30 October 2023
Tokenisation: The blockchain revolution for funds
There is a growing buzz around 'tokenisation' of securities. In this article, Tom Carey and Matt Brehaut describe what tokenisation is (and - just as importantly - isn't), how it works, how they think it is likely to change the funds industry, and how Guernsey is well placed to be at the forefront of this revolution.
Although this is a developing area, many billions of assets under management have already been tokenised. High profile managers such as Franklin Templeton, Abrdn, KKR, Mitsui and Hamilton Lane have already launched tokenised products. Tokenised assets nonetheless still represent a tiny percentage of the funds industry. We expect this area to grow exponentially in the coming years.
What is tokenisation?
Tokenisation is the digital representation of 'traditional' financial assets (e.g. bonds, equities, real estate, PE/VC) on a blockchain infrastructure. Transactions in - and thereby ownership of those assets are recorded on a decentralised ledger (a blockchain).
It also helps to understand what tokenisation is not:
- It isn't a 'new' asset. By tokenising an asset, you aren't creating a new asset; you are simply recording the information about who owns those assets on a new infrastructure.
- It isn't crypto. Newcomers to tokensation often mistakenly conflate tokens and crypto such as bitcoin. Tokenisation is similar to crypto as - like crypto - tokenisation uses blockchain infrastructures to record transactions in those assets and, thereby, ownership.
We think that the key to understanding tokenisation is to consider it as a shift in the infrastructure on which ownership data and transaction records are stored.
Storage of ownership data and transaction records has evolved from a manually inscribed share register or bearer share certificates held in a vault. The digital age meant computerisation of records, likely stored initially on individual computers within a bank branch, or on a server held at a bank's central data storage facility, before eventually moving to cloud based solutions.
The common element up to now was that a specific financial institution ultimately 'held' the data - whether in its own vault, its own computers or cloud servers it had procured. Moving to another service provider invariably meant a transfer of data.
Tokenisation makes the leap to decentralisation of data, where no-one 'holds' the data like before. The blockchain becomes a single store of information - a 'single source of truth'. The service providers now access and manipulate the data, rather than holding it.
The development of permissioned tokens and digital identities is a fundamentally important development. Permissioned tokens can only be sent or received based on the verified credentials of investors. This key feature facilitates the compliance necessary for mainstream financial assets to exist on the blockchain.
Essential attributes can be 'hard coded' into a token, for example that it can only be held by a non-US investor who has satisfied the AML requirements of a Guernsey fund. Assuming the programming is correct' that token cannot be transferred to a digital 'wallet' unless the person to whom that wallet belongs has been appropriately permissioned (in the example, that wallet must be linked to a non-US investor). In practice, an appointed agent - i.e. the local administrator - will determine whether the relevant prospective investor has satisfied those criteria, designate their wallet accordingly and thereby permit a transfer of the token to that investor's wallet.
It is "smart contracts" which impose specific restrictions on the tokens (mirroring "real world" requirements) which we think marks a paradigm shift in this area.
Tokens can now be subject to the same compliance oversight as is currently the case, whilst benefitting from the advantages that the blockchain offers.
What does the future hold?
Trying to predict the future with any certainty is impossible, but we think that tokenisation is likely to become mainstream, and fairly soon.
We believe the principal benefits of tokenisation will be:
- Efficiency. The single source of data – the blockchain – eliminates the need for duplicative, labour intensive and error strewn data inputting. AML and KYC processes can be streamlined.
- Risk. Smart contracts with instant settlement means the elimination of counterparty risk, meaning less need for central counterparties and reduced collateral requirements.
- Capital. The ability to "fractionalise" the tokens (break them down into smaller and smaller pieces – see bitcoin for an example!) means smaller investment sizes and increased liquidity are possible for hitherto highly inaccessible asset classes; this in turn increases the pools of capital (mass affluent, retail) managers may access.
Guernsey's funds industry currently has a significant percentage (70% by number) of closed-ended funds, typically structured as limited partnerships with large minimum investment sizes and very little liquidity in the partnership interests. Tokenisation could facilitate smaller minimum investments, whether into the main fund itself or via "access products": feeder vehicles specifically set up for such investors, whether established by the manager itself or by private wealth institutions for their clients. The technology platforms offer the promise of increased liquidity by facilitating an electronic order book where selling and buying interest could be posted and transacted.
In the same way that nobody could have foreseen the myriad ways the internet would change our lives when first introduced in the mid-1990s, we simply can't predict all of the benefits which tokenisation might bring.
How is Guernsey placed?
Given its large closed-ended funds industry and its legal and regulatory environment, Guernsey is ideally placed to benefit from tokenisation.
Our Lending, Credit and Finance Law makes clear that tokens are not "virtual assets" and fall outside of that law, regulated instead as ordinary securities.
Our Electronic Transactions (Guernsey) Law and Electronic Transactions Ordinance facilitate electronic business, the use of electronic documents and processes, the storage of information in electronic form and the enforceability of a contract carried out by means of an "electronic agent", all of which facilitate the shift to tokenisation.
Carey Olsen and Tokenisation
At Carey Olsen, we've been keeping a close eye on tokenisation developments. We recently invited Daniel Coheur (co-founder & CCO of Tokeny, an industry leading provider of tokenisation solutions), to Guernsey to talk to representatives of the Guernsey funds industry on the technology and opportunities of tokenisation.
Visit careyolsen.com/tokenisation to watch the presentation.
If you would like to find out more, please feel free to contact us.
"blockchain", "distributed ledger technology"
A blockchain is a decentralised digital ledger, which records transactions across a peer-to-peer network of computers ("nodes"). It consists of a "chain" of "blocks" which contain a list of transactions. The transactions are secured using cryptographic algorithms, intended to ensure their integrity and their immutability. Each block contains a unique identifier (a "hash") and references the previous block, thereby forming a continuous chain – hence the portmanteau "blockchain".
The distributed nature of the blockchain (hence "distributed ledger technology" and it being "decentralised") means all participants can have access to the same information, thereby ensuring transparency. Nobody holds the data; rather, they are granted permissioned to view and amend it.
"Smart contacts" are lines of code that permit the automatic execution of a specific action when specific conditions are satisfied – a simple example being a delivery-versus-payment transaction: the asset will automatically be transferred when – and only when – payment is made. Smart contracts can specify rules, like a regular contract, and automatically enforce them via the code.
An original version of this article first appeared in Business Brief, October 2023.