Tokenisation has been touted as the saviour of private and illiquid markets. Nicholas Pratt asks how it can be done and how long it will take.
The use of digital security tokens has been touted as a way to generate greater activity and liquidity in secondary markets and illiquid asset classes such as real estate, private equity and fine art, as well as making these markets more accessible to a wider range of investors.
In 2019, analysts at Deloitte stated that “tokenisation allows the creation of a new financial system – one that is more democratic, more efficient and more vast than anything we have ever seen”. They go on to say that “tokenisation is already a reality” with “both new players and traditional infrastructures paving the way for mainstream adoption”.
A more recent report examines this claim. In April, the Security Token Group issued ‘The Security Token Market Secondary Trading Analysis: 2019’, which looked at the rate of security token adoption and the health of the secondary markets. It drew two major conclusions.
Firstly, security token infrastructure is beginning to permeate traditional markets, including mutual funds. It refers to Franklin Templeton’s efforts to tokenise its latest fund, announced in September 2019 when it made a secondary filing to the Securities and Exchange Commission (SEC). And it details prominent players in the market.
Secondly, it concludes that there is little interest among investors in the current batch of security tokens on secondary markets. “Hundreds of millions of dollars have been invested directly into security token infrastructure,” states the report. “However, we have yet to fully see the same seal for the current assets on the secondary markets.”
It does, however, note that one important thing was achieved in 2019: the successful bifurcation of security tokens from the world of cryptocurrencies and bitcoin. For those looking to establish new businesses in the tokenisation world that can appeal to institutional investors, this distinction is important.
“We’re not talking crypto here,” says Richard Johnson, chief executive of Texture Capital. “It’s about issuing tokens on the blockchain. The difference between the two – cryptocurrencies and security tokens – is definitely not clear enough in too many people’s minds.”
The essential distinction is that security tokens apply the tokenisation concept to real assets or financial instruments within a regulated environment such as an exchange. While this will grant institutional investors more comfort, it will take longer to establish than the less stringent world of cryptocurrencies, bitcoin mining and initial coin offerings.
Incompatibility
Texture Capital is aiming to help companies issue and trade security tokens and is awaiting a licence in the US. Johnson believes the application of tokenisation to private and illiquid markets makes more sense than with established markets and asset classes.
“As an analyst of market infrastructure, I saw a lot of companies applying the blockchain to vanilla markets like equities but then not getting off the ground. There was incompatibility with existing infrastructure such as trading and settlement systems and exchanges. Plus those markets already work quite well.
“In contrast, many private markets lack basic electronic infrastructure – it’s mostly filing cabinets and spreadsheets. I see it as a greenfield site,” says Johnson. It is also an incredibly large site and he admits he did not fully appreciate the size of private markets at first. “The value of the assets sold on private markets is two-thirds bigger than the IPO market. It is a tremendous opportunity.”
Much will depend on regulation, he adds. “It needs to fit with existing rules but it could actually enhance regulation. It can provide a digital record of ownership and you can apply smart contracts on top of that to streamline the compliance process instead of waiting a year before you can sell an asset because you have to file a REG-D submission.”
Only then can extra benefits be added, such as consensus-based settlement. “It is not possible at the moment, but I am hopeful we can unlock those kind of things,” says Johnson. “There are still a lot of pieces that need to fall into place and other entities that we need, like custodians and fund administrators. A lot more has been done in Europe than the US but tokenised assets only represent a fraction of the market – sub 0.1%.”
Like many other start-ups in this space, Texture Capital is aiming to be a partner to issuers and asset owners looking to tokenise. And while many investors do not care whether an asset is issued on the blockchain or not, nothing can be tokenised without the consent of the issuers and asset owners. “Their concern is that it is still early days and no one wants to go first,” says Johnson.
In essence, there needs to be more security tokens on trading platforms, he says. “There is a trading platform in the US that has just eight security tokens. You need a critical mass, about 50-200 at least. You don’t necessarily need fewer platforms but you do need more tokens. And you need more custodians and administrators. Every bank has a blockchain team and has made investments in blockchain companies. But at the same time, they are not known for their streaks of innovation.”
Things are happening, though. In late January, the first real estate fund in Europe to be tokenised was launched. The AARGOS Global Real Estate Fund, a Sicav supervised by the Financial Market Authority of Liechtenstein, offers a chance to invest in a blockchain-based security token in a real estate portfolio.
Regulated under the Alternative Investment Fund Managers Directive (AIFMD), the portfolio manager is ArcInvest, the AIFM is Ahead Wealth Solutions and the depositary and paying agent is Liechetenstein-based Bank Frick. In addition, a fintech – Token Factory – was contracted to develop the technology for the smart contracts.
“As the depositary, we take care of asset servicing, record-keeping and safekeeping. Furthermore, as paying agent we are also responsible for the settlement of the share transactions – which in this case are executed on the blockchain,” says Raphael Haldner, Bank Frick’s head of funds and capital markets.
Counterparty
There are two major changes in the trading of a tokenised fund, says Haldner. Firstly, there is no central securities depositary (CSD) involved. Secondly, the investor becomes a direct counterparty in the fund as opposed to placing an order with a fund administrator or depositary bank. To deal with the second difference, Bank Frick established a new subsidiary – 21.finance – to provide identity verification and client onboarding.
This whitelisting and identity verification is a gateway to tokenising funds, says Haldner. The second crucial development was the Liechtenstein Blockchain Act, which came into force in early 2020. The Act recognised the legitimacy of a tokenised fund and laid out the responsibilities for the different counterparties involved, from the token issuers to the distributors to the custodians and the identity verification providers. This allowed the AARGOS Fund to be launched on January 27. “With the Act in place, we know who does what,” says Haldner.
But while the primary markets for tokenised funds have been well established, the same cannot be said for secondary markets, he says. “We don’t yet have regulated trading venues for security tokens and that is a serious issue. We need an exchange to be connected to a CSD but no one is offering that at the moment. This means that the extra liquidity that was promised to investors remains a promise rather than a reality.”
The likes of Euronext (which acquired tokenisation platform Tokeny) and SIX (which established a digital assets subsidiary, SDX) are developing plans, but the wait for anything concrete continues and may be even more prolonged given the reduced appetite for investment that will likely result from the Covid-19 crisis.
It is still possible to operate on an over-the-counter basis and through various multilateral trading facilities rather than exchanges. But, says Haldner, that was not the promise made to the institutional investor market. “A trading venue normally requires a bank to be the trading entity and to have direct membership as opposed to the individual investor, so it will take time for that to happen,” he says.
“Another problem is that as the transfer agent (TA) of the fund, we would need to maintain a register of the fundholders. What would be better for that than a blockchain? With the use of smart contracts, only a known wallet-holder could receive the tokens. But the regulator raised concerns about an individual selling their wallet to another individual without the TA knowing. So what we need now is the entrance of regulated custodians so that a wallet can only be sold or transferred with the knowledge of the custodian.”
While most of the established players within the traditional asset management market are involved, there is some caution, says Haldner. “We have been creating customised financial instruments for many years. One of the tasks is to deposit those new instruments with a CSD, which is normally done within a day. But whenever there was crypto involved, the process got more complex and much more time-consuming, weeks rather than days, and were asked to provide additional information again and again.” That is still the case today, he says, but at least the CSDs have all established internal working groups to consider how blockchain can be integrated into their infrastructure. “It could make things easier for them but I think the market, especially in the banking sector, must continue to mature before a corresponding offer finds buyers.”
Awash with cash
Custodians are emerging, however. In December 2019, Fidelity Digital Assets launched in Europe, a year after opening in the US market. The European business currently offers services for bitcoin only but is targeting two different client types: digital natives (such as crypto exchanges and corporates and bitcoin miners) as well as traditional asset managers, hedge funds, family offices and pension funds.
“We have seen a tremendous rise in interest during the pandemic,” says Chris Tyrer, head of Fidelity Digital Assets Europe. The rise of quantitative easing means the market is awash with cash, and bitcoin has become a safe haven in some eyes, capping quite a turnaround from previous years.
“The price of bitcoin has definitely been volatile for some time, but the narrative of bitcoin as a store of value has been progressing for some time. And the development of a credible asset servicing and custody market for bitcoin has certainly helped to cement that ‘store of value’ argument,” says Tyrer.
But it is tokenisation that will likely prove more durable for institutional investors, he says. “Investment banks are far more interested in tokenised assets and securities and we purposefully built our infrastructure to cater for both bitcoin as well as tokenised assets.”
The benefits of tokenisation are manifold, not least bringing more liquidity, transparency and post-trade efficiency to illiquid assets such as commercial real estate (RE), where there is currently an extremely high bar for individual investors, says Tyrer.
Meanwhile, RE funds that have attempted to make the asset class more accessible have suffered from a mismatch between the daily liquidity favoured by investors and the inherently illiquid nature of the assets, resulting in a redemption crisis for many RE funds – a problem that could potentially be solved by an active secondary market that results from tokenisation.
Key to this will be regulatory clarity, says Tyrer. “For example, the concept of dematerialised securities is not recognised everywhere. And as the use of blockchain-based trading increases, it may render some existing regulations and standards irrelevant. If the ultimate source of truth is the blockchain, do you need all of those incremental steps? We fundamentally believe that bitcoin will persist and be increasingly prominent going forward, but there are complexities and risks in how it is stored. So developing custody services for bitcoin is good for tokenisation.”
It is not just about the service providers, though, says Tyrer. “The asset managers’ ultimate involvement is going to be required,” he says. “The journey has already begun and the benefits are clear – liquidity, transparency and efficiency (settlement, DVP mismatch). We have the opportunity to replace the traditional infrastructure with a much more efficient, digital alternative, but to do this will take time. We generally overestimate the pace of change over two years but underestimate it over ten.”
Haldner is not worried that the wait for regulated trading venues will lose the audience for tokenisation, but it may claim some of the many fintechs offering tokenisation services. “A lot of the important institutions are now getting involved but some of the fintechs are losing patience and money. For the ones offering identity verification services, banks would not currently accept their data as a single source of truth, so that means they are struggling.”
Consequently Haldner expects there to be a wave of consolidation with major institutions buying up the fintechs, as we are already seeing to some degree with Euronext’s investment in Tokeny. If the major institutions do take a greater share of the tokenisation market, the big issue will be whether they are able to provide the scale and credibility needed to make it appeal to an institutional audience without slowing down the pace of development to something glacial.
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