Does tokenisation mean the retailisation of private funds is inevitable

The recent publication of the Investment Association's Second Interim Report on Fund Tokenisation¹ and regular news articles in the financial press evidence continued enthusiasm for the adoption of digital technologies such as tokenisation amongst players in the financial services markets. Indeed, the global market for tokenised real-world assets is already currently estimated to be around $600 billion and has been predicted to reach $16 trillion by 2030.² However, questions remain about the benefits and risks of such new technologies for players in the private funds and alternatives markets where sponsors typically target investment by sophisticated, long-term institutional investors.

Tokenisation is the process of converting a holder's rights in an asset into a digital token on a decentralised, digital ledger called a blockchain which records transactions on multiple computers in a way that is secure, transparent, and resistant to interference. Each token represents a share or unit of ownership of an underlying asset, for example, real estate or financial instruments such as an interest in a limited partnership, a conventional vehicle for private funds.

A frequently cited advantage of tokenisation is the increased liquidity it grants investors. Typically, an investor in a closed-ended private fund would be locked in for a period of 8 or more years unless they are able to find a private buyer. If a private buyer is found, an investor would then negotiate with the buyer and the fund's manager to agree and execute transfer documents. Block chain technology and, specifically, the use of smart contracts (self-executing contracts with terms directly written into code) have the potential to simplify transfers and allow interests to be more freely traded and with a reduced need for intermediaries.

Proponents of tokenisation also cite the operational cost savings expected to result from the automation of certain processes and the reduced need for intermediaries (as noted above with respect to transfers). The results of a recent simulated tokenisation of a private equity fund were said to have had demonstrated that the issue and custody of tokenized interests could be achieved in a way which was compatible with existing bank systems. As part of this simulation, fund distribution rules were encoded into an underlying smart contract which determined how tokens should be split and transferred to the simulated clients.³ These results give hope that potential cost savings can be achieved from simplifying or automating the processes around not only distributions but also other commonplace and typically time-consuming or complex fund processes such as subscriptions, transfers, anti-money laundering/know your customer checks and capital calls.

Transparency is also seen as a key benefit of tokenisation because blockchain provides an immutable public record of transactions involving a tokenised asset. While the advantages of transparency in a private fund's context seem limited and indeed some sponsors may prefer not to open themselves up to such a degree, transparency has been identified as one driver of a perceived global trend towards co-investing through digitalisation, where investors may require enhanced visibility and control over their investments.⁴

The above perceived advantages mean that tokenisation has been widely identified as a means for retail and high-net worth investors to gain access, by way of fractional interests, to private funds from which they would have previously been excluded due to the typically high minimum commitment amounts demanded. Such investors potentially may be attracted by the reduced costs and simplicity offered for funds with typically complex and bespoke processes and the benefits of enhanced liquidity. For example, PEI recently reported on Evident, a Hong Kong tokenisation investment platform for alternative assets in which professional investors can open an account with a minimum of $100 (USD) and on other players such as US-based Securitize and Singapore-based ADDX, who have signed partnerships with the likes of Hamilton Lane and Partners Group.⁵

Tokenisation is not without risks. Despite prioritisation of this area by regulators, such as the UK Financial Conduct Authority, the regulatory environment, and the law regarding recognition of ownership rights (and their enforcement) over digital assets is still evolving and navigating it remains a challenge for issuers and investors alike. Similarly, the immature and fragmented nature of the markets, lack of established custodians of digital assets, opaque valuation methods, slow adoption, and a degree of skepticism from traditional investors all have the potential to impact trust in the technology, pricing and liquidity. In addition, although few would argue that blockchain technology is not secure, it is not completely immune to the threat of cybercrime and the possibility of significant financial losses for market participants remains a concern as does the cost of increasing and monitoring cybersecurity.

While there remain some concerns around the technology, the widely perceived benefits of tokenisation and positive results of early adoption suggest that it will be a significant driver of the retailisation of the private funds markets in the coming years.

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