How close is the next financial revolution?

On October 29, 2024, The Boston Consulting Group, Aptos Labs and Invesco published a white paper entitled Tokenized Funds: Decoding the Third Revolution in Asset Management. While the title is interesting and potentially thought-provoking, is there any truth to it? Is tokenization of funds the next step in financial evolution, and if so, for what purpose?

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. He claims that at the end of 2024, tokenized funds backed more than $2 billion in assets under management by BlackRock, Franklin Templeton and WisdomTree. While this is a small portion compared to the rest of the three institutions’ AUM, this behavior shows interest on the part of virtual asset owners. Moreover, it appears that more banks are launching tokenized investment funds – the latest UBS issued a Money Market Investment Trust Token (uMINT) on November 1, 2024..

What is fund tokenization?

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

Let’s compare the company’s shares and the fund’s tokens:

Stocks are traditional pieces of paper or electronic entries in systems operated by stock exchanges or banks. They represent ownership in the company and have certain rights, such as voting on company decisions or receiving dividends. Buying and selling shares usually involves through brokers and they are registered in centralized financial systems. A business model that has been around for centuries.

Now imagine the tokens as completely decentralized and digital property versions. They have the same rights and obligations as shares, but their form is recorded on a decentralized digital ledger. The tokens are different in form because they do not rely on traditional stock exchanges or brokers. Instead, they are completely digital, allowing people to buy and sell them directly, often around the clock, without intermediaries.

What is the added value of fund tokenization?

The value of fund tokenization, building on ideas BCG White Paper And Bain Company and JP Morgan Analyticsis focused on transforming the asset management landscape by creating a more accessible, efficient and liquid market. Here’s a quick overview of the added value:

1. Increased liquidity and flexibility: Tokenized funds provide 24/7 trading, allowing investors to buy and sell fund shares at any time. This constant 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 the blockchain can automate processes such as compliance, record keeping and settlements, reducing administrative costs. These operational savings can result in lower fees for investors and potentially higher net returns through streamlined, automated transactions.
3. Partial ownership and greater access: Tokenization breaks down investment barriers by allowing fractional ownership, which means smaller and more manageable investments. This is especially important for alternative assets such as real estate or private equity, which typically require higher capital expenditures. By lowering the barrier to entry, tokenized funds can attract a more diverse pool of investors.
4. Instant provision: Tokenized assets allow for greater flexibility in using investments as collateral for borrowing or lending. With secure blockchain records, investors can quickly borrow against their tokenized funds, creating new liquidity without the need for sales or traditional lending processes.
5. Access to income-generating opportunities: Tokenized funds open up new investment opportunities for both traditional and digital investors. Savvy investors can benefit from intraday price movements in tokenized funds, generating additional profits through faster and more accurate trading strategies that are not possible with conventional mutual funds.
6. Scalability and revenue potential: Industry estimates suggest that tokenized funds could significantly increase AUM, reaching up to 1% of global AUM (around US$600 billion) by 2030. In addition, the turnover of tokenized funds can generate up to $400 billion in annual profits from activities such as collateral and price trading. .

Fundamentally, fund tokenization can bring significant benefits by democratizing access, improving liquidity, and increasing efficiency for both investors and asset managers. It positions asset management for future growth by responding to changing market needs while improving the investor experience and returns. This could also potentially lead to increased scrutiny and trust in the industry.

Which funds are best suited for tokenization?

According to InvestaXsome funds are better suited to tokenization. In particular, those with high barriers to entry, such as high minimum investments or geographic restrictions, and funds with illiquid assets, such as private equity or real estate, may benefit from this.

Ideal means for tokenization include:

1. Real estate funds – Typically illiquid and have high entry costs; tokenization can create a secondary market for shares, increasing liquidity and lowering investment minimums.
2. Debt funds – Tokenized debt funds, which are currently having trouble raising money.
3. Private equity and venture capital funds – Often limited by high minimum investments; tokenization enables fractional ownership, increasing access to these high-growth assets.
4. Hedge funds – Known for its complex structure and limited access; tokenization can make these strategies more accessible and easier to administer.
5. Infrastructure funds – Tokenization of large-scale project investments allows for greater investor participation and greater transparency if these infrastructure funds are to go public.
6. Commodity funds – Tokenization of funds investing in commodities such as gold or oil makes trading easier and faster.

How close is the next financial revolution?

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

1. Adequate regulation and investor protection – Some tokenized funds are launched in the US, while others are based in Singapore. However, clear and comprehensive regulations for blockchain-based financial products are still lacking. While regulators appear to be unsympathetic to crypto assets, financial products appear to have received the green light. The lack of standardized rules increases uncertainty regarding investor protection, compliance and oversight.
2. Operational issues and compatibility – tokenized funds require seamless integration with traditional financial infrastructure, which is often incompatible with blockchain systems. For tokenized assets to operate smoothly, compatible standards and systems are required, which are still in development. Lack of integration can create friction in transactions, complicate administration, and slow down trading and overall adoption.
3. Reliability of the smart contract: Smart contracts automate key functions, but any errors in the code can lead to losses, security vulnerabilities, or ineffective asset management. Smart contracts are immutable, so errors or security flaws cannot be easily corrected, creating risks in terms of both financial loss and legal liability.
4. Dependence on stable money online: The benefits of tokenized funds, especially regarding real-time settlement and instant collateral, depend on the availability of stable, regulated money on the network (such as stablecoins or central bank digital currencies). Without widespread forms of on-chain money, tokenized funds may face challenges achieving full liquidity and efficiency potential.

Tokenized funds represent an exciting innovation with significant potential value, offering increased liquidity, greater accessibility and operational efficiency. However, traditional banks would be wise to take a more transparent approach regarding the risks involved. A balanced approach that openly addresses both benefits and limitations is essential to building trust between investors and stakeholders.

It is also notable that just a few years ago, the financial sector largely dismissed crypto assets as speculative or fringe. However, we are now seeing that large financial institutions are not only recognizing, but also actively leveraging the potential of blockchain technology for a range of their activities. This shift highlights how quickly the outlook can change as the underlying technology of digital assets begins to disrupt traditional finance in significant ways.