The Future of Funds is Tokenised

The history of institutional funds dates back to the 18th century, initially established for specific financial goals like government financing and trade. With time, these funds evolved, notably with the introduction of mutual funds and exchange-traded funds (ETFs) in the 20th century. ETFs, in particular, brought a significant change by offering diversified portfolios that could be traded like stocks, enhancing accessibility and liquidity for individual investors.

Today, the field of fund management is poised for another significant shift with the emergence of tokenisation. Enabled by blockchain technology, tokenisation simplifies and streamlines the process of investing in funds. It offers a more efficient, accessible, and transparent way of handling assets, potentially transforming the traditional landscape of institutional investing.

The Current State of Funds

Traditional funds, including both private entities like venture capital (VC) and private equity (PE), and public ones such as exchange-traded funds (ETFs), operate on foundational structures that have been established over decades. 

In private funds, such as VC and PE, the operational model is typically structured around the relationship between Limited Partners (LPs) and General Partners (GPs). LPs, usually consisting of individual or institutional investors, provide the capital for the fund. They have limited liability, meaning their risk is capped at their investment amount, and they typically do not participate in the day-to-day management of the fund. GPs, on the other hand, are responsible for managing the fund's investments and operations. They make strategic investment decisions, source deals, and oversee the portfolio, while also bearing more significant liability and performance pressure.

In public funds like ETFs, the operation is more akin to traditional stock trading, offering investors a diversified portfolio through a single tradable security. ETFs track an index, commodity, bonds, or a basket of assets like an index fund, but trade on stock exchanges like a common stock. This structure provides liquidity and accessibility, allowing investors to buy and sell shares of the ETF throughout the trading day at market price.

Both private and public funds are governed by regulatory frameworks and are subject to market dynamics and investor demand. However, the level of liquidity, investment horizon, and risk profiles differ significantly between these types of funds. Private funds often involve longer investment scopes and higher risk in exchange for potentially higher returns, while public funds like ETFs offer more liquidity and are typically seen as less risky, though they are subject to market fluctuations.

What are tokenised funds?

Tokenised funds represent a modern iteration of traditional investment funds, where the fund's shares or units are converted into digital tokens on a blockchain. This process of tokenisation involves creating digital representations of fund shares, making them tradable as tokens on blockchain networks. These tokens can embody various types of assets, from equity in the fund to specific asset-backed securities. 

For example, SPiCE VC, a blockchain-focused seed fund, exemplifies this with their recent $250M AUM fundraise, partially tokenised for LPs. Additionally, UBS tokenised a money market fund on the Ethereum blockchain, a move that's part of a broader initiative to integrate real world assets with blockchain technology. This pilot by UBS explores on chain activities like subscriptions and redemptions, showing the potential of tokenisation in enhancing efficiency and accessibility in both private and public fund sectors.

Changes with Tokenised Funds:

• Capital Raising: Funds can tokenise their assets or equity, offering these digital tokens to raise capital. This method can streamline the fundraising process, making it more accessible and efficient.
• Operational Efficiency: Tokenisation automates many aspects of fund management, from issuance to transfer of shares, reducing administrative overhead.
• Broader Investor Access: By tokenising fund shares, smaller investors can participate in investment opportunities previously available only to large investors due to high minimum investment thresholds.

Benefits of tokenised funds

Benefits to LPs/Investors

Tokenisation introduces several key benefits for Limited Partners (LPs) in investment funds. Firstly, it significantly increases liquidity for LPs looking to exit fund positions, as tokenisation creates a secondary market that facilitates easier selling of fund stakes. This is particularly beneficial for LPs seeking early liquidity. Secondly, tokenisation offers LPs global investment access and efficiency, streamlining cross-border transactions and opening up a wider range of international investment opportunities. This global reach, combined with the streamlined processes of blockchain technology, improves the overall investment experience for LPs.

Thirdly, a significant benefit of tokenisation is the access it provides to DeFi instruments. LPs in tokenised funds can leverage their positions to participate in various DeFi applications, such as staking or yield farming, offering potential for additional returns and diversification of investment strategies Lastly, tokenisation helps solve alignment issues between LPs and General Partners (GPs), especially regarding fund extensions. Unlike traditional funds where LPs might be compelled to agree to extensions, tokenised funds provide the option to sell tokens in the secondary market, offering LPs greater control over their investment timelines and exit strategies. This flexibility aligns LPs' interests more closely with their investment goals, addressing a common challenge in traditional fund structures (Suarez, 2018).

Benefits to Funds

Tokenisation offers several advantages to funds, enhancing their operational and strategic capabilities. Firstly, it significantly broadens the investor reach, allowing funds to attract investments from a global audience, unrestricted by geographical boundaries. This expansion into new markets can lead to increased capital inflows and diversification of the investor base. Secondly, tokenisation leads to increased efficiency in fund operations. By automating processes through smart contracts, funds can streamline various administrative tasks, leading to reduced operational costs and faster transaction processing.

Thirdly, smart contracts inherent in tokenised funds can be made to ensure regulatory compliance, thereby minimising the risk of non compliance with local and international regulations. This is particularly key as funds manage the strict regulatory landscape of digital assets. Lastly, the real-time valuation of tokenised assets provides funds with up-to-date and accurate asset pricing, enhancing transparency and enabling more informed decision making for both fund managers and investors. These benefits collectively make tokenised funds an attractive proposition for modernising fund management and operations.

Challenges facing funds

While tokenised funds present numerous opportunities, they also face several challenges that need to be managed carefully:

Legal and Regulatory Challenges: One of the primary hurdles for tokenised funds is the complex legal and regulatory landscape. Different jurisdictions have varying regulations regarding digital assets and tokenisation. However, some countries are making strides in providing clear legal frameworks. For instance, the UK and Luxembourg are among the jurisdictions actively working to establish legal structures that accommodate tokenised funds, aiming to create a more conducive environment for their growth and operation. Despite these efforts, the global disparity in regulations remains a challenge, requiring funds to navigate a patchwork of legal systems.

Expertise in Tokenisation: Tokenisation is a niche area that requires specialised knowledge in blockchain technology, digital assets, and relevant legal frameworks. Many traditional fund managers may lack this expertise, necessitating either significant training or the hiring of specialists. This expertise is crucial not just for the technical aspects of tokenisation but also for understanding the implications of blockchain technology on fund operations and compliance.

Market Acceptance and Trust: Despite the growing interest in blockchain and digital assets, there is still a degree of scepticism and lack of understanding among many investors and stakeholders. Building trust in tokenised funds and educating potential investors about their benefits and risks is essential for wider market acceptance.

Integration with Traditional Systems: Integrating tokenised assets with existing financial systems and processes poses technical and operational challenges. Funds need to ensure that their tokenised assets can interact seamlessly with traditional financial infrastructures, which may not be readily equipped to handle blockchain based assets.

Cybersecurity Risks: As with any digital technology, tokenised funds are susceptible to cybersecurity risks. Ensuring the security of digital tokens, particularly against theft and fraud, is paramount. This requires robust cybersecurity measures and continuous monitoring to safeguard digital assets.

Conclusion

Tokenisation marks a significant evolution in the world of institutional funds, offering a blend of increased liquidity, operational efficiency, and broader access for investors. While it presents opportunities like fractional ownership and real time asset valuation, tokenised funds also face challenges including navigating complex legal landscapes, requiring specialised blockchain expertise, and ensuring cybersecurity. With progressive jurisdictions like the UK and Luxembourg shaping conducive legal frameworks, tokenised funds are poised to reshape the investment landscape, promising a more efficient, transparent, and accessible future for fund management.

Sources

https://innovate-and-grow.beehiiv.com/p/tokenisation-will-revolutionise-funds-investment-strategy 

https://www.linkedin.com/pulse/what-tokenized-fund-danielle-faul