So many middlemen, so much complexity
As we have seen already, there are a lot of intermediaries involved in the delivery of conventional investment funds. Take, for example, a simple UK equity ISA, the most straightforward of tax-efficient collective investments. It takes up to 16 regulated intermediaries, and a battery of technology platforms, to deliver this basic product.
There is the fund entity itself, the fund manager, the fund custodian, the transfer agent, the fund accountant, the fund depositary, the authorised corporate director, the fund auditor, the fund’s CASS auditor, the fund’s legal adviser, the fund’s payment bank, the fund’s broker, the market in which the fund buys its investments, the tax-wrapper provider, the fund distributor, the investor’s financial advisor…and the rest. Some of these services can be combined, but most can’t.
All of these intermediaries take a slice of value from the fund in the form of fees: it is a feeding frenzy. This is not to say that each intermediary doesn’t do its job well or take its responsibilities seriously: most of them do. The problem is the sheer scale of intermediation mandated by current regulation, the extraordinary complexity which this embodies, and its negative impact on value for the investor. You would believe that the challenge of buying more than one asset for more than one investor, and delivering it tax-free, was the most complex problem ever faced by mankind.
The fees and costs of all these entities are ultimately paid by the investors, and are charged irrespective of any loss suffered by the investors. Over time, this unedifying picture has become ever more complex, as new entities have been added to patch over the cracks in the process.
ETFs are only low-cost by contrast with our longer established, and insanely inefficient mutual funds. ETFs are no angels, either
We have now reached an absurd level of entanglement, which, bizarrely, is accepted as normal in our conventional financial services world. There is a strong sense of ‘emperor’s clothes’ here: anyone objective, looking at this from an external perspective, would think that we are mad to tolerate such a bloated and costly ecosystem.
ETFs are pointed at as efficient collective vehicles that allow investors to access markets at low cost. The truth is that ETFs are only low-cost by contrast with our longer established and insanely inefficient mutual funds. ETFs are no angels either. They too kick all of the risk over the fence to the investor. They too only offer investors the single speculative product that other investment funds offer. They too have intermediaries: arbitrageurs, market makers, authorised participants and ETF managers all take value out of the fund: the value extraction is just less obvious than it is with the plethora of charges taken directly from OEICs and unit trusts.
A better product – native digital funds
Native digital funds are simple structures, which work to a common issuance and operating model, while giving total flexibility in the outcome delivered to the investor. This achieves a dramatic simplification of technology, process and regulation. There can be a single structure delivering across different products, not one structure per product type. The same operating model, and the same issuance model, can support every level in the value chain, too.
The investor’s outcome objectives can be codified into a set of tokens, representing flows at points in the future, when the investor foresees the need for that outcome. Fund manufacturers and distributors can bid to deliver to those objectives, and the tokens become contingent or non-contingent liabilities against the successful bidder. Return on investment is implicit in the bids, there is competitive tension between providers, and the whole process is driven from what the investor wants as an outcome, not what the manager wants to deliver as a fund.
So, in a native digital fund, the investor holds one or more tokens which commit a future value flow from the fund to the investor, not shares or units in the fund vehicle or the underlying assets. The tokens are self-executing, so neither the fund nor the investor needs to manage the processes of settlement and distribution: there is no register maintenance, no calculation of entitlement or proceeds, and no need for reconciliation.
The form of future value committed is wholly flexible, so the outcome can be defined to suit both the investor and the fund. The committed flow is a flow of tokens from the fund to the investor, and can comprise tokens of any kind. They may be asset tokens or cash tokens; they may be tokens collateralised by off-ledger assets or cash, they may be native digital assets or cash. The triggering of the flow is similarly wholly flexible: it can be a date, a sequence of dates, an event, a sequence of events, or a combination of dates and events.
The constituents of a native digital fund are flexible too, and can be conventional assets, tokens of any type, or a combination. So the fund’s assets don’t have to be purely digital, but the more that the fund moves towards a 100% digital ecosystem, where all of its constituents are in token form, the more efficient it becomes, and the simpler it becomes to match assets and liabilities.
Delivering a native digital fund is not a binary ‘no risk or all of the risk’ choice for the fund manufacturer: it is an opportunity to share risk as both the manufacturer and the investor choose.
If you want to deliver, or to invest in, a purely speculative product, then you can: as now, you will get whatever the selected assets return, less the costs and profits of the fund. The good news is that those costs will be much, much lower. If you want to receive a defined outcome on a risk-free basis, then you can have it, so long as a manufacturer is prepared to offer it. The same applies to a mid-point where risk is shared: this may be structured as a defined outcome, qualified by risk tolerance, and/or compounded with some exposure to speculative market returns.
The most important operational strength of native digital funds is that all of the different products across the risk-sharing spectrum are issued and operated through exactly the same model. As we have seen, currently there are different operating models, entities and regulations for each fund product type on the spectrum: a DB pension fund, an insurance fund, or an endowment fund, foundation fund, investment fund etc.
The operating models supporting all of the levels in the value chain are also currently very different too: underlying assets, funds, platforms, distributors and financial advisors all have their own technology, entities, operating models and regulations.
With native digital funds, these distinctions evaporate, and we are left with a single model at all levels and for all products. The only thing distinguishing one fund type from another, and one product from another, is what is defined on the token. Everything else is exactly the same: the cost of delivery is dramatically reduced as a result. The level of automation is maximised too, as the single operating model is powered by self-executing tokens, further driving down the cost of delivery.
If funds are to remain the heroes of democratic investment, then we need to move swiftly and decisively towards a native digital fund future. There is a world of benefit to gain for whichever of the major European fund centres – such as the UK, Ireland, or Luxembourg – forges the lead.
Before another jurisdiction beats us to it.
