seem a practical solution but you would also have a significant central point of failure. Conversely, one can have all the data held in decentralized databases, all structured in the same way, and then agree to share a common layer. This common layer is the DLT.

"Shared decentralization and processes enable frictionless transactions and automation of workflows – all actors can have a real end-to-end view"

Looking at the level of day-to-day operations, DLT creates a common registrar of shareholders. Every party involved in, for example, a subscription operates in their own environment but sees – in a permissioned way – exactly the same information at the same time. This is the common vision of the process that leads to so many other day-to-day operational efficiencies.

Efficiency is improved through shared decentralization and processes that enable frictionless transactions and automation of workflows. All actors can have a real end-to-end view. DLT-based infrastructure for fund distribution means vastly improved and cost-effective connectivity between operations, distribution, and asset management.

Looking at the challenge from a regulatory viewpoint, If we return to the funds created by operators in the US, these – and their stable coins – are some way off from being accepted as regulated financial products. This explains why some chose to make their tokens accessible only via apps, even if the blockchain is a public one. On the other hand, In Europe, we have built a next-generation model that is fully regulated and uses a private blockchain. This means that access to tokens is only possible through participants, who are regulated entities.

Built for data and information flows

Due to the siloed environments in today’s distribution chain, the retrieval, aggregation, and processing of data can be costly and complex.

Shared decentralization not only reduces this problem but also creates the conditions for the capturing of more and better-quality data in real time and thus opens up possibilities for real-time data analytics.

"Asset managers can finally have a comprehensive view of who is actually buying their products, while transfer agents can become a central partner for asset managers and distributors"

In a DLT infrastructure, because of the data and information flowing within the network, transparency is enhanced for all actors. That is to say, each actor can see – again in a permissioned way – who is buying their services or products, how they are using them and how can they be better served.

Having better data easily at hand means that actors can have a deeper understanding of their respective businesses. They can thus create product offerings that are finely tuned to real needs. This is particularly the case for asset managers and transfer agents. For example, asset managers can finally have a comprehensive view of who is actually buying their products, while transfer agents can transition more easily from a support role to a distribution integration role, becoming a central partner for asset managers and distributors.

By laying down the groundwork for next-generation fund distribution, this returns us to the vision of mass market adoption. Ultimately, better distribution is focused on the end investor and their real needs. Better tech and more data by themselves are not sufficient to make this model work: it requires putting investors back center stage.

The future is sooner than you think

At the heart of the move to full issuance tokenization lies the desire to improve financial inclusion and access to financial products and this means improving relationships with and understanding of retail investors.

This can only be achieved by first concentrating on value-creation processes within existing actors. Improving their core efficiency and creating better information flows is the way to the future. DLT infrastructure and solutions are on the market do this.

Such an infrastructure is all about streamlining operations and shared processes in a way that transparency and efficiency work together for the benefit of all actors in the chain.

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