The digitisation of the asset management industry, specifically of the private markets sector, is gradually taking shape. The evolution of businesses to a digital phase will happen on two levels: digitisation of processes, and digitisation of assets. The latter, also referred to as tokenisation, is an important enabler. Without digitised assets, the new possibilities of asset issuance, transactions and management along electronic workflows will not materialise.
Tokenisation refers to the process of creating a digital representation of rights in real assets using distributed ledger technologies. It’s the buzzword among financial technology enthusiasts, and it has the potential to reshape the asset management industry in the long run. It is the core of asset digitisation that could drive further growth in private markets.
The digital issuance of an asset includes its structuring, in other words, defining and interrelating the rights of involved parties, and the creation of a digital container, or a token, to hold this bundle of rights. Therefore, tokenisation follows the logic of securitisation but takes it further by adding certain qualities and functions.
Digitising an asset does not only mean packaging some or all of the rights attached to it into a token; each token can also be equipped with executable code. This so-called smart contract function allows event-triggered automation of actions tied to the asset, such as dividend or interest payments, or the automated enforcing of rules, such as trading restrictions.
A tokenised approach also enables the direct exchange of assets, where market players can directly swap a token representing a company or object with a token representing another company or object, bypassing the stage of conversion into cash as in the case of securities.
A standardised digital representation of rights, as opposed to the material representation on paper, is divisible at almost no marginal cost. This quality facilitates the fractional ownership of almost any kind of asset, and thus can potentially generate significant benefits to investors. It reduces entry barriers for trading and investing because assets available only in large and expensive blocks can be broken down into much smaller units and become accessible to a broader group of investors.
Fractional ownership, combined with eliminating temporal and territorial barriers on investments, enhances liquidity of assets and allows broader diversification of asset classes to reduce risk.
From a private markets industry perspective, moving gradually to integrated electronic processes that utilise digital assets holds the potential to impact important dimensions of business: cost, income and risk. A decline in cost is based on reduced complexity, better management of data, and a high degree of automation.
The unlocking of additional revenue pools is facilitated by a more direct connection between professional counterparties, broader distribution to more clients, and more active trading of the asset. Beyond that, greater flexibility to rebalance portfolios in more liquid markets allows more targeted and granular management of risk and exposure.
A fundamental change in any industry comes with challenges, particularly from the perspective of established incumbents. What works very well in theory meets practical hurdles and yet unsolved issues when actually implemented. We illustrate the benefits and challenges of tokenisation using some concrete examples.
In October 2018, a US$30 million luxury condominium in the East Village of Manhattan was tokenised on the Ethereum blockchain platform. The two firms behind this project, Propellr and Fluidity, created a digital platform which allows investors to own and trade tokens representing the property.
According to some estimates, the global real estate market is worth around $230 trillion, with less than 5% in the form of real estate investment trusts (REITs), which are publicly investable assets. This suggests over 95% of real estate are private market assets. It’s an extremely large but relatively illiquid asset class, making it a viable candidate for tokenisation.
Issuing a digital token to represent the ownership of real estate on blockchain and smart contracts could create a large liquid secondary market for real estate. It will make it easier for developers to raise capital, and also allow investors to diversify more broadly and efficiently.
Although that sounds great from a business perspective, one key issue is that it causes a dilution of ownership, which can make it more challenging to manage and govern a property since it’s harder to reach consensus. While this problem can be addressed with new mechanisms such as digital voting rights, fundamental questions around shareholder rights still need debate and solutions.
Then there is also the question of whether greater liquidity can generate more speculative activity in the real estate market and give rise to property bubbles. After all, a large asset like a building would be priced with every single, even small, transaction of ownership shares in the market. A significant deviation between expert valuation models determining fair value and a more sentiment and speculation-driven market perspective on the real value of an asset is conceivable. So how can issuers, asset managers, and potentially regulators, adapt to manage higher price volatility and prevent problems in the market structure?
Enter the world of Sotheby’s and Christie’s where expensive and rare artworks are auctioned to an exclusive club of wealthy individuals in a private venue. For example, Leonardo da Vinci’s painting of Jesus Christ, “Salvator Mundi”, was sold for $450 million at a Christie’s auction in 2017.
These are again highly illiquid assets accessible only to the lucky few. But the art market has generally been growing significantly, largely fuelled by the creation of new wealth in expanding economies. Artworks also account for a considerable share of private market investments and are part of many diversified investor portfolios. And thanks to startups like Maecenas, it’s now possible to tokenise expensive paintings by great art masters like da Vinci.
To be sure, securitisation of artworks – democratising them so that retail investors can buy and own small fractions – is not an entirely new concept. Art investment funds have been around for quite some years. But they haven’t really taken off because concerns about the authenticity and true value of the artworks backing these funds deter some investors from taking an active interest.
Thanks to blockchain technology, the authenticity of a piece of expensive art can now be verified and recorded permanently on a blockchain platform before digital tokens representing them are issued to investors. Token owners can then trade their ‘shares’ of these valuable items on specialised trading venues, increasing their liquidity and facilitating more efficient pricing.
For owners and issuers, this opens up the possibility of generating liquidity by selling only a portion of art and collections and retaining majority ownership. This allows for carefully curated collections to stay intact and complete, preserving market valuations of the individual pieces.
The question here is whether such digital tokens would appeal to buyers, and what unintended market consequences are to be expected. Would the valuables become less valuable as their accessibility to ownership increases? After all, it is their rarity and inaccessibility that drive at least part of their valuation.
In addition, the final custody of such items could also provoke debate. Should the custodian rights be given to the owner with the highest share of digital tokens, or should some specialised firms and institutions be hired to manage and keep these collectibles safely? Again, technical mechanisms exist already to solve these problems, but it all comes down to market players agreeing to new practices and rules.
Private credit instruments
A significant part of the attention, discussion and hype in asset digitisation is focused on real assets and the quest to open up markets to more participants. At the same time, we observe the quiet exploration of more pragmatic applications by industry incumbents that have the potential to impact dealings in the private equity and private credit subsectors, and at a much larger scale. These initiatives are mainly focused on improving efficiency and generating new markets via digital processes, leveraging the digitisation of financial assets.
One example is projects in syndicated loans. Many smaller banks face the challenge of not being able to extend larger loans to their corporate clients for reasons of risk concentration and balance sheet management limitations and rules. Most players resort to finding partners for loans, assembling a syndicate of lenders for one borrower.
This process is mostly manual, from structuring to counterparty discovery and syndication, resulting in significant costs. To cover overhead costs, a minimum deal size is generally required by participants, limiting the type of deals and amount of business that can be entered into.
The core workflows of syndication can be digitised by tokenising the loan instrument, Counterparties can find each other quickly and efficiently on jointly accessed deal platforms. Instrument due diligence, information exchange, and eventually subscription to a slice of the loan, can happen digitally. Downstream processes such as settlement, including delivery-versus-payment will also improve.
Furthermore, a digital syndicated loan offers lenders greater ability to sell their stake in a more liquid market to buyers who are looking for a specific exposure. This supports a more active rebalancing of loan portfolios.
This new approach enabled by technology opens new opportunities, and several pilot projects are already underway. One example is the technology solution and project ‘Fusion Leader Comm’. Advanced by the technology firm Finastra in collaboration with global banks, including BNP Paribas, BNY Mellon, HSBC, ING and State Street, it’s a platform digitising syndicated lending, underpinned by the distributed ledger protocol R3 Corda.
But even these more pragmatic use cases have their own unresolved questions. A digital workflow comes with higher standardisation and rigidity. This may be a hindrance in the definition of the asset and negotiation and agreement of specific terms, even before the instrument is digitally issued. Practical challenges like these will require further research and development for solutions to fully fit market requirements.
What to expect
In the long term, the digitisation of the private markets sector will shape its nature, size and impact. Through digital assets and processes, automation can help lower costs, and new business models become possible, opening the space for broader retail investor participation, and in effect growing the reach of the sector. We expect regulations to gradually evolve to further support and enable this development.
However, not all of these effects will be immediately sought after by the industry. For example, liquidity in private markets per se is not seen as an important issue by institutional investors with long investment horizons, and the value and perils of making complex private market assets more accessible to retail investors are still disputed by academics and practitioners.
While fundamental change at scale will take time, the early signs of an evolution in the sector are clearly visible. A growing group of institutional players, led by industry innovators, appears to be increasingly taking an interest and actively working on pilot projects in this context. It’s certainly an interesting time to engage with new technologies and collaborators, to learn and experiment, and be prepared for what’s on the horizon.
* Dr. Seen-Meng Chew is associate professor of practice and associate director of the MBA programme at CUHK Business School. Dr. Florian M. Spiegl is co-founder and chief operating officer of Hong Kong fintech company FinFabrik.