Alternative Investments and Tokenisation

Investing in alternative assets is usually reserved for high net worth individuals and institutional investors. It is also often a slow and paper intensive process, one that is out of date relative to new retail investing apps. In this note, we discuss how blockchain technology can enable a more efficient and accessible process through tokenisation. Tokens are digital representations of assets that are issued and traded within a distributed ledger. They allow for faster and cheaper transactions, greater liquidity and access to a wider base of investors, as well as potentially greater transparency for managers, clients and regulators.

Introduction

Alternative investments are generally used to describe all investments which are not stocks, bonds or cash. The main categories are private equity, real estate, hedge funds, debt, commodities, collectibles and structured products. These investments are traditionally reserved for high net worth individuals and institutional investors, as they are generally less liquid, regulated and transparent, while requiring a high minimum investment. However, since the financial crisis their popularity has increased tremendously, as shown in the figure below. In this note, we discuss how tokenisation can transform alternative assets, by broadening access while improving liquidity and transparency.

Figure 1

Source: https://www.preqin.com/academy/lesson-1-alternative-assets/past-present-future-of-the-alternative-assets-industry 

A token is a digital representation of an asset. It is issued within a distributed ledger, such as a blockchain, where it can also be traded. The asset that the token represents can either be real (off-chain) or digital (on-chain). Examples of off-chain assets are commodities, fiat currencies, real estate and stocks. If the underlying asset is a security, then the token is a security token as it needs to comply with existing securities regulations in the relevant jurisdictions. The process of digitally representing an asset is called tokenisation and can be thought of as an evolution of securitisation, enabling more automation via smart contracts, embedded logic and data. It involves the initial deal structuring, creating the tokens on the blockchain, enabling the primary distribution and post-token management, as well as trading in the secondary market. However, a token on a blockchain is qualitatively different from a digital representation of a security that resides in a centralised database. We explore their characteristics and benefits below.

Efficiency Gains

The immediate benefit of tokenisation stems from the efficiency gains that it can bring in issuing and trading tokens, thus providing better securitisation of assets. Clearing and settlement can occur faster if it is programmatically coded on a distributed ledger shared between service providers (broker, depositary, exchange etc.). 

Figure 2: Securities Trading Infrastructure with Blockchain Post-token Management

Source: Archax

For example, payment of dividends can be programmed using smart contracts, resulting in a quicker and more transparent procedure. The change of ownership of a token can be as simple as registering a transaction on the blockchain, and thus can happen within seconds. Quicker settlement of transactions is more capital efficient, as less capital is locked while trades are waiting to be settled. Back office costs can be cut if there is one shared ledger that is continuously updated, rather than several, partly compatible ledgers that need to be reconciled every time there is a trade. The rights and potential claims of the token holders can also be enforced in an easier and faster way, as they can be implemented in the blockchain using smart contracts. A token holder can immediately see their net position, without having to ask for a paper statement from their prime broker. Moreover, when the shared distributed ledger becomes accepted as the only authoritative data source for transactions, the process of reconciliation becomes obsolete, making the trade process much more efficient and reducing the risk of failed trades. Finally, another often ignored efficiency gain comes from the standardisation of processes. Currently, funds often use different IT systems, often incompatible with one another, to record transactions and complete AML and KYC checks. Manual paper statements often act as a bridge between different systems. Blockchain technology has the potential to consolidate these separate systems and increase digital interoperability.

Automated Compliance

All token transactions are recorded on a shared blockchain, hence there is greater potential for transparency on the actions of the funds and their investors. This has the benefit of allowing a regulator to continuously monitor whether inflows and outflows are compliant. Moreover, the smart contract capabilities of blockchain technology allow for a more automated process of compliance, where rules execute automatically when a particular clause is triggered. This could reduce the time it takes to get approval for buying a regulated token and complete KYC and AML checks for investors and asset managers. More generally, access to auditable data is immediate because all transactions are recorded on the shared blockchain, creating time-stamped and immutable records. The amount and type of information that is available to each party (client, regulator, fund manager) is determined at the start of the fund and can be accessed immediately. In traditional fund platforms, the regulator would need to ask for specific pieces of information and usually only if there is a specific reason. Finally, because the shared ledger provides a unique source of truth that is accepted by consensus, it is less likely that in the event of a regulatory inquiry, there are disputes about what actions each party took. Newer alternative asset managers generally are not on fund platforms until they achieve sufficient AuM and track record length, meaning that they have to rely on less efficient paper-based compliance onboarding. Tokenisation also increases the potential for automated compliance checks before investments are made, cutting trading costs and providing fund investors with greater protection.

Broadening Access and Liquidity

The specific characteristics of tokenisation enable a democratisation of access and make alternative investments more liquid. First, because a token can represent only a fraction of the underlying asset, it is easier to lower the minimum viable investment amount, allowing for a broader group of investors to participate. This fractionalisation is valuable not only to retail investors with lower net worth, who were not able to gain broad access before, but also to high net worth individuals who can now participate in a larger range of funds, which can help them diversify their portfolio. Second, liquidity increases because tokens can be exchanged with lower transaction costs in the secondary market. For example, closed ended funds do not allow for direct withdrawals from the fund manager and large discounts are the norm for secondary markets due to their fractured and over-the-counter structure. However, if the investor can sell their tokens on a secondary market which is an exchange, then there will likely be increased access, transparency and efficiency. This all contributes to increasing the liquidity of markets relative to over-the-counter markets and blockchain can be good for more transparent, accessible and efficient markets.

Conclusion

Tokenisation on the blockchain has the potential to democratise access to alternative investment markets, by enabling fractionalised ownership. Moreover, it can provide a faster and more transparent process of investing, that benefits the funds, the clients and the regulators. Finally, by enabling a secondary market for the tokens, it can increase the liquidity of the underlying asset, which in turn can increase its value.

Disclaimer

Aaro Capital is the trading name of Aaro Capital Limited (“Aaro”), a private limited company, registered in England and Wales with number 11419585, whose registered office is at 5th Floor 14-16 Dowgate Hill, London, United Kingdom, EC4R 2SU. Aaro is not authorised or regulated by the Malta Financial Services Authority ("MFSA") or any other financial regulator.

The material provided in this article is being provided for general informational purposes. Aaro does not provide, and does not hold itself out as providing, investment advice and the information provided in this article should not be relied upon or form the basis of any investment decision nor for the potential suitability of any particular investment. The figures shown in this article refer to the past or are provided as examples only. Past performance is not reliable indicator of future results.

This article may contain information about cryptoassets. Cryptoassets are at a developmental stage and anyone thinking about investing into these types of assets should be cautious and take appropriate advice in relation to the risks associated with these assets including (without limitation) volatility, total capital loss, and lack of regulation over certain market participants. While the directors of Aaro have used their reasonable endeavours to ensure the accuracy of the information contained in this article, neither Aaro Capital Limited nor its directors give any warranty or guarantee as to the accuracy and completeness of such information.

Please be sure to consult your own appropriately qualified financial advisor when making decisions regarding your own investments.

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