How Close To The Next Financial Revolution?

On October 29, 2024, The Boston Consulting Group, Aptos Labs, and Invesco published a Whitepaper with the title Tokenized Funds: The Third Revolution in Asset Management Decoded. Although the title is interesting and potentially thought-provoking, is there any truth in it? Is fund tokenization the next step in financial evolution, and if so, to what end?

According to the White Paper, fund tokenization (which they call the third revolution in asset management) offers the potential to create billions of dollars of value for both financial institutions and end investors. It claims that in late 2024, tokenized funds had secured more than USD 2 billion in assets under management by BlackRock, Franklin Templeton and WisdomTree. Even though it is a fraction in comparison to the rest of the AUM by these three entities, this behaviour shows an interest from virtual asset owners. Moreover, more banks seem to roll out tokenized investment funds – the latest has been UBS that released its Money Market Investment Fund Token (uMINT) on November 1, 2024.

What is Fund Tokenization?

Fund tokenization is the process of converting ownership of a fund, like a real estate, mutual fund or private equity fund, into digital tokens (on a blockchain). Each token represents a small share or unit of the fund, similar to a stock in a company.

Let us compare the company shares and fund tokens:

Shares represent traditional pieces of paper or electronic entries within systems managed by stock exchanges or banks. They represent ownership in a company and come with certain rights, like voting on company decisions or receiving dividends. Buying and selling shares usually involves going through brokers, and they’re recorded in centralized financial systems. Business model that has been around for centuries.

Now, think of tokens as fully decentralized and digital versions of ownership. They have with similar rights and obligations as the shares, but in their form they are recorded on a decentralized digital ledger. Tokens are different in form because they do not rely on traditional stock exchanges or brokers. Instead, they are fully digital, allowing people to buy and sell them directly, often 24/7, without needing intermediaries.

What is the Added Value of Fund Tokenization?

The value of fund tokenization, drawing insights from the BCG Whitepaper and the Bain Company & JP Morgan Analysis, centers on transforming the asset management landscape by creating a more accessible, efficient, and liquid market. Here is a brief overview of the added value:

1. Enhanced Liquidity and Flexibility: Tokenized funds provide 24/7 trading, enabling investors to buy and sell fund shares at any time. This continuous liquidity, akin to the flexibility of exchange-traded funds (ETFs), increases accessibility for investors who want more control over timing without the traditional restrictions of mutual funds.
2. Cost Efficiency through Automation: Smart contracts on blockchain can automate processes like compliance, record-keeping, and settlement, reducing administrative costs. These operational savings can translate into lower fees for investors and potentially higher net returns due to streamlined, automated transactions.
3. Fractional Ownership and Broader Access: Tokenization breaks down investment barriers by allowing fractional ownership, meaning smaller, more manageable investments. This is especially significant in alternative assets like real estate or private equity, which typically require higher capital commitments. By lowering entry thresholds, tokenized funds have the potential to attract a more diverse investor pool.
4. Instant Collateralization: Tokenized assets enable more flexible use of investments as collateral for borrowing or lending. With secure blockchain records, investors can borrow against their tokenized fund holdings quickly, creating new liquidity without requiring sales or traditional lending processes.
5. Access to Yield-Generating Opportunities: Tokenized funds open up new investment avenues for both traditional and digital-native investors. Sophisticated investors can capitalize on intra-day price movements within tokenized funds, generating added returns through faster, more precise trading strategies not feasible in conventional mutual funds.
6. Scalability and Revenue Potential: Industry estimates that tokenized funds could increase AUM significantly, reaching up to 1% of global AUM (around $600 billion) by 2030. Furthermore, tokenized fund turnover could generate up to $400 billion in annual returns from activities like collateralization and trading on price fluctuations.

In essence, fund tokenization could offer a significant value by democratizing access, improving liquidity, and increasing efficiency for both investors and asset managers. It positions asset management for future growth, responding to evolving market needs while enhancing investor experience and returns. Potentially, it can also bring more oversigth and trust into the industry.

Which Funds Are Better Suited for Tokenization?

According to InvestaX, certain funds are better suited for tokenization. Particularly, those with high entry barriers, like high minimum investments or geographical restrictions, might benefit from it, as do funds with illiquid assets, such as private equity or real estate.

Ideal funds for tokenization include:

1. Real Estate Funds – Typically illiquid with high entry costs; tokenization can create a secondary market for shares, boosting liquidity and lowering minimum investments.
2. Debt Funds – Tokenized debt funds, which currently have challenges to raise money.
3. Private Equity & Venture Capital Funds – Often restricted by high minimum investments; tokenization enables fractional ownership, broadening access to these high-growth assets.
4. Hedge Funds – Known for complex structures and limited access; tokenization can make these strategies more accessible and administration straightforward.
5. Infrastructure Funds – Tokenization of large-scale project investments allows broader investor participation and greater transparency, should these infrastructure funds be public.
6. Commodities Funds – Tokenizing funds investing in commodities like gold or oil allows easier and quicker trading.

How Close to the Next Financial Revolution?

Before envisioning the next financial revolution, it is also important to recognize the potential risks and limitations of tokenized funds. While neither of the two above mentioned documents address these risks, we should at least consider the following:

1. Adequate regulation and investor protection – some tokenized funds have launched in the US, while others are based in Singapore. However, clear and comprehensive regulations for blockchain-based financial products are still lacking. While crypto assets seem to be disliked by regulators, financial products seem to get a green light. The absence of standardized rules increases uncertainty around investor protection, compliance and oversight.
2. Operational challenges and interoperability – tokenized funds require smooth integration with traditional financial infrastructure, which is often incompatible with blockchain systems. To function seamlessly, tokenized assets need interoperable standards and systems, which are still in development. This lack of integration could create friction in transactions, complicate the administration and slow trading and the overall adoption.
3. Smart Contract Reliability: Smart contracts automate key functions, but any errors in code can result in losses, security vulnerabilities, or mismanagement of assets. Smart contracts are immutable, so bugs or security flaws can not easily be corrected, posing risks in terms of both financial losses and legal liability.
4. Dependence on Stable On-chain Money: Tokenized funds’ benefits, particularly around real-time settlement and instant collateralization, depend on the availability of stable, regulated on-chain money (such as stablecoins or central bank digital currencies). Without widely accepted forms of on-chain money, tokenized funds may face challenges in achieving their full liquidity and efficiency potential.

Tokenized funds represent a fascinating innovation with significant potential value—offering enhanced liquidity, greater accessibility, and operational efficiencies. However, it would be prudent for traditional banks to adopt a more transparent approach regarding the associated risks. A balanced perspective that openly addresses both the advantages and the limitations is essential to build trust among investors and stakeholders.

It’s also noteworthy that, just a few years ago, the financial sector largely dismissed crypto assets as speculative or fringe. Now, however, we see major financial institutions not only recognizing but actively embracing the potential of blockchain technology for a range of their own activities. This shift underscores how rapidly perspectives can change, as the underlying technology of digital assets begins to reshape traditional finance in meaningful ways.