Securities, funds and investors

Financial services and asset management cover $trillions of assets from shares and bonds to real assets. Blockchain technology is set to change operations and create many opportunities. Tokenisation and AI are specific examples (whose synergies are highlighted in Ethereum co-founder Vitalik Buterin’s January 2024 blog post).

Tokenisation

Tokenisation for these purposes is where “security tokens” are issued essentially as the digital representation on a blockchain of a specific set of rights, such as shares, bonds or a participation in an investment fund. 

But have you considered what happens when you turn a traditional security, such as a bond, or an existing real asset, such as a property, into a digital version of the same thing? The answer depends on what the law allows you to do in a particular country.

Different nations are moving at different speeds on regulatory matters and the stakes are high for both existing and growing financial centres. Most traditional financial centres are keen to capture digitalised financial services given the amounts, jobs and revenues involved. Singapore, Switzerland, France and Germany amongst others have been making early changes and have been home to issues of tokens including digital bond issues. Most are assessing many of the potential, legal and regulatory implications ready for change. 

Benefits

Advocates for the tokenisation argue that it will:

Financial sector change

Financial institutions, including asset managers, increasingly see tokenisation as another stage in the development of how business is done and an exercise in achieving economies of scale and efficiencies. Many banks have already dipped a toe or two in the water, and in September 2023 it was reported that the London Stock Exchange Group has plans for a blockchain-powered digital markets business, making it the first major exchange to take that step. Investment and fund managers are also alive to the growing changes.

It is not just about trades in shares and bonds. There are many fund uses for tokenisation too, such as the creation of a securitised interest around real estate, venture capital and private equity firms. Funds can be tokenised, enabling participation from individual investors who would not otherwise have been able to access those opportunities. Some market observers believe that the tokenisation of alternative assets has the potential to change fundamentally the dynamics of investment and asset management.

November 2023 saw the publication of The Investment Association’s ‘UK Fund Tokenisation: A Blueprint for Implementation,’ a report setting out the use cases of distributed ledger technology (DLT) through investment fund tokenisation; which CMS was proud to contribute to. This, along with the Financial Conduct Authority (FCA) signing up to Project Guardian, were watershed  moments in the UK’s traditional finance (TradFi) industry’s embrace of blockchain and tokenisation. 

Forecasts predict that the tokenisation of financial and real world assets could reach $ trillions in value by 2030.

Considerations for business

What should be top of mind for a business as it considers creating security tokens?

Understand and adapt

Financial services firms and service providers need to understand and adapt their existing operations and new business opportunities alongside their existing infrastructure, resource and regulatory positions. AI further adds to the digital evolution. Regulators also need to develop rules, products and guidance in a similar way. 

Investment opportunity

For a person wishing to create a security token or advise on an issue the best place to start is to ask the simple question: does it work commercially? A product should be a good investment opportunity. Prioritising the technology over the underlying investment will leave the issuer selling a technological feature rather than an investment based on its fundamentals. 

Market demand

There also has to be a certain degree of demand. As many benefits of tokenisation relate to improving liquidity and transparency, using it for an investment which will be narrowly traded among specialist investors may not be commercially worthwhile. 

Interaction with investors

For new and existing issues, advisers and managers, as well as facilitating dealing in an investment, the technology can be used to communicate with investors, allow voting, perform governance functions, transmit data about the underlying asset, save costs and achieve various other enhancements. 

Benefits

Businesses embarking on tokenisation may start by looking for projects where the benefits would be significant and getting the operational, technological and regulatory basics right.

Getting the basics right

Above all, a business moving into this area will need people – whether in-house or advisers – who thoroughly understand the technology. At the most basic level, that technology needs to be:

Regulation

Tokenisation can’t be used to side step regulatory requirements. For example, fund managers already have a regulatory infrastructure for their business and this will probably treat a token in the same way it treats an underlying traditional security. 

In some cases, the use of technology may mean there are extra regulatory requirements or the tokens themselves will. Crypto assets are an example of tokens which may or may not be security tokens depending on their form and jurisdictions involved. Technology may also attract additional attention from regulators concerned about abuses such as money laundering.

The investor's angle

What needs to be top of mind for an investor who might be buying into a tokenised issue?

The paramount consideration should always be the characteristics and risks of the underlying investment. Arguably, the technology should be largely incidental to the investment decision. Unless the investor has an unusually deep understanding of the technology around tokenisation, the nuts and bolts of the process will always be opaque. But they do need to understand the benefits they may derive from it. 

Investors will also want to understand any risks deriving from tokenisation itself. These will typically be external to the technology – concerns such as fraud may exist in any issue traditional or otherwise. But investors will be mindful that there is still very little case law on tokens, and that in some cases there may be uncertainties about legal status and regulation. 

Whilst a major potential benefit of tokenisation is disintermediation where technology allows investors to invest directly rather than through intermediaries, until the market is more mature many investors will be encouraged by the presence of familiar regulation, issuers or intermediaries, especially those who are accountable from a regulatory perspective.

The next steps

This is an evolutionary process, with complex decisions about risk and reward. Countries that open the door to all forms of digital issuance, without thinking too much about it and without protecting the integrity of the market, run the danger of a backlash if something goes wrong. The balance between enabling and protecting is a subtle one. 

Opening up the retail market will make many regulators anxious. Certain types and levels of activity will likely be restricted, with many regulators wanting to see anything highly geared or volatile left to sophisticated investors who fully understand the risks of participation. It may be some time before a real regulatory balance on tokenisation is achieved in all major markets.

The future

The near future for tokenisation, as for AI, is about efficiencies and operational benefits. Beyond that it is about digital transformation for securities and all the related infrastructure. 

The ideal end game for security tokenisation is one where the investment ecosystem functions as it does now, but is better, faster and cheaper. A system in which tokenisation is common can attract more investors by democratising investment. It should enhance transparencies and increase markets and pools of liquidity that may not otherwise be so accessible.