Digitised private assets demand more than a token approach to adoption

DEEP LOOK | Positive forecasts for adoption of private asset tokenisation must be tempered by recognition that buy and sell-side institutions looking to engage with distributed ledger infrastructure face some significant challenges. PostTrade 360° contributor Paul Golden speaks with six experts from across the stakeholder spectrum.

Tokenization refers to representing ownership and properties of an asset as a programmable piece of code – known as a smart contract – on a blockchain or other distributed ledger. In a private asset context, it improves transparency and audibility in private markets by using distributed ledger and smart contracts to standardise and share data across multiple participants on a permissioned basis.

Lack of automation across the end-to-end lifecycle, the need for handoffs among multiple parties, and constant reconciliation significantly increase the administrative burden and operating costs for financial institutions dealing in private assets.

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“Lengthy timelines and complex processes involved in issuance, syndication, settlement and post-trade servicing limit growth potential and reduce liquidity, which investors cite as a key barrier to accessing private markets,” observes Kelly Mathieson, chief business development officer at blockchain technology developer Digital Asset.

Research suggests that tokenised assets are on the verge of entering the mainstream. A survey conducted late last year by global funds network Calastone found that 67% of US-based asset managers and 61% of those based in Asia expected to have a tokenised offering in place within 12 months and almost 40% of firms in both regions were actively implementing tokenization projects in their businesses.

In February, Citi completed a proof of concept which tested the tokenization of a Wellington Management-issued private equity fund. The underlying fund distribution rules were encoded into the smart contract and embedded in the token, which was transferred to hypothetical clients of WisdomTree, an asset manager also involved in the pilot.

Bain & Company estimates that enabling the creation of a shared platform and workflow that supports more seamless, automated order processing, settlement, ownership tracking and data management could generate $400 billion in additional annual revenue for the alternative asset management industry by facilitating easier access to private equity and private credit funds for individuals as well as traditional institutional clients.

Technology complacency

But another finding from the Calastone survey highlights the potential for complacency around the implementation of blockchain technology. Two thirds of the asset managers surveyed said they expected to be able to manage the introduction of tokenised investment vehicles without having to make any additional investment in infrastructure and expertise.

Cristiano Ventricelli, vice president of DeFi and digital assets at Moody’s Ratings agrees that the added programmability of smart contracts could empower investors to scrutinise every aspect of transactions and issuers with remarkable granularity, significantly reducing counterparty risk and lessening the need for capital and liquidity buffers.

“However, the integration of distributed ledger technology with legacy systems presents various challenges that require attention,” he warns. “Issuers must digitise their processes to ensure visibility on the blockchain. Moreover, maintaining synchronisation between on-chain and off-chain data necessitates the deployment of secure and reliable oracles.”

Blockchain oracles are entities that connect blockchains to external systems, thereby enabling smart contracts to execute based upon inputs and outputs from the real world.

Then there are operational considerations. Justin Chapman, global head of digital assets and financial markets at Northern Trust describes tokenisation as only a partial solution to increasing the visibility of transactions and asset servicing of private assets.

“Full transparency across private markets will require the active participation of all actors to provide more information on underlying assets and reduce the opaqueness of the market, which impacts investor confidence,” he says. “Demand for transparency in private markets is also taking many forms, with a major focus on ESG credentials, for example.”

Tokenisation in private markets might standardise data elements and create more transparency and efficiency around operational processes such as issuance, subscriptions, capital calls and redemptions, observes Sandy Kaul, head of digital asset and industry advisory services at Franklin Templeton.

Liquidity considerations

“On the other hand, it may not be applied to the underlying investments any time soon as asset managers are trying to figure out how to best wrap illiquid assets in more liquid investment vehicles,” she explains. “In addition, these asset managers need to fully understand the implications of having tokens trade freely in a secondary market and, in particular, how the valuation of tokens impacts the value of the underlying fund.”

Pricing of secondary shares will likely be based at least in part on investor supply and demand, adds Kaul. “This often results in mismatches that may cause token prices to trade at a discount to the main fund, which in turn can dampen investor interest and the ability to exit investments,” she says.

Distributed ledger technology-based infrastructure has the potential to enable new operating models for the industry based on a verifiable single source of truth that is very difficult to tamper with. But it also likely introduces the need for a regulatory perimeter around new activities such as smart contracts auditing, transaction validation and governance of shared infrastructure.

“Regulators need to be able to assess and be comfortable with market participants’ capabilities and procedures around new risk management vectors – including cyber risk and data privacy – introduced by distributed ledger technology,” says Nisha Surendran, emerging solutions lead for Citi digital assets. “They also need to be able to factor in technical design elements that could impact the risk level of applications and require the industry to design appropriate fail-safe procedures.”

Distributed ledger and related technology has the potential to blur boundaries between traditionally defined roles in asset servicing, leading to more vertical integration, so regulators need to define protocols and criteria to ensure smooth and stable functioning of financial markets and adequate investor protection. 

“These solutions might also span jurisdictional boundaries, requiring regulatory and supervisory bodies to come together to determine common standards and frameworks,” says Surendran.

Rule revision

Regulators will want to ensure that any distributed ledger technology-based ecosystem remains compliant with existing rules and regulations. Ashley Oerth, associate global market strategist at Invesco expects issuers and distributors to engage appropriately.

“Moving forward, there will likely be opportunities for revising existing rules to facilitate distributed ledger technology-based solutions to fully realise their expected benefits,” she says.

Moody’s Cristiano Ventricelli refers to governance, compliance, and security as the primary considerations for regulators. 

“Addressing fundamental questions about the oversight of network operations, authority over transaction processing, and the ability to upgrade technical infrastructure is essential within evolving regulatory frameworks,” he says.

It is also imperative that network participants are identifiable and subject to know your customer and anti-money laundering checks to deter malicious actors from engaging with other participants. All entities involved in transactions on distributed ledger technology platforms – including technology providers and custodians – must adhere to applicable local licensing regimes.

“Institutions conducting transactions on distributed ledgers must assure regulators that they have robust business continuity and disaster recovery plans in place to mitigate potential technological failures without compromising the successful execution of a transaction,” adds Ventricelli.

In addition, the shift to distributed ledger technology and tokens requires investor wallets, which may raise questions about the transparency of investor information versus transaction information.

“At present, regulators seem to be leaning towards the use of permissioned private chains,” says Franklin Templeton’s Sandy Kaul. “But for private funds, early proposals have been to limit views of the blockchain to only individual issuers and distributors even on private chains (thus siloing the blockchain views) in order to protect investor privacy and prevent other distributors from seeing customer and subscription/redemption information.”

Obviously, this would undermine the value of having the ledger distributed. An alternative would be to adopt the pseudo anonymity of public chains for transactional data and utilise a different solution for investor information, which Kaul suggests could be either digital ID solutions such as soulbound tokens (a type of token that can only be owned and transferred by a specific address) linked at the wallet level or separate off-chain ledgers for personally identifiable information.

Evolving standards

Kelly Mathieson, Digital Asset, acknowledges that legal and regulatory standards on tokenization are still evolving, but says there appears to be an emerging consensus around the principle of ‘same risk, same regulation’ across leading global financial centres.

“When it comes to private markets, the most relevant regulations are perhaps each jurisdiction’s criteria on who can access such investments,” she says. “In the US, for example, investors must be either qualified purchasers with $5 million or more in investments, or accredited investors with more than $1 million in liquid net worth. In Singapore the requirements are lower – net worth over S$2 million (approximately $1.5 million), net financial assets over S$ 1 million or income of S$300,000 or more.” 

Northern Trust’s Justin Chapman agrees that the specific regulatory implications of engaging with distributed ledger infrastructure will depend on the jurisdiction.

The investor restrictions imposed in the US, Singapore and elsewhere are a product of regulators’ desire to protect retail investors from illiquidity and a different risk profile in private markets. That dynamic could shift considerably if private assets were tokenized as it would address concerns over both liquidity and transparency.

“This, in turn, could warrant different regulatory approaches for traditional and tokenized private assets,” concludes Mathieson.