The fund industry is poised to undergo radical change in the coming years thanks to the introduction of tokenization. Said Fihri, partner and head of fund distribution services and of digital ledger services at KPMG Luxembourg, and assistant manager for alternative investments Mesut Yilmaz, discuss how blockchain technology originally, conceived for cryptocurrencies, is set to bring dramatic improvements in the cost and efficiency of the investment world.
Said Fihri: Tokenization can enhance the financial efficiency of investment by reducing barriers to entry and increasing the capacity for transfer of shares or assets represented on the blockchain. It offers not only increased transparency but disintermediation – the removal of middlemen from transactions through automation, facilitating increased economies of scale and better management of investors. This multi-dimensional impact of tokenization enables more people to invest in a bigger volume and wider range of assets.
In traditional financial transactions, intermediaries who stand between issuers and buyers of assets, which may include banks, brokerages and clearing and settlement platforms, carry out functions such as selling the assets and reconciling their transfer with receipt of the money from the buyer.
Mesut Yilmaz: Digital ledger technology gets rid of all the financial intermediaries because it automatically matches the cash and the assets, keeping records of ownership of the assets and any changes in them, rather the traditional bookkeeping familiar today.
Based on our experience, it is difficult for small investment funds to manage a large number of investors because the manual character of day-to-day functions. Tokenization helps them manage higher numbers of investors, with less paperwork and manual intervention.
The motivation for investors is that tokenization can broaden their investment horizons by making subscription to financial products much cheaper than it is today. Currently the financial intermediaries in between are all receiving fees or margin for their work, which ultimately is paid by the investors.
Said Fihri: However, because intermediaries’ fees are encompassed within the global management fees of financial products, it’s not transparent. Getting rid of them would reduce considerably the cost for investors – a study we made found that tokenization could decrease the transaction cost by of 75%.
It can also dramatically increase speed of execution. At present, the standard for completion of a financial transaction is T+3 – three days after the order is introduced. But for investment funds, in reality it’s more like T+7 or T+8 because of the need for know-your-customer compliance checks to curb money laundering, depending on investors’ reactivity in providing the AML documentation.
But with tokenization the subscription is carried out online, while digital AML processes including scanning identification and matching it with a webcam image of the investor’s face, as well drawing on a library of compliance checks already carried out by other providers. This can reduce the delay to T+1, just the time needed for calculation of the value of the assets to be issued to the investor.
While automated due diligence checks already exist, blockchain-based e-KYC systems, notably for crypto-currencies or other digital assets such as non-fungible tokens, offer investors a digital key that identifies them and enables their information to be retrieved by counterparties for future transactions.
The technological capabilities also mesh with the idea being pursued for several years by authorities, asset managers and service providers in Luxembourg to save in routing costs through the mutualization of certain fund services.
Mesut Yilmaz: Several active blockchain platforms already exist, but the technology is still very much in emerging mode and is only gradually catching on among assets. Things are happening more rapidly in Asia and the US, but Europe continues to lag in tokenization as well as in digitalization of financial services more generally.
European authorities have been in the forefront of providing a regulatory framework for blockchain, but traditional financial service providers struggle to transform themselves as it requires substantial investment and deep transformation.
Look at the example of smartphones. They didn’t come from Ericsson, Nokia Sony and Motorola, the traditional mobile phone players of the 1990s, but from Apple and Samsung, who were newcomers to the mobile phone space. A new system to simplify financial transactions and make them very cost-efficient may come from China or from a tech company in California.
Trust is a critical benefit of tokenization – the confidence that records are automatically saved on the blockchain and cannot be altered by other parties. Effectively it is an automated notary. It is inviolable – we can be sure that the information saved in a blockchain is legitimate. In the real estate sector, this could be information on rent paid over the past decade, or the ownership registry, even a history of sale-purchase contracts.
Said Fihri: A few years ago, sceptics could point to the need to validate blockchain transactions through the mining of bitcoin and other digital tokens as an inherent stumbling block preventing a huge ramp-up in volume.
Today a switch to new validation protocols such as proof of stake and proof of authority has not only removed the need for energy- and climate-costly computation but vastly expanded the volume of transactions blockchains can handle – at least for investment funds market, if not yet for those on stock exchanges or other financial markets.
This makes a huge difference in the cost to asset managers of customer acquisition. A study around five years put the cost of acquiring a fund investor, including KYC checks, registration of shares and other subscription formalities, at between €2,500 and €3,000, plus a further €1,500 a year in ongoing expenses – almost certainly more now given inflation.
Mesut Yilmaz: Achieving the scalability offered by blockchain is particularly critical to the much-touted democratization of private fund investment. We are increasingly seeing fewer institutional and more retail investors targeting alternative funds rather than traditional UCITS.
Today most alternative funds are used to handling maybe 20 or 30 investors, including high net worth individuals, but there is huge potential to unlock among retail investors. At present the subscription process is too complicated and not cost-efficient enough for this type of product, but tokenization of fund shares would be a very valuable enabler for the democratization of private assets.
