Fund Tokenization – A Game changer in Asset management

Overview

 Fund tokenization refers to the use of blockchain based digital tokens to represent fund ownership. Although the industry players took a cautious approach in adopting the distributed ledger technology until 2020, it has steadily grown from 2020 onwards as regulated on-chain money such as stablecoins, tokenized deposits and CBDCs became more prevalent. The interest in fund tokenization has also grown among the asset managers in the last 2 years supported by the regulators and is on the growth trajectory to become an industry wide initiative. The main drivers of the tokenization initiatives are substantial cost reduction and revenue growth for asset managers, while investors find opportunities in portfolio diversification, personalization through smart contracts and instant collateral management with increasing liquidity. Private assets tokenization is also on the rise paving way for retail investors to gain access through fractionalization. The global AUM of the tokenized funds is expected to reach USD 600bn by 2030 from the current USD 2bn levels.

In this article we look at the industry initiatives, the tokenization considerations and some of the industry wide challenges that should be overcome for it to become a game changer for the asset management industry in the next 12-18 months.

Industry initiatives across the globe

      A brief summary of the readiness across geographies in terms of Government sponsorship, Legal & regulatory framework and Market infrastructure in place for the tokenization adoption indicates that jurisdictions like EU, UK, Singapore, Hongkong and Switzerland are far more advanced in terms of formulating a legal and regulatory framework making it easier for the financial institution’s adoption. However in the U.S., despite being a fast growing market for tokenized treasuries and money market funds, the tokenized assets have to comply under the existing securities act thus restricting the current investor pool to high net worth individuals and entities. The SEC has also recently published an accounting guidance (SAB 121) where the crypto assets are also included as part of the balance sheet thus increasing the capital requirements for the digital assets custody.

 Singapore on the other hand has initiated an industry initiative ‘Project Guardian’ which is an international collaboration of industry and regulators led by the Monetary Authority of Singapore that is exploring the standardization of fund and asset tokenization framework and regulations. The UK regulatory authority FCA and Treasury are also part of the industry led working group which also includes global asset management firms for formulating regulations and digital assets sandbox for implementation of tokenization in the UK and other geographies.

 The ‘Markets in Crypto Assets(MiCA)’ regulation introduced by the European Union in 2023 has paved way for creating a unified in the European markets . In parallel, the Distributed Ledger Technology (DLT) Pilot Regime, launched in 2023, allows financial institutions to experiment with blockchain-based trading and settlement of financial instruments within a controlled environment. Similarly, Hongkong and Switzerland have been leading in the legal framework formulation which has led to increased adoption of tokenized funds by the major players.

  The distribution ledger technology ecosystem has been rapidly developing in the US with private platforms offering distribution, transfer agency, fund administration and other services over popular blockchains like Ethereum. Other market infrastructure providers like stock exchanges, custodians and depositories have also collaborated with the platform providers to offer DLT services.

The Building Blocks

    Following are the basic building blocks and considerations for adopting tokenization.

1. Infrastructure: Identification of the most appropriate blockchain network in terms of supporting the required set of controls, costs, scalability for large transaction volumes, Tokenization/Distribution partners etc.
2. Regulatory control: Data privacy & compliance requirements based on jurisdictions, KYC/AML checks, permission/identity controls etc.
3. Technology enablers: Operational stability, Interoperability across on-chain/ cross chain and traditional networks, designing smart contracts etc.
4. Tokenized funds use cases: Usage of tokenized fund for distribution to new investor base, collateralization, secondary transfer, global passporting etc.
5. Asset Identification: Identification of type of fund to be tokenized, fund administration, operations, on chain/off chain settlement etc.

Industry challenges and next steps

       A tokenized fund ecosystem requires global standardization of regulatory framework and data standards to ensure interoperability across various jurisdictions and infrastructure. Below are some of the challenges where a global collaboration is necessary.

1. Regulatory standardization: The current regulations are fragmented across jurisdictions and a common framework is required for standardization of fund structures for tokenization, guardrails for operations (Fund management, transfer agent, security/custodian guidelines for digital assets), KYC/AML guidelines for digital identification, acceptance for tokenized money. Addressing legal treatment of digital assets and standards for legal claims is also of paramount importance.
2. Operational standards: Formulation of global standards for global passporting is important for cross border investments for global firms. A common data taxonomy is also a key component for data management of on chain/off chain settlement and ledgers including managing smart contracts and fund operations.
3. Technical standards: Blockchain interoperability for cross chain interfaces is still under evolution for operating in a multi chain setup, while data privacy/cyber security rules setup remains a challenge across firms.
4. Collaboration between financial institutions and market infrastructure players: Stakeholders like the sell side players, intermediaries and buy side players need to collaborate and achieve interoperability across data systems, platforms, processes and protocols across networks.

As we are all aware the global asset management industry is facing serious challenges with margin and fee pressures, increasing costs and growing investor demand in digital, tokenization is a mechanism which could help fund managers to reduce costs from an operation and distribution perspective. Although a lot of asset managers are experimenting with tokenized funds, industry wide adoption will largely depend on geography, shifting macro environment, regulatory frameworks and technology standardization. The Project Guardian initiative is a positive step working towards the vision of evolving tokenized funds from a product focused to client driven experience. This requires significant collaboration from the industry participants, and we expect industrywide adoption of tokenization in the next 12-18 months.