What if you could launch an investment vehicle that offered significantly lower up-front and ongoing fees – as well as more flexibility and transparency – but could still give differentiated returns based on the expertise of portfolio managers? What if that fund had radically lower operating risks and costs, by cutting out many of the supporting processes fund managers have managed for decades? This is the opportunity that tokenisation could offer to investors and the financial industry. While the concept is still in its early stages, Australia is starting to embrace tech-driven innovation more quickly, meaning that this new era of digitalised collective investments could arrive sooner than we may think.
The transformative power of distributed ledger technology (DLT) has perhaps best been seen through the growth of Bitcoin and other crypto-currencies and assets, transactions in which are managed securely and transparently on a blockchain, a type of distributed ledger. So far, the practical impact on the traditional investment sector has been limited, with some elements of the overall process being migrated to DLT. But there is potential for a much more fundamental, indeed game-changing, shift.
In the crypto-assets arena, tokens are often used as a simple, standardised way of representing, storing and exchanging value. But ‘off-chain’ assets – e.g. securities, property, private equity investments etc – can also be tokenised, that is, digitally represented on a distributed ledger. In the investment world, this could enable a customer to directly own and manage a range of assets represented as tokens in a virtual portfolio. The purchase, sale, and settlement of these tokenised assets would be instant, immutable and irrevocable if executed on a distributed ledger, requiring no post-trade reconciliation or manual intervention.
This could have a radically streamlining effect on the investment value chain, rendering a number of underlying processes and intermediaries obsolete, reducing cost and risk, and boosting speed, efficiency and transparency. Tokenisation also allows assets to be fractionalised, meaning individual investors could effectively purchase a small portion of either a physical asset or a highly-priced security or investment.
It’s true that buying a share or unit in a managed fund is a form of fractionalised ownership, but the investor is very much tied to a collective structure and outcome. Buying a tokenised asset can provide a more direct and transparent form of ownership, in terms of performance and returns.
Unlike crypto-assets, the securities in a managed fund do not derive their value from ‘on-chain’ transactions. Also, a managed fund portfolio typically contains a range of instrument and asset types, even if specialising in one. Both facts complicate the relationship between the on-chain token and the off-chain assets.
Although tokenisation is technologically feasible, practical challenges abound, with potential for investor protection concerns over the availability of professional advice on low-fee products. Internal legacy systems at investment management firms could prove a stumbling block, as could linkages to external market infrastructures.
These linkages will be crucial to ensure accurate valuations, but may be hampered by the long-term implications of tokenisation for the business models of incumbents. For widespread industry acceptance, consensus will be needed on matters such as what a token is, how it is constructed, and how the value of assets is associated with the tokens.
We are working actively with technology firms and financial institutions as part of the InterWork Alliance, a platform-neutral, non-profit organisation established in June 2020 to develop the standards frameworks needed to make tokenisation a reality.
Solving the active challenge
Particularly among the younger generation, investors are more worried than ever about their financial security, but are finding it harder to set aside the capital needed to invest in active funds. In a recent Calastone survey, 69% of respondents based in Australia and 66% in New Zealand said they worry about future financial security.
With the significant rise of passive options over the past decade, it is imperative that asset managers meet demand for products that are better tailored to Millennial investors, with smaller minimum thresholds and lower fees and charges. In the same Calastone survey, 69% of Australians said the ability to invest in smaller increments would increase the likelihood of investing in the future, with this figure rising to 80% of New Zealanders.
Investment managers also need to respond to customer demand for real-time, responsive and customised user experiences, not just through digital interfaces, but through an overhaul of underlying back-office and distribution processes and infrastructures. Tokenisation has the potential to address all these challenges, stripping out cost and risk and delivering simplicity, control and transparency to investors, whilst providing a platform for innovation.
In Australia as elsewhere, the funds market is becoming increasingly competitive and outdated, with many firms struggling to retain the market share they need to build a sustainable long term future.
For this and many other reasons, we expect discussion of tokenisation to grow louder and more frequent. We have already seen in many Asian countries for example, which have a long history of innovation and competition in retail investments, disruption from thrusting fintechs, some targeting the young affluent, others tackling financial exclusion.
The pace of change is already accelerating and while a lot of the innovation is happening abroad, Australia will be set to benefit as these new technologies start to spread globally. Over the past few years we have seen the Australian financial industry make significant progress with regards to blockchain, including the ASX’s shift towards blockchain technology. It is technologies like these that will ultimately make tokenisation a reality.
We at Calastone are already actively looking at the practical usage of tokenisation in terms of how collective investments work today, as well as what future models could become possible.
The funds industry has grown unwieldy in recent years, weighed down by non-core tasks and responsibilities, in part driven by regulation, and squeezed by ever tighter margins. It remains very early days, but tokenisation could pave the way back to basics and back to growth.