In March, The Investment Association released its ‘phase two’ report on the tokenisation of funds, outlining ways the industry was exploring the technology and a call to action for firms to ‘execute’ their tokenisation plans or work with peers and authorities on ‘emerging use cases’.
The report follows the FCA’s approval for the development of tokenisation of UK funds in November last year, prompting the startup of businesses looking to capitalise on the new market area, and industry players investigating how tokenisation could play into their businesses. The Investment Association is currently gathering firms who would like to be part of use case explorations until 26 April.
However, one of the main hurdles for tokenisation is distributing understanding of how the technology works, and how it will operate in the UK financial world and under UK law.
Tokenisation Structure
A tokenised equity is a representation of a share through a digital token, or coin, operating on a blockchain. The method is designed to simplify some of the bookkeeping typically associated with purchases and allows for a single system to represent ownership.
Pierre Mottion, head of DLT and Strategy at Clearstream Fund Services, a security depository, said: “Tokenisation is one way to facilitate the access and distribution of fund units towards the end investor, and opening capacity to have direct to-customer channel in a unique way where the position that you have in your wallet as an investor or distributer is the exact same position as the one identified in the book of the fund. Meaning you have full transparency on who has purchased what and you reduce the intermediaries.”
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In addition to tokenisation within the realm of investing, the idea is popular among areas such as property ownership and arts. Marc Proudfoot, partner and head of investment trusts at law firm Howard Kennedy, cited the example of Wembley Stadium. A proposed sale of Wembley would have allowed fans to own a part of the stadium, but Proudfoot said due to the way English property law is structured, that sort of joint ownership couldn’t be represented.
However, under a tokenisation structure, joint ownership could be represented, allowing deals such as this to potentially take place in the future.
New companies
Following the approval of the FCA last November, Tokenbridge, a technology company geared towards distributed ledger technology for wealth managers, fund managers, and infrastructure providers, launched on the market. Distributed ledger technology works in conjunction with blockchain to give access and verification to a digital record of assets.
Stephen Ashurst, CEO and co-founder of Tokenbridge, pointed out a benefit to tokenisation for fund and wealth managers could be a reduction of fees made possible through the simplicity of the system.
“The savings for investors in terms of fees could be substantial. We know that fund managers, who issue mutual funds, save more than 50%, and in certain scenarios, even over 75%, on their internal fund and transfer agency costs,” Ashurst said.
“Similarly, wealth managers, the distributors of mutual funds, are also expected to achieve similar levels of savings through the distribution and aggregation of innovative fund tokens, including those offering personalisation features.”
Legal Ramifications
However, there is a lack of clarity on how tokens would be represented under British law, and therefore what rights the assets would be afforded. The Investment Association established two use cases in its March report for how tokenisation could function. The first is through tokenising a money market fund unit and allowing it to be “pledged” in bilateral uncleared trades, or through using it as collateral in the repo market, the market for collateralised loans. The second investigates tokenised securities with an emphasis on the bond market.
“There’s so many hurdles that we need to get through before we get to be able to tokenise funds in the UK that people are still a bit weary of it. The FCA definitely made some strides forwards in terms of the regulation. The Investment Association paper talks about this baseline model, which is quite interesting. But I still don’t really see how it works from an English legal perspective,” Proudfoot said.
“The problem that you have at the moment is that English law is a historical law, it’s not really changed that much over centuries. The idea is that property is something that you can either hold in your hand, or something that gives you a right to sue someone, like money in a bank account or something like that. Whereas tokenisation is something completely different, that doesn’t fit well into either of those things. We need English Law to catch up with that development and for people to understand completely how tokenisation works in terms of ownership.”
Market Adoption
Mottion said the success of tokenisation will come down to its market adoption to help investors become comfortable with the technology, but acknowledged “you don’t play with other people’s money”. He said two of the main questions when approaching tokenisation will be if the counterparty is trusted and if there’s a thorough understanding of what tokenisation represents.
“That’s not only from a technology standpoint, there’s also some financial security behind that, there’s some risk, there’s some compliance elements, and some financial capacity,” Mottion said.
“So let’s try to make it a proof of work. Let’s do a minimal investment and see what we can achieve together. Basically, people can become convinced and then go back to their boards and report it works.”
Proudfoot pointed out that safety and security are some of the factors that make tokenisation so appealing, because it creates a unified ledger.
“Tokenisation offers a lot more security for investors. The fact it’s on a single database and that database is the authority, there’s no doubt and there’s a lot less room for human error. That is one of the positives of tokenisation. You would be amazed by the time that people spend trying to pull together lists of shareholders or lists of unitholders and make sure they’re right and keep them right.”
Ashurst believes that as market adoption takes place, tokenisation will also raise the opportunity to expand investing to a wider range of consumers who did not previously have the means to access investing in the same way, shrinking the advice gap.
“Less wealthy consumers or those with less liquid investible assets will become economically viable clients for professional advisers,” Ashurst said.
“Consequently, a new market comprising hundreds of millions (if not potentially billions) of consumers previously unreachable will now be accessible to the advice marketplace.”
However, Proudfoot said when it comes to private markets, there would be barriers in making the funds readily available to UK retail investors because of the regulation in place.
“Even if you were able to tokenise these funds, you can’t just sell them to the man on the street because there’s still so much regulation in place that prevents you from doing that,” Proudfoot said. He also noted that the UK markets may be trying to shift to a system which allowed retail investors more autonomy.
The Investment Association recognised in its report that some of the payment systems currently in use in the UK “cannot accommodate at the scale required by the funds industry” and raised awareness that the quickening of fund settlements in other markets could have an impact on the UK system.
The report stated: “As modern-day investor expectations on speedier access become more prevalent, and pressure increases on the fund settlement process, reliance upon existing payments infrastructure is likely to become more problematic.”
