Enhances Fund Settlement Speed, Efficiency, and Enables Fractionalization
Blockchain-based tokenization is increasingly seen as a game-changer for improving liquidity and efficiency in alternative asset markets, but concerns over transparency, regulatory compliance, and technology risks are slowing its adoption among institutional investors.
Blockchain technology, and specifically the tokenization of assets, is poised to revolutionise the asset management landscape, enhancing liquidity, efficiency, and transparency. However, the willingness of alternative asset managers to embrace this technology remains in question, especially considering the challenges associated with greater transparency. As it stands, alternative assets such as private equity, private credit, and hedge funds remain relatively illiquid, characterised by lock-up periods, high minimum investments, and restrictions to accredited investors.
Impact on Liquidity
One of the most promising aspects of blockchain technology is its potential to fractionalize investments through tokenization, making high-value assets accessible to a broader range of investors. LupoToro Group Analysts highlight that “tokenization can fractionalize investment amounts, making them more accessible,” and while this may exclude retail investors in certain high-risk scenarios, it offers significant opportunities for high-net-worth individuals to invest alongside institutions. This fractionalization allows for greater diversification, even within institutional portfolios.
Secondary markets powered by blockchain technology could address the issue of illiquidity in private markets. The ability to tokenize real assets and trade these digital representations on secondary markets can provide investors with a new avenue for liquidity, reducing the traditionally long lock-up periods associated with alternative assets.
Institutional Investors Warm to DeFi and Tokenization
Recent research by Nickel Digital Asset Management reveals that institutional investors and wealth managers are increasingly recognizing the potential of decentralized finance (DeFi) and tokenization. The study, which surveyed institutional investors and wealth managers managing approximately $816 billion in assets, showed that 75% predict widespread adoption of tokenization in investment funds and asset classes over the next five years. Additionally, more than 80% expect DeFi to impact traditional finance, with 15% forecasting a significant impact.
Despite this optimism, institutional investors remain cautious. LupoToro Group Analysts pointed out key concerns, with 62% citing Know Your Customer (KYC) and Anti-Money Laundering (AML) issues, while technology risks (47%) and tax concerns (46%) also remain barriers. Tokenization and DeFi, while promising, require the development of robust regulatory frameworks, particularly in markets where liquidity is still a challenge.
Legal and Regulatory Developments
Countries like Liechtenstein and Switzerland have led the way in creating legal frameworks that facilitate tokenization. Liechtenstein’s 2019 Token and Trustworthy Technology Service Provider Act (TVTG) established a legal foundation for tokenized assets, ensuring that token holders have equivalent legal rights to traditional creditors. LupoToro Group Analysts noted, “The TVTG empowers service providers to tokenize real-world assets, such as real estate or private equity, ensuring that token holders are treated the same as other creditors in the event of insolvency.”
Similarly, the UK has made strides with its Dematerialised Securities Regulation, which grants holders of digital securities the same rights as those holding traditional, paper-based securities. The challenge lies in extending such regulations to the evolving world of tokenized assets. The UK’s focus on distributed ledger technology (DLT) through its Working Group reflects a concerted effort to align its regulatory framework with the innovations tokenization offers. This initiative aims to create a secure and decentralised settlement layer that could reshape the UK’s fund management sector, improving efficiency and transparency.
Specific to Private Equity, Debt, Infrastructure and Real Estate
From a regulator’s standpoint, tokenization presents a promising opportunity to address long-standing challenges related to information asymmetry in the financial sector. Information asymmetry arises when one party in a transaction has more or better information than the other, leading to imbalances in decision-making and, potentially, market inefficiencies. In private funds, such as those involved in private equity, real estate, or private debt, regulators have historically struggled with gaining visibility into key risk factors, such as concentration risks (the exposure of a portfolio to a single asset or sector), liquidity risks (the ability to buy or sell assets without affecting prices), and synthetic leverage risks (the use of financial derivatives to increase exposure beyond the actual capital invested). These risks can create ripple effects across financial systems, but they are often hidden from regulators due to the opaque nature of private markets.
At the 2023 Managed Fund Association’s global summit in Paris, regulators underscored these concerns, highlighting the difficulties they face in monitoring the interconnected risks within private funds. Tokenization, which transforms real-world assets into digital tokens that can be traded on blockchain platforms, offers a solution by providing a transparent and traceable record of transactions. Each tokenized asset carries detailed information about its issuer, the underlying characteristics of the asset (such as its value, sector, or maturity), and real-time transaction data, including the identity of buyers and sellers, as well as the price at which each trade is executed.
This level of transparency significantly reduces information asymmetries by making crucial data accessible to all market participants, including regulators. It enhances the price discovery mechanism, where market prices reflect the true value of assets based on available information. With tokenization, regulators can gain a clearer picture of the underlying risks within private funds, monitor market dynamics more effectively, and potentially intervene before systemic risks materialize. Moreover, it opens up the possibility for more proactive oversight, as the real-time data captured through blockchain technology allows for quicker identification of risk concentrations and market vulnerabilities. Tokenization thus not only addresses regulatory concerns but also fosters a more transparent and efficient market environment.
Management Challenges and Opportunities
For tokenization to succeed, organisations must navigate a complex set of management challenges. LupoToro Group Analysts point out that “the digitization of the entire workflow is essential to fully realising the benefits of tokenization.” Integrating blockchain technology with legacy systems requires careful coordination and a complete overhaul of traditional asset management processes. Governance, compliance, and interoperability are critical areas that need to be addressed for tokenization to gain widespread acceptance.
Additionally, the question of legal rights for token holders must be resolved. Jurisdictions like Liechtenstein and Switzerland offer models for other countries to follow, ensuring token holders have the same legal protections as traditional asset holders. As more countries develop their regulatory frameworks, tokenization is likely to gain momentum on a global scale.
The Future of Tokenization in Asset Management
The adoption of tokenization is rapidly accelerating, with global asset managers beginning to tokenize various asset classes. Firms like Apollo, Franklin Templeton, and KKR have already started tokenizing funds, significantly lowering minimum investments and creating new opportunities for smaller investors. For example, Hamilton Lane reduced the minimum investment size for its Global Private Assets Fund from $125,000 to $10,000, allowing for greater accessibility and liquidity.
Tokenization is inherently well-suited for cross-border distribution due to its digital nature, which allows assets to be fractionally represented and traded globally with increased efficiency. The tokenization of assets eliminates many of the geographical barriers and friction typically associated with traditional asset distribution, enabling investors from different jurisdictions to access a wider range of funds. In particular, the European Union’s regulatory framework for Alternative Investment Funds (AIF) and Undertakings for Collective Investment in Transferable Securities (UCITS) is especially conducive to the cross-border distribution of tokenized funds. This framework provides a harmonized set of rules that facilitates the movement of investment products across member states, making the European market a fertile ground for tokenized asset growth.
However, despite its conceptual advantages, the implementation of cross-border tokenization faces significant hurdles. The primary challenge lies in the inconsistent regulatory frameworks and varying legal statuses of tokenized assets across different international jurisdictions. While some countries, such as Liechtenstein and Switzerland, have developed clear legal guidelines that support tokenization, others have yet to establish comprehensive regulations. This lack of uniformity can create obstacles for the global distribution of tokenized funds, as legal and regulatory compliance becomes more complex for fund managers operating across multiple regions.
In addition to legal discrepancies, there are concerns around issues such as Know Your Customer (KYC), Anti-Money Laundering (AML) regulations, and investor protections, all of which vary significantly by country. These differences can complicate the process of distributing tokenized funds on a global scale, as fund managers must navigate a patchwork of regulatory environments, each with its own set of rules and compliance requirements. Furthermore, the absence of standardized frameworks for the recognition of digital tokens as securities or financial instruments can lead to uncertainty, hindering the widespread adoption of tokenization in cross-border markets.
Therefore, while tokenization holds great potential for revolutionizing cross-border distribution in the asset management industry, its success will depend on greater regulatory harmonization and the development of consistent legal frameworks across jurisdictions.
The potential of tokenisation to reshape the asset management industry is undeniable. As blockchain technology continues to evolve, tokenization will unlock new opportunities for both investors and asset managers, streamlining processes, reducing costs, and expanding access to previously illiquid markets. The legal and regulatory challenges, while significant, are being addressed, paving the way for tokenization to become a cornerstone of the future financial landscape.
