Tokenisation: the future of the investment management industry?

As an industry often considered slow to embrace change, innovation and asset management do not typically go hand in hand.  However, the Investment Association’s (IA) report ‘Investing for the future: three potential paths for a tech-powered UK fund industry‘ seeks to break ranks with traditional thinking and outlines how the industry can harness technology and innovation to deliver a new type of investment fund for consumers.

Primarily concerned with the introduction, and increasing use, of decentralised finance and tokenisation, the report outlines three possibilities of what the ‘Investment Fund 3.0’ could look like and how it might operate.  This is set in the context of wider trends in the industry, such as the wealth transfer between generations and changes in investor mind-set, particularly among under-35s that show different priorities to previous generations. 

For starters, given the wealth of jargon, it may be helpful to clarify what we mean. Tokenisation refers to the process of converting an underlying asset (tangible or intangible) into a digital ‘token’ to act as its proxy.  This can occur at the level of the fund itself (i.e. converting the units of the fund into a digital token) or at the level of the underlying asset, such that the fund holds tokens representing investments.  Decentralised finance (or “DeFi”) refers to the provision of financial services on distributed ledger technology (DLT), operating without centralised intermediaries or institutions. Blockchain is an example of DLT.

So what might the future look like?

• Version 1- the report’s first vision looks at the enhancements to the back-office infrastructure of investment funds that tokenisation can bring, helping to improve efficiency and reduce costs for consumers.  This sits within the ‘tokenisation of units in the fund’ bucket and involves structuring the operation of the fund using DLT.  Here, advantages include:
  • eliminating the need for reconciliations given the decentralised, shared register;
  • reduced order execution costs through the removal of messaging;
  • potentially quicker settlement;
  • the possibility to restrict investor access to those verified for AML purposes reducing duplication of verification; and
  • embedding fund details, such as ESG data, in the token itself. 

Changes to the UK’s current funds regime may be required to reflect the difference operationally in an ‘on-chain fund’ if the UK is to keep pace with other jurisdictions that have already implemented tokenised share classes of existing funds.  Current AML registration requirements may also prove a barrier.

The report also discusses the tokenisation of the underlying assets in the fund’s portfolio.  While the pace of such developments may be slow, benefits could include quicker settlement, improved transparency of transactions, lower counterparty risk, fractional ownership, and greater diversification and liquidity. 

• Version 2 - the second possible scenario builds on the enhancements of version 1 and contemplates greater customisation and the diversity of ‘building blocks’ that make up a portfolio, tailoring more effectively to investor preferences.  In this world, consumers (or their financial adviser or wealth manager) could package together mini baskets of stocks (from a similar market category or strategy type) to build a desired portfolio.  The number of model portfolios available in the market may also significantly increase or evolve.  In the context where the traditional roles of stakeholders in the market start to shift, the principle of ‘same activity, same regulation’ will remain key to ensure a level playing field.

Voting is another area where new forms of technology such as DLT can have an impact. Good stewardship and shareholder democracy is certainly on the agenda and can be enhanced through new solutions that technology can bring (i.e. surveys, apps etc.), potentially providing all types of consumers with greater say over the fund and the companies it invests in.

Building further on the tokenisation of the underlying assets, the report examines the potential to open up the range of investible assets to consumers by tokenising illiquid investments (building on the work of the Long Term Asset Fund or LTAF).  This could provide consumers with a lower entry point through smaller denominations of ownership and potentially more liquidity by trading via a secondary market in tokens. 

• Version 3 - the third possibility is defined by ‘hyper-customisation’, where risk and return exposure is tailored by customers at individual stock and securities level rather than at the fund level. In this context, the customised portfolio, constituted as a non-fungible token (NFT), contains tokenised underlying asset classes in broad areas such as private companies, infrastructure and native digital assets.  NFTs would be specifically built for the investor and non-transferable, with the underlying assets housed within them. Here, the concept of the fund itself shifts from its large collective nature with limited personalisation to potentially small groups managing their money more locally via a Decentralised Autonomous Organisation (DAO).

Reflecting this shift, delegation and the role of the investment manager, wealth manager and financial adviser would take a different form (some more involved, some less).  Whether this results in bespoke investment services for the masses is anyone’s guess however the report notes that customisation of this ilk would provide a greater degree of participation and control on the part of the consumer.

Products that are delivered direct to consumer (D2C) (via platforms or wealth managers) would also signal a shift from the decade-long trend of intermediated sales and while there are clearly benefits to the hyper-customisation model, the downsides of limited access to value-add services such as research and the complexities that arise from investors holding underlying assets directly are also cited and should not be neglected.  Such revolutionary change will require thinking through.  

The report concludes that we are likely to see a combination of all three scenarios materialise, with the industry’s centre of gravity determined by the extent to which incumbents and new entrants drive innovation over the next decade. It notes that modernisation of product and service delivery and capital markets infrastructures is inevitable and will likely bring significant long-term benefits in terms of operational efficiency and lower cost. 

However, the regulatory and broader policy environment will be an important factor that determines the outcome here.  The report therefore outlines a range of policy and regulatory actions aimed at creating an environment in which regulation can better support innovation, while ensuring consumer protection is upheld. 

Regulatory recommendations

Regarding innovation:

• establishing the framework for tokenised funds to operate in the UK;
• creating a DeFi taskforce to assess the overall policy implications for the UK fund industry;
• retaining the stance of ‘same activity, same regulation’ (including with respect of competing investment products and services in the retail market);
• considering establishing regulated routes for native digital asset exposure (including the eligibility of cryptoassets within UCITS and domestic funds); and
• approaching DeFi reforms in an open-minded way - recognising that existing industry functional divides may not be relevant if technology provides more efficient ways of achieving the same outcomes.

Regarding the regulatory perimeter:

• defining the ‘rules of the road’ for cryptoassets to mitigate consumer loss and harm;
• monitoring closely the unregulated arena for emerging developments that may threaten financial stability; and
• ensuring that investment firms are not exposed to the costs of failing stablecoin firms or other crypto firms through the FSCS.

Regarding regulatory change:

• addressing the advice gap by facilitating better support for consumers;
• completing UK Funds Regime Working Group reform implementation; and
• enabling next generation digital information provision and disclosure to investors.

Although a focus on long term use-cases of cryptoassets and DLT in financial services is not typically headline-grabbing ‘crypto-news’, it is clear that industry stakeholders are increasingly looking towards tokenisation and blockchain technology as the next wave of innovation in an industry ripe for change. Offshore funds markets are seeing this development too, and so it is an increasingly global phenomenon.

Progress may not occur overnight, and the future of the industry remains unknown, but the increasing interest we see from clients and market participants in this space - both in developing tokenised propositions and the provisions of services around this - is likely indicative of which way the wind will blow.  

"The way we regulate needs to be dynamic. We shouldn’t be thinking of regulation as a static, rigid thing. Instead, we should be thinking in terms of regulatory ‘code’, like computer code which we refine and rewrite when we need to; tailored and proportionate, yes, but also nimble and tech-neutral" - John Glen, MP

https://www.gov.uk/government/speeches/keynote-speech-by-john-glen-economic-secretary-to-the-treasury-at-the-innovate-finance-global-summit