Asset and fund representation has undergone slow but significant change over the last 50 years. Traditionally, mutual funds were divided into units for investors to represent their ownership within the fund, which then evolved with the introduction of share classes to allow flexibility in fee structures and voting rights depending on investor needs/preferences. With the continuous advancement of technology and electronic trading platforms, shares have further evolved, recently embracing fractionalization. Yet, as the industry looks forward, there is a growing question about whether tokenization will be the next stage of evolution, and whether the change will be any faster than those seen over the past half a century.
At its core, tokenization involves utilizing blockchain or distributed ledger technology (DLT) for record keeping with issued tokens representing value and the ownership or other rights associated with an asset. In the context of traditional asset and wealth management, key focus currently surrounds issuance of the underlying asset, both in terms of representation type and asset complexity.
Representation type — Generally speaking, there are two types of representation – native asset tokenization and asset-backed tokenization. Native asset tokenization includes the issuance of an asset for the first time on-chain, whereas asset-backed tokenization issues a digital replication of an existing asset for which the current process for record keeping persists. Popularity of representation types vary across the investment value-chain, with managers currently focused on asset-backed tokenization and the distribution opportunity for existing strategies.
Asset complexity — Complexity of the underlying asset can range across asset classes (e.g., real world assets, listed equity, etc.), and across the investment value-chain (e.g., tokenization of a single traditional asset, bundling multiple already tokenized assets, or tokenizing a single traditional asset with multiple constituents). Most recent interest for managers is currently focused on the tokenization of money market funds (tokenization of a single traditional asset), and existing strategies (tokenizing a single traditional asset with multiple constituents).
As mentioned above, the most popular use case for tokenization has been money market funds, with approximately $1.9 billion in assets under management across tokenized products offered by firms such as Franklin Templeton, BlackRock, Fidelity, Coinbase, Arca and abrdn. While tokenized money market funds are expected to continue in popularity, the replication of privates/alternatives is anticipated to fuel investment by asset managers to leverage tokenization as an alternative “investment wrapper” for existing strategies in order to meet general demand and inefficiency within the market. A few examples include Hamilton Lane’s $3.8 billion private assets fund and KKR’s $4 billion healthcare fund, of which portions are tokenized to provide democratized access to these funds. Looking further into the future, native asset tokenization anticipates the issuance of financial instruments directly on-chain via smart contracts (or programs on chain that automate transactions or processes once predetermined conditions are met), with critical mass adoption expected when tokenized exchanges move "upstream,” indicating a deeper integration of native tokenized assets into the financial ecosystem.
Integration of tokenized products with the investment management industry aims to solve key points of friction that exist in the market. For investment products that have low liquidity, long lock-up periods, high investment minimums, lack of transparency, and limited access, tokenization helps mitigate some of this existing friction by enabling liquidity, transparency, and accessibility. Tokenization allows for cheaper secondary transactions, with investors being able to sell their stake more efficiently in a fund within the five to seven-year fund maturity time frame. It also enables public tracking of ownership and transactions, which will provide investors with a view of the underlying assets in real-time. This is specifically important for money market funds, given that managers have transparency into the flows within the fund, which helps them manage their short-term and medium-term cash flow needs. Finally, investors can own fractional shares of assets and/or funds, broadening access to a wider range of potential LPs due to smaller minimum investments.
The ongoing evolution of blockchain technology is marked by a gradual standardization of frameworks and blockchain features, with a focus on choices between public and private blockchains and varying permission levels. Simultaneously, efforts are underway to streamline KYC ("know your customer") and investor onboarding workflows, emphasizing pre-approval based on key investor characteristics like geography and accreditation status. As the industry matures, a natural consolidation of providers is anticipated, with leading platforms securing market share and fostering strategic partnerships. A notable advancement lies in the trajectory of tokenized exchanges, potentially moving "upstream" by facilitating initial tokenized offerings on their platforms, akin to traditional financial exchanges handling IPOs. This transformative shift is poised to occur once tokenized exchanges effectively address central distribution and liquidity challenges, marking a significant milestone in the evolution of the digital assets landscape.
The key challenge for asset managers is determining the optimal entry point into tokenization. While Alpha anticipates a continuation of current adoption rates in the short-term, there is an expectation that acceleration will happen swiftly, driven by market innovation and a reliance on tangible benefits as critical mass approaches. Recognizing the potential of tokenization, asset managers are compelled to define a strategic approach, emphasizing the importance of making calculated investments in this evolving technology. Proactive measures taken now empower managers to stay ahead of the curve, mitigating the risk of future overspending to catch up with competitors. The implications of tokenization extend across both the buy-side and sell-side of an asset manager's operating model and product strategy, emphasizing the necessity for a well-prepared playbook for pivotal market milestones. This strategic foresight ensures that asset managers are not merely reactive but are actively positioning themselves to harness the advantages offered by tokenization.
Christian Pellegrino is director, head of digital assets at Alpha Financial Markets Consulting, a global consultancy to the asset and wealth management industry. He is based in New York. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I’s editorial team.
