Tokenisation – creating a digital representation of traditional assets via blockchain – offers the prospect of liquidity in hard-to-reach assets to categories of retail investors for whom they are otherwise off limits.

In theory at least, tokens could democratise the kind of investment previously inaccessible to swaths of investors – offering them round-the-clock trading in secondary markets into the bargain.

Exponents of tokenisation say expressing fractional interests of illiquid assets on distributed ledger technology (DLT) will increase the pool of investors in less liquid instruments by reducing minimum investments to more bite-sized portions. A December 2022 Moody’s report found that asset managers expect to convert shares previously available only to institutional investors – such as those in private equity funds – into tradeable digital securities via decentralised finance.

But sceptics say it’s a solution in search of a problem.

I’m finding the reality is, [tokenisation] doesn’t bring a new kind of liquidity. It doesn’t bring access to new buyers and sellers

Arjun Jayaram, Baton Systems

“On the periphery, all the noise seems to suggest that tokenisation can bring access to disenfranchised retail investors,” says Arjun Jayaram, chief executive of fintech Baton Systems. “I’m finding the reality is, it doesn’t bring a new kind of liquidity. It doesn’t bring access to new buyers and sellers.”

One asset management firm, abrdn, has bought into the tokenisation concept – quite literally – by taking a stake in digital securities exchange Archax. But abrdn believes the immediate future of this evolving field lies in tokenising more liquid assets.

“As a regulated securities exchange, what Archax offers abrdn is a venue to admit tokenised assets, digital ownership of funds and – down the line – private equity, real estate and hedge funds,” says Duncan Moir, abrdn's senior alternatives investment manager. Long term, Moir sees most investors – retail, high-net-worth and institutional – eventually moving to a “digitisation” model of storing ownership.

The asset manager is “well progressed in shaping the operating model” and expects to be live later this year with a proof-of-concept demonstration. But rather than private assets, its first foray will be “the most straightforward product,” in the form of a money market fund. Target investors include those wanting to “de-risk their digital asset investments without moving into fiat [currency]”, says Moir.

Digital asset start-up PV01, created by some of the same people who built crypto liquidity provider B2C2, also intends to tokenise short-term debt securities, such as T-bills and commercial paper, aiming for its first issuance by July. The firm’s CEO, Max Boonen, agrees that reasonably liquid assets provide the best initial prospects for tokenisation. Their issuance on blockchain can solve “clearing bottlenecks”, as well as simplifying on-boarding procedures, he says.

While the token proposition is gaining traction in cash-like instruments, its benefits for assets lower down the liquidity spectrum are proving slower to materialise – and may not apply to all asset classes.

Secondary trading markets, for example, are seeing little tangible progress.

Investment manager Hamilton Lane has partnered with digital securities exchange ADDX to tokenise its Global Private Assets Fund, making it accessible at a ticket size of $10,000, compared to a $125,000 minimum through traditional channels. The firm’s chief risk officer Fred Shaw says a secondary market for its tokens, “where maybe you can gain some liquidity from what otherwise isn’t a liquid asset … is very far out in the future”, and would require the entrance of market-making entities.

Meanwhile, a healthcare-focused fund from private equity giant KKR has been tokenised by digital asset securities firm Securitize. “Mass adoption of real-world assets on-chain continues to face headwinds, given how early we still are,” says Morgan Krupetsky, director of business development at Ava Labs, creator of the Avalanche blockchain used by Securitize. “Generally, tokenised versions of liquid assets such as money market funds or Treasuries are becoming popular, particularly among emerging markets investors and others who might not historically have had ready access to comparable types of investments.”

But Krupetsky is confident that lower transaction sizes, investment minimums and fees can be achieved through tokenisation, and that a secondary market would “unlock greater utility from illiquid investments through on-chain borrowing with tokens as collateral”.

In future, Archax will be able to facilitate peer-to-peer secondary trading of tokens for abrdn and the participation of market-makers and brokers. Again, implementation is a way off.

“Day one, we can be realistic and probably not expect a huge amount of activity with buyers and sellers,” says Moir. “We think this is a 10-year project.”

Get real

Champions of tokens, however, insist they can help private markets function more effectively.

ADDX CEO Oi-Yee Choo says a tokenised secondary market for private equity would improve upon the current market structure, giving relief to investors who need cash urgently. If a tokenised structure existed to manage liquidity outside of existing vehicles, alternative asset manager Blackstone, which has been hit by a spate of withdrawals in some funds, following economic turbulence, “wouldn't be in the pain points that they [are] today, because they didn't realise everybody would rush to the gates all at the same time”, she claims.

Moir maintains that, in principle, tokenisation of illiquid investments can act as a pressure valve to reduce the need for redemptions of underlying assets. Hedge funds, for example, often offer quarterly redemptions coinciding with the date when net asset values (NAVs) are calculated. A tokenised feeder fund would provide a mechanism to get out sooner, although the trade-off for getting liquidity might be to suffer a discount to NAV.

It's not hard to see why innovators believe tokenising illiquid assets is worth their effort. The total addressable market for global private equity assets, according to data provider Preqin, is expected to rise to $7.6 trillion in 2027, from $4.2 trillion as of year-end 2021.

But secondary trading in private equity already takes place – largely without tokenisation – and did little to calm market jitters last year when funds were hit by waves of redemption requests. Reuters reported an unprecedented $224 billion in private equity stakes offered in the secondary market for the year to mid-November.

Property is difficult for most people to value in their own local markets, let alone other markets, due to the large number of different variables

A former clearing industry executive

If the lessons from take-up of real estate tokens are anything to go by, private equity also faces an uphill struggle. According to digital securities company Atlas One, last year the tokenised real estate sector made up about 40% of the digital securities market, yet was still worth only around $200 million. By contrast, global real estate was worth $317 trillion in 2020, calculates consulting firm Bain & Co, with $10 trillion managed in funds and available to a broader investor base.

A traditional finance executive who has moved into digitised finance relates his personal experience of trying to create digital tokens on real estate. “I tried to do it for three years. The problem is the value of a building in the UK, for example, is not the same as the value of a building in New York or Singapore or anywhere else. The interest in buying tokenised real estate does not meet the selling interest yet.”

Lack of a standardised price makes real estate difficult to offer as a tokenised asset,” he says. Unlike gold or oil, where a standardised unit of value trades at the same price across the globe.“Property is difficult for most people to value in their own local markets, let alone other markets, due to the large number of different variables,” he says. “Determining what is a fair price for the existing Aspen Coin, backed by ownership in a Vail Hotel, or any other property valued on its free cashflow and assumed exit valuation, requires a lot of specific information that is often not publicly available.” He thinks the success of real estate tokenisation also hinges on other real world asset tokens gaining mainstream acceptance first.

ADDX’s Choo concedes that real estate is a tough nut to crack: “An apartment in Chicago is very, very unlikely to appeal to an Asian investor base. It just doesn't work that way,” she says.

Clemens Wan, a solution architect at ConsenSys, says the blockchain firm he works for built an "on-chain Carta-like product” that helped with launching real estate tokens, but has since jettisoned the project. “Because illiquid assets do not get more liquid through tokenisation,” he says.

The typical potential investor base is also chasing a venture capital model of accessing new Web3 companies “rather than old asset classes”, adds Wan.

The initial wave of tokenisation focused on “all sorts of things like real estate and venture capital”, says David Easthope, head of fintech, market structure and technology at analytics firm Coalition Greenwich. “But there are fewer options for a secondary market for fractionalised real estate or venture capital. You're not really solving for the entirety of industry problems.”

A few small broker-dealers in the US are betting on the creation of a marketplace for fractionalised residential real estate, says Easthope, “but you can't predict what will happen with secondary liquidity”. Easthope is sceptical that tokenisation of any risk asset will eliminate the problem of “everyone rushing for the door at the same time. Tokenisation, fractionalisation doesn't solve any of that”.

Solution seeks problem

As landmark DLT projects have faltered, some question the real worth of its applications in banking. Could tokenisation, after all, be addressing problems that don’t necessarily exist, in asset classes it can’t fix?

The former trad-fi executive thinks so. He questions the current benefits of tokenised private equity. Although investment valuations are more consistent across the globe than real estate, prices aren’t live. They are reliant on private equity firms determining the fair market value of assets, often quarterly, he points out.

Tokenising can allow private equity investments to be sold in smaller units, “but the reality is you don’t really need to tokenise it to do that”, he says. iCapital, for example, offers access to private equity investments with KKR and other managers through a $25,000 investment minimum.

Proponents of tokenisation often laud its ability to enable non-stop trading. But continuous trading can be a double-edged sword.

“On the practical side, you can trade 24/7,” says Jean-Marc Bonnefous, managing partner of Tellurian Capital Management, an investment manager that manages crypto asset funds. “Tokenising is basically an around-the-clock, frictionless ability to trade something without being constrained by the market structure that is quite rigid,” he says, contrasting it with trading crude oil futures. Bonnefous was previously global head of commodity derivatives at BNP Paribas.

But non-stop trading will not be welcome in all markets, says Greg Schvey, CEO of DLT firm Axoni: “If you wanted on Saturday night to express risk, you can do that basically only in crypto at this point.” The difference is crypto is “largely removed from the broader economy”, he says. Agricultural producers getting stopped out of positions and liquidated in trading periods when human beings aren’t paying attention could have a “dire impact on the real economy and society generally”, says Schvey.

Tokenising is basically an around-the-clock, frictionless ability to trade something without being constrained by the market structure that is quite rigid

Jean-Marc Bonnefous, Tellurian Capital Management

The head of innovation at a bank issuer of a digital bond agrees market practices are not set up at this point to provide hedging or risk management outside current cut-offs: “The industry would need to cover off how they provide for 24/7 markets. If you're regulated, risk managers would have to be in the office 24/7 watching stuff.”

Some limited benefits of tokenisation can accrue by improving administrative processes in illiquid assets.

Hamilton Lane’s Shaw touts faster on-boarding as an advantage. The current process to purchase a private markets fund is “rather arcane”, he says. Investors must complete subscription agreements that can run to over 100 pages, go through anti-money-laundering and know-your-client reviews, then deal with funding capital calls and receiving distributions.

For a large, limited partner subscribing to tens of funds a year that means duplicating a lot of work, which can potentially be streamlined, says Shaw. A potential limited partner can instead complete a profile on an immutable blockchain which is verified by service providers and the chain then handles fund flows between digital wallets and bank accounts.

Yet technologists point out the same ends could be achieved by different means.

Lee Braine, managing director in Barclays’ chief technology office, separates out the benefits of DLT and tokens from those devised by improved design. One of Barclays’ interests in this space, interest rate derivatives, could leverage DLT to improve efficiency. “But 95% of those existing inefficiencies are about improving process and data standards and having authoritative data stores,” Braine believes. “You don't have to have DLT. But a DLT can help enforce standards and provide an industry authoritative data store.”

Assumptions are therefore being built in when tokenisation is advanced to deliver a reworking of the financial industry’s operating platforms, he concludes: “I think it’s useful to separate out which benefits are due to standardisation, [and which] to authoritative data stores or to tokenisation, specifically. That allows more informed design decisions.”

Called out

While tokenisation of private assets could promote wealth democratisation, legal frameworks are a sticking point.

The European Union is piloting a regime for tokenising financial instruments but take-up is muted as high volume thresholds are called for. The UK is allowing similar trials through its financial market infrastructures (FMI) sandbox.

By contrast, Singapore is relatively advanced in its thinking. It clearly distinguishes between utility, payment and security tokens. While payment tokens operate as currency, utility tokens offer the right to benefit from a service, and security tokens are investment products.

In the US, meanwhile, its various regulatory agencies are divided over who has responsibility for supervising digital assets. The Securities and Exchange Commission (SEC) though applies the Howey test to determine if tokens are securities.

Ava Labs’ Krupetsky cites regulation as among factors needed to spur adoption of tokens. Securitize’s offering operates under the SEC’s Reg D 506(c) rule on offerings of so-called restricted securities, which subjects purchasers to a year-long holding period, a factor slowing the set-up of secondary trading.

Moody’s notes that while tokenisation could open investment opportunities to a broader set of investors – notably retail buyers – regulators need to safeguard consumer protection and market integrity.

A European prudential regulator concurs that making illiquid assets more easily accessible carries with it a concern that non-specialised investors could be exposed to increased credit and liquidity risks.

Moir of abrdn says dialogue with regulators should examine why some assets aren’t deemed suitable outside institutional investment: “If it’s liquidity risk, and you’re solving for that with the secondary market, then maybe it should be appropriate,” he reckons.

In relatively liquid assets, PV01’s Boonen thinks retail investors have been excluded from investments marketed to institutions for reasons that no longer apply.

Boonen believes one reason institutional investment-grade bonds have historically restricted retail participation through large denominations is because know-your-customer checks were previously more difficult to perform than they are with current resources. But, in principle, fractionalised bonds are suitable for retail investors, he says: “There is a profitable opportunity in making government bonds and other products accessible to everyone who has decided to keep their money in crypto rather than at the banks.”

Taking an even stronger stance, ADDX’s Choo pushes back against the notion that retail should be naturally excluded from institutional-style investing opportunities. Choo says in the case of hedge funds or private equity investments, the debate should not necessarily focus on whether they are risky products if allocations are anyway quite small – say 2% of a portfolio. At that level, the type of diversification benefits enjoyed by institutional investors can be achieved through fractionalisation – justifying participation by retail investors on that basis.

But smaller investors granted access to tokenised illiquid assets can’t expect the same deals that institutions get through traditional means. Tokenised private equity funds typically call capital all at once rather than drawing it down over multi-year periods. A pension fund, by comparison, would not have all its capital called at once.

This structure makes sense because private market funds can’t put bite-sized tickets to work immediately, says abrdn’s Moir, but adds that a drawdown structure leaving cash in a portfolio can act as a drag on returns.

ADDX’s Choo estimates the drag for a 10-year private equity fund could amount to four percentage points of internal rate of return. She wants to improve on that though. “Now, it is hugely inefficient,” she admits. “I hate that structure for now. But it’s the easiest to maintain. Frankly, for a lot of our investors, it’s the price of entry for funds they just cannot access in the first place.”

A Hamilton Lane closed-end fund tokenised by ADDX, for example, is fully paid upfront by investors and may hold cash in a money market fund.

Choo explains that every fund has a different call schedule and that it’s operationally difficult to manage capital calls for a plethora of non-institutional investors: “As a small company, we’re not really set up to do that yet.”

At $20,000 entry level, Securitize says it offers much lower minimums than the millions of dollars previously necessary to take part. Its tokenised private equity feeder funds collect all investments in advance, recycling money market yields to investors. Yet, according to a spokesman for Securitize, while the initial rate of return may be less than through the underlying fund, “the actual rate of return is the same”.

Wholesale success

In the wholesale space, meanwhile, tokenisation of liquid assets through digital bonds is finding a natural home. A major incentive is streamlining settlement processes.

Regulators are keen on the idea, according to Gonçalo Lima, capital markets ecosystem lead at blockchain firm R3. Tokenisation piloted by regulators in the European Union and UK is aiming to “converge liquidity pools and speed up trade-processing to reduce settlement risk”, he says.

The biggest names in banking are taking tentative steps.

In January, Goldman Sachs launched a platform that collaborated with the European Investment Bank on a digital bond. Shaul Kfir, co-founder and chief operating officer of Digital Asset, the technology provider for Goldman’s platform, says it cuts transaction times “from days to minutes”.

Others dabbling in the space include Deutsche Bank, which has done intra-day repo on JP Morgan’s blockchain, as well as BNP Paribas, HSBC and RBC, which settled a sterling bond on HSBC’s Orion blockchain. UBS, meanwhile, has created a digital bond on Six Digital Exchange in Switzerland, whose regulatory framework allows for listed issuance and secondary trading.

You can do token-versus-token or token-versus-cash in a riskless exchange. Then you’re enabling more assets to be settled. That will release liquidity

Arjun Jayaram, Baton Systems

JP Morgan tokenised money market funds (MMFs) in May 2022 to be used as collateral for margin through its Oynx Digital Assets platform, reducing settlement timeframes, says its blockchain head Tyrone Lobban. In the transaction, which the bank dubs a “blueprint for the future”, two JP Morgan entities acted as collateral provider and collateral receiver for shares that were held at a transfer agent.

A similar outcome could be achieved via a book transfer, but that would require counterparties to use the same transfer agent. “Digitally transferring collateral on a blockchain means everyone can continue to hold assets where they want. Through this, you enable a frictionless transfer of the ownership of the collateral without transferring the underlying asset,” says Lobhan.

Compared to cash and government bonds, MMF shares are used less frequently as collateral as they are subject to redemptions in times of market stress, but the solution could increase the utility of MMFs. JP Morgan intends to expand the platform across equities, fixed income and other asset classes.

Technologists also extol the improvement of settlement efficiency in wholesale markets through tokenisation.

T+2 settlement times for securities are partially a result of the need to synchronise broker and custodian checks, says Axoni’s Schvey, while in FX markets, spikes at the end of the day are largely a product of inefficiencies in managing risk. Minimising this friction could potentially reduce margin requirements and introduce capital efficiencies. Transferring money “in seconds” would mean the volatility band a clearinghouse puts on current positions to cover how much price movement can occur before collateral moves would “tighten substantially,” predicts Schvey.

Baton’s Jayaram envisages a role for tokens particularly in facilitating asset mobility. Bonds outside G7 currencies, for example, are less liquid and by the time transactions settle in some jurisdictions settlement cut-offs cause failed trades. Tokenisation “just at that point in time” makes sense, he says. “You can do token-versus-token or token-versus-cash in a riskless exchange. Then you're enabling more assets to be settled. That will release liquidity.”

At a central securities depository, Clearstream has produced around 100 tokenised issuances on its digital securities platform D7 since launch last year, across fixed income, structured products, certificates and warrants.

Thilo Derenbach, head of business development and digital securities services at Clearstream, agrees tokens help to mobilise assets, reducing the cost of capital. The value of a token representing €100 million of corporate or government debt is putting it on-chain, for lending, repo or collateral management, he says. “It’s not only about the creation of liquidity, it's also the cost of capital.”

Token advocates hope the technology can ultimately deliver a single blockchain network encompassing the separate roles currently undertaken by disparate systems. Conor Svensson, founder and CEO of blockchain strategy firm Web3 Labs, thinks it inevitable that all financial products will be tokenised to improve liquidity.

Svensson recognises, however, that there will “likely remain a division between wholesale and retail activities due to differences in scale and regulation for those markets”. He adds existing regulatory frameworks “need to evolve significantly to support these new market infrastructures”.

Indeed, in Europe, potential token issuers and FMIs complain the markets regulator’s DLT Pilot regime needs to increase thresholds to encourage participation. The US, meanwhile, lacks even a sandbox, leaving firms “waiting for clarity and some potential no-action letters saying they comply with existing securities law”, according to Coalition Greenwich’s Easthope.

If tokens are to fulfil their potential, not only must current policy become more encouraging, but mechanisms must be created to solve the illiquidity challenges facing a number of these asset classes.