Fund tokenization, the next financial revolution?

Original author: Alexandra Andhov

Original translation: Luffy, Foreisght News

Last month, Boston Consulting Group, Aptos Labs, and Invesco jointly released a White Paper 'Tokenization Fund: Interpreting the Third Revolution of Asset Management.' The title is attractive and thought-provoking, but does it make sense? Is fund tokenization the next step in financial evolution? If so, what will be the endgame?

In 1889, investors traded in the New York Stock Exchange hall.

According to the White Paper, the tokenization of fund has the potential to create billions of dollars in value for Financial Institutions and investors. By the end of 2024, the Assets Under Management of token funds from BlackRock, Franklin Templeton, and WisdomTree had exceeded $2 billion. Although $2 billion is only a fraction of the overall Assets Under Management of these three institutions, it indicates the growing interest in fund tokenization by investors. In addition, an increasing number of banks are also launching tokenized investment funds, with the latest news being the launch of uMINT, a tokenized money market fund, by UBS on November 1, 2024.

What is fund tokenization?

Tokenization of funds is the process of converting the ownership of funds (such as real estate, mutual funds, or private equity funds) into Tokens. Each Token represents a small portion of the fund, similar to stocks in a company.

Let's compare company stocks and fund Token:

Stocks are traditional paper or electronic records within the exchange or banking system. They represent ownership in a company and come with certain rights, such as voting on company decisions or receiving dividends. Buying and selling stocks typically requires a broker and is recorded in a centralized financial system. This business model has been around for centuries.

And Token can be seen as the ownership of Decentralization and digitization. They have rights and obligations similar to stocks, but their records are on the digital ledger of Decentralization. Tokens come in different forms because they don't rely on traditional securities exchanges or intermediaries. Instead, they are fully digitized, allowing people to buy and sell them directly without intermediaries.

What is the value of fund tokenization?

According to BCG White Paper and analysis by Bain & Company and JPMorgan, the value of fund tokenization lies in changing the asset management landscape by creating a market that is more accessible, efficient, and with stronger liquidity. A brief overview of its additional value is as follows:

• Enhance Liquidity and Flexibility: Tokenization funds provide 24/7 trading, allowing investors to buy and sell fund shares at any time. This continuous Liquidity is similar to the flexibility of exchange-traded funds (ETFs), suitable for investors who want better control of their timing without being restricted by traditional mutual funds.
• Automating cost drops: Smart contracts on the blockchain can automate processes such as compliance, record-keeping, and settlement, thereby reducing management costs. These operational savings ultimately translate into lower fees for investors, and due to simplified automated trading, net returns may be higher.
• fractional ownership and a broader access threshold: tokenization allows fractional ownership to break down investment barriers, which means smaller and easier-to-manage investment scales. This is particularly important in alternative assets such as real estate or private sale equities, which typically require higher capital investment. By lowering the access threshold, tokenization funds may attract a more diverse group of investors.
• Instant Collateral: tokenized assets can be used more flexibly as loan collateral. With the help of secure blockchain records, investors with tokenized assets can quickly borrow funds without the need for traditional lending processes to create new liquidity.
• Opportunity for Profit: The tokenization fund has opened up a new investment channel for traditional investors and digital native investors. Experienced investors can take advantage of the intraday price changes of the tokenization fund to achieve additional returns through faster and more precise trading strategies that traditional mutual funds cannot achieve.
• Scalability and income potential: Industry estimates suggest that the Assets Under Management of tokenization funds will rise significantly, reaching 1% of global AUM by 2030 (approximately $600 billion). In addition, tokenization funds can generate annual returns of up to $400 billion from activities such as mortgage and price fluctuations trading.

Essentially, fund tokenization can provide significant value by lowering entry barriers, improving liquidity, and enhancing the efficiency of investors and asset managers. It prepares for the future rise of asset management, can respond to evolving market demands, and enhances investors' experience and returns; it may also bring more supervision and trust to the industry.

Which funds are more suitable for tokenization?

Some funds are more suitable for tokenization, especially those with higher entry barriers (such as high minimum investment or funds with geographical restrictions) and funds with illiquid assets (such as private sale equity or real estate) may benefit from it.

Funds suitable for tokenization include:

• Real estate funds: usually have poor Liquidity and high entry costs; tokenization can create a Secondary Market, improve Liquidity, and drop the minimum investment amount.
• Debt fund: tokenization debt fund, currently facing challenges in raising funds.
• Private sale equity and venture capital funds: usually subject to minimum investment restrictions; tokenization enables fractional ownership, expanding access channels to these high-rise assets.
• Hedging Fund: Known for their complex structure and limited accessibility; tokenization can make them more accessible and manageable.
• Infrastructure funds: If large project investments are public, the tokenization of these infrastructure funds will allow for wider investor participation and greater transparency.
• Commodity Funds: Tokenization funds that invest in commodities such as gold or oil can make trading easier and faster.

How far away is the next financial revolution?

Before looking forward to the next financial revolution, we need to recognize the potential risks and limitations of tokenization funds, and at least consider the following points:

• Regulatory and Investor Protection: The United States has launched some tokenization funds, and so has Singapore. However, blockchain-based financial products still lack clear and comprehensive regulation. While regulatory authorities seem to dislike encryption assets, they are giving the green light to financial products. The lack of standardized rules increases uncertainty in terms of investor protection, Compliance, and supervision.
• Operational Challenges and Interoperability: Tokenization funds need to integrate smoothly with TradFi infrastructure, which is often incompatible with blockchain systems. In order to achieve seamless integration, tokenized assets require interoperable standards and systems, which are still under development. Currently, this lack of integration may cause transaction friction and complicate management.
• Smart Contract Reliability: Smart Contracts can automatically execute key functions, but any errors in the code can lead to losses and security vulnerabilities. Smart Contracts are immutable, so errors or security vulnerabilities cannot be easily corrected, resulting in financial losses and legal liability risks.
• Dependence on stable on-chain currencies: The advantages of tokenization funds, especially in real-time settlement and instant collateral, depend on the availability of stable and regulated on-chain currencies, such as stablecoins or Central Bank Digital Money. Without widely accepted on-chain currencies, tokenization funds may face challenges in realizing their full liquidity and efficiency potential.

Tokenization represents a fascinating innovation with enormous potential value: improving Liquidity, accessibility, and operational efficiency. Open discussions about the advantages and limitations are crucial for establishing trust between investors and stakeholders.

It is worth noting that a few years ago, the financial industry generally considered encryption assets to be speculative and marginal. But now we see that major Financial Institutions not only recognize the potential of Blockchain technology in a range of financial activities, but also actively embrace this potential. As the underlying technology of digital assets begins to reshape TradFi in meaningful ways, people's perceptions are also rapidly changing.