Trading Tokenised Funds - Efficiencies and Challenges

Trading Tokenised Funds: Efficiencies and Challenges

Franklin Templeton recently launched the first mutual fund that is solely traded on the blockchain.1 Although it is a pilot, it provides a powerful proof of concept for an asset class that is both very popular for retail investors and massive in terms of assets under management. In this note, we discuss the potential challenges and efficiencies from using blockchain technology to process transactions and record share ownership in tokenised funds.

Introduction

The size and popularity of mutual funds are mind boggling. In the US alone, almost half of US households own shares of mutual funds and their net assets were just under $24 trillion in 2020.2 Is there scope for using blockchain technology to process transactions and record share ownership in this asset class? Even if moderate efficiency gains can materialise, the sheer size of this market has the potential to generate one of the strongest use cases for blockchain technology. In this note, we discuss the potential efficiencies and challenges of trading tokenised funds.

Tokenisation

A token is a digital representation of an asset. It is issued within a distributed ledger, such as a blockchain, where it is traded. The asset that the token represents can either be off-chain or native (on-chain). Examples of off-chain assets are commodities, fiat currencies, shares in mutual funds, real estate, equity and debt securities.

The process of digitally representing an asset is called tokenisation and can be thought of as an evolution of securitisation, enabling more automation via smart contracts, embedded logic, and data. It involves initial deal structuring, creating the tokens on the blockchain, enabling the primary distribution, and post-token management, as well as trading in the secondary market. However, a token on a blockchain is qualitatively different from a digital representation of a security that resides in a centralised database. For example, an investor can buy and self-custody the security tokens without the involvement of any intermediary, which is not the case if they are in a centralised database.

Efficiency Gains

Tokenisation, viewed as an evolution of the securitisation of assets, can confer several efficiency gains. First, the asset’s characteristics and the transactional data becomes more transparent as they are recorded on the blockchain, hence there is better information flow and less information asymmetry between market participants. Assets are natively traded 24/7 across jurisdictions, contributing to a more efficient allocation of capital globally. Transparency is also good for regulation and compliance, as the actions of the funds and the investors are recorded on the blockchain, allowing regulators to continuously monitor whether inflows and outflows are compliant. Moreover, smart contracts can enable a more automated process of regulation and compliance, where rules execute automatically when a particular clause is triggered. This may eventually force regulators to come up with simple and clear rules that all market participants can understand and follow, removing the human factor that is prone to mistakes or politically motivated decisions. Authorities across jurisdictions will also need to harmonise their regulatory frameworks, as trading in the blockchain is inherently borderless. A simple and global regulatory framework will inevitably generate a much more efficient marketplace.

Clearing and settlement can occur faster as the process is programmatically coded on a distributed ledger which is shared between service providers (broker, depositary, exchange etc.). Settlement in funds usually takes T+3 days, whereas transactions in the blockchain can be instant. Payment of dividends can be programmed using smart contracts, resulting in a quicker and more transparent procedure. The change of ownership of a token can be as simple as registering a transaction on the blockchain, and thus can happen within seconds. Quicker settlement of transactions is more capital efficient, as less capital is locked while trades are waiting to be settled. Back-office costs can be cut if there is one shared ledger that is continuously updated, rather than several, partly compatible ledgers that need to be reconciled every time there is a trade. The rights and potential claims of the token holders can also be enforced in an easier and faster way, as they can be implemented in the blockchain using smart contracts. A token holder can immediately see their net position, without having to ask for a paper statement from their broker. Moreover, when the shared distributed ledger becomes accepted as the only authoritative data source for transactions, the process of reconciliation becomes obsolete, making the trade process much more efficient and reducing the risk of failed trades. 

Finally, an often-ignored efficiency gain comes from the standardisation of processes. Currently, funds often use different IT systems, often incompatible with one another, to record transactions and complete AML and KYC checks. Manual paper statements often act as a bridge between different systems. Blockchain technology has the potential to consolidate these separate systems and increase digital interoperability.

Challenges

The biggest challenge is the uncertainty about the regulatory framework for trading tokenised funds. Tokens are traded 24/7 and across jurisdictions in one truly global market, whereas existing regulations are designed for fragmented markets that reside in different jurisdictions and they are not interoperable. Eventually, regulators across countries will need to design one set of rules that apply globally, giving investors and firms legal certainty about how tokens and smart contracts should operate.

The governance of blockchains is another important challenge. Permissioned blockchains are controlled by a small number of entities, making governance and regulation easier as there is accountability. However, if the issuers of the tokenised funds are also the owners of the blockchain, then they may engage in anti-competitive behaviour, for example by not onboarding rival funds. Permissionless blockchains are governed collectively so no entity is accountable if something goes wrong, for example it is hacked or it stops operating.  However, a large permissionless blockchain that has numerous uses may be more robust to these considerations.

Conclusion

Investors stand to gain the most if tokenisation is executed well, whereas the various intermediaries stand to lose as their role is diminished. Investors can access a wider range of financial assets that are traded 24/7, without being tied to a particular brokerage. They can benefit from fractional ownership of assets, allowing the construction of a more diversified portfolio without being constrained by minimum investment levels. More importantly, they can benefit from the inherent composability of DeFi, as each financial service project on the blockchain is automatically interoperable with all other projects. Therefore, an investor can compose their own bespoke set of financial services, without being tied to a specific bank or brokerage and the bundles that they offer.

Footnotes

1See https://www.ft.com/content/fd57521c-a2e9-415b-9c4f-4f74b4587f9e. 
2See          https://www.statista.com/statistics/246224/mutual-funds-owned-by-american-households/  and https://www.statista.com/statistics/255518/mutual-fund-assets-held-by-investment-companies-in-the-united-states/. 

Disclaimer

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