Tokens of appreciation?

Fund tokenisation is the process of creating digital tokens that are recorded on a blockchain and represent units of ownership in an investment fund. 

It has been on the industry’s radar for some time, with various initiatives being explored over the past few years – but, as with any new technology, adoption takes time. After many years of 'proof of concept’ projects, we’re now starting to see growing interest from market participants and there has been meaningful progress in  bringing the technology to market.  

At LGIM, we have recently partnered with Archax (a leading UK digital asset exchange) to make some LGIM liquidity funds available via their platform in tokenised format. 

What is fund tokenisation?

A token is a representation of share ownership captured in a digital format using Distributed Ledger Technology (DLT). This can be done either directly on the underlying fund register, or as a means to record ownership on a sub-ledger via a ‘tokenisation agent’ – without impacting the fund register.  

Standard onboarding procedures need to be completed either by the fund or agent,  ensuring that only authorised investors can transact in the fund. Tokenisation via an agent has been more prevalent to date while investors, fund providers and record keepers get used to the new technology and its application to investment funds. We expect that DLT will be further embedded throughout the fund ecosystem over time as the industry cottons on to the true benefits of the technology.

What are the benefits?

We expect several benefits to materialise following tokenisation of fund ownership:

• Increased efficiency – DLT provides a single source of truth, with ownership updated automatically subject to the rules and coding that govern the tokenisation process. Operating with a single source reduces duplication of activity and the need for reconciliations within the investment value chain, reducing costs and removing frictions
• Additional utility for investors – providing the ability to transfer assets in digital format, meaning investors may be able to remain invested in the market for longer
• Democratised access via fractional ownership – ability to transact in smaller sizes than current minimum requirements allow, which could be impactful in particular for alternative asset classes and make them accessible to a wider range of investors, including those who have traditionally been precluded due to large investment lot sizes
• Increased transparency – subject to controls and relevant permissions, investors, fund providers and potentially even regulators may have access to real-time information such as fund exposures and investor concentration, allowing for better risk management 
• Better liquidity and faster settlement – when asset transfers can occur directly between approved participants, liquidity may be achievable outside of traditional fund cut-off times, potentially without restriction. With progress being made in digital currencies, it could become mainstream for near-instantaneous settlement which reduces risk and transaction costs.

Public and private blockchains

Blockchains can be either public or private; one thing that is consistent across both is a permanent immutable record and strong audit trail for ownership.

Public chains ensure rightful ownership is maintained through consensus mechanisms where all transactions are validated by a large number of participants, whereas private blockchains are administered by a trusted central authority who has control over all entries into the ledger. 

Where tokenisation has been undertaken via an agent, as opposed to directly, that agent will undertake the necessary activities to ensure transactions are recorded in line with protocol.  

There have been a lot of news stories about investors losing access to their digital assets either by losing their personal key (the password to their digital wallet where their assets are held) or via malicious activities such as hacking or theft.

While storage considerations are very important, we are seeing a development of more robust solutions that allow investors to manage digital assets within familiar infrastructure from trusted custodians consistent with how they manage traditional assets today.

Investors and fund providers should ensure that they are aware of new and additional risks and take steps to mitigate those risks, working with regulated players in the market.

Where do we go from here?

We are still in the very early stages and while mass adoption will likely take some time, there is growing interest and real commercial opportunity for investors and fund providers today with investors already using tokenised funds.

A lot of early consideration was given to alternative assets, such as private equity and real estate funds. However, more recently interest in money market funds has grown.  Many managers now offer tokenisation of money market funds (MMFs) either through an external provider or directly within the fund infrastructure. We think this is likely to continue, particularly as interest rates are, in our view, currently attractive and likely to stay meaningfully above zero for the foreseeable future; investors are looking to earn yield on their digital cash.  

There is also increased focus on the tokenisation of MMFs in relation to collateral management. Typically, investors with leveraged positions will hold some cash, often in MMFs, and would have to redeem and move cash to meet margin calls. With tokenisation allowing shares to be freely transferred, potentially even based on rules built into smart contracts, the collateral management process could be simplified subject to relevant regulatory developments.

We expect the journey towards tokenisation to be one of evolution as opposed to revolution, and we are excited to play our part in this.