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KEY INSIGHTS
Tokenisation will reshape funds: The UK is stepping up its efforts to help the fund management industry to tokenise funds, ultimately promising bespoke portfolios and efficiency gains, although current initiatives are focused on retail funds.
Digital benefits are real: Tokenisation offers a range of potential operational benefits, but the most significant gains will be in the longer term and depend on broader developments in the digital assets ecosystem.
Barriers to adoption: Trusted digital money, robust custody, and operational scale are needed before tokenisation can disrupt traditional models, making immediate change unlikely but strategic preparation sensible
A regular briefing for the alternative asset management industry.
The UK regulator overseeing pooled investment vehicles apparently believes that they will, one day, be consigned to history. In a recent consultation paper on fund tokenisation, the FCA suggests that the digital revolution could eventually change the role of asset managers. It says that direct holdings of tokenised assets will facilitate the emergence of cheaper, customer-specific segregated managed portfolios. (Click here for our detailed note on the FCA's consultation document and its impact on asset managers.)
That may be the long view but is probably for the next generation to worry about. In the meantime, though, tokenising funds may still offer a range of benefits – even if it doesn't yet mean we can entirely do without pooled vehicles.
What is tokenisation? Put simply, it involves creating a digital representation of an underlying asset. This digital token is normally recorded on a platform which allows its participants to execute transactions that are updated in a shared decentralised ledger held in multiple places simultaneously (hence the term "distributed ledger technology" or "DLT").
For funds, the FCA notes that tokenisation may take place in stages: the initial stage might involve transferring the fund's register of investors to DLT, so that ownership of fund interests is recorded and can be transferred on-chain. In the longer term, this could also facilitate subscription and redemptions of fund interests being settled via DLT using digital forms of cash. Subsequent stages could involve tokenisation of the underlying assets held by the fund, and eventually tokenisation of specific cash flows arising from tokenised assets, allowing greater customisation of investor returns to match financial needs. Although the FCA's consultation looks at tokenisation primarily through the lens of authorised (public) funds, it notes that tokenisation has already been adopted by some money market funds and could, in principle, also be used by private funds.
Advocates of tokenised funds predict multiple potential benefits. Transitioning registration of investor ownership to an on-chain environment may lower administration costs due to easier maintenance and reconciliations. Conversion of fund interests into tokens may facilitate fractional ownership, increase liquidity and reduce settlement times and costs. DLT records may allow near real-time information sharing between a fund manager and distributors and could facilitate easier eligibility checks and onboarding processes for individual investors. Smoother digital interfaces may appeal to new generations of investors who have grown up in the digital age and expect to be able to access products almost instantaneously online.
"The UK FCA's more active stance compares favourably to the current EU approach, which lacks the same energetic push."
Many of these benefits will accrue to retail funds, which have wider investor bases, generally offer more frequent subscription and redemption rights, normally have greater rights of transferability, and are typically subject to more onerous reconciliation requirements. With the increasing growth of retailisation structures in private markets, efficient on-chain processes may eventually start to look attractive to alternative asset managers to lower costs, ease the administrative burden of wider investor pools, and facilitate new distribution models – although this may be some way off.
In the longer term, it is also possible that increasing tokenisation of underlying assets may facilitate faster and cheaper investment transactions by private funds, even if they only have institutional investors.
The UK regulator's partnership with industry demonstrates a concerted effort to help the fund management industry to tokenise funds. The FCA is also actively looking to other jurisdictions, such as Singapore – which in this respect are more advanced than the UK – to identify lessons that can be learned. The UK's more active stance compares favourably to the current EU approach which, despite the EU's DLT Pilot Regime, lacks the same energetic push and may be hampered by over-zealous regulation.
Nonetheless, to spark a tokenisation revolution within the UK alternative asset management industry, a number of stars would need to align. Although transactions can be recorded via DLT but settled with conventional cash settlement processes, achieving efficient on-chain settlement of transactions in fund interests or in underlying assets would require a trusted form of digital money, such as stablecoins, tokenised deposits or central bank digital currencies. The UK is still finalising its regulatory regime for stablecoin issuers, and the emergence of a GBP stablecoin that commands widespread investor confidence may still take considerable time.
There will also need to be trusted and cost-effective custody arrangements for the holding of stablecoins on behalf of the relevant funds and investors, matched by efficient operational processes and certainty on the applicable regulatory framework. Similarly, managers will need to be confident that they have access to trusted DLT networks and that they have appropriate back-up systems in case of disruption or cybercrime. Economies of scale may also take time to materialise, meaning that early adopters may initially face higher costs as the required digital asset ecosystem develops – there may be a second-mover advantage. In the early days, the benefits might accrue to digital-native organisations looking to displace traditional fund administrators, registrars, depositaries and payment intermediaries. The purely financial incentives for fund sponsors and managers may be fewer.
Viewed in this light, the imminent demise of pooled investment funds in a rush to tokenised bespoke investment portfolios seems unlikely – and, to be fair, the FCA is trying to get ahead of what it thinks will be a long game. Nonetheless, as the implementation of tokenised solutions gathers pace, investor expectations may change, and traditional distribution and operating models may start to come under more pressure.
For private fund managers, especially those facing a retail investor base, it is worth starting to think about the longer-term strategic opportunities and challenges presented by the emergence of tokenisation. While they may prefer to adopt a "wait and see" approach for the time being, the industry will still want to keep abreast of future policy developments in this area to avoid one day becoming an analogue relic in a digital age.
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