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Fund Tokenization

April 11, 2024 Tokenization

Breaking Barriers with Fund Tokenization

Fund tokenization is increasing in scope and becoming more and more available to investors around the world. But what are the steps involved in fund tokenization, and how exactly does the process work?

Here, we look at how fund tokenization has the potential to break down barriers and we review the benefits and drawbacks of this approach to investing.

What is the tokenization of funds?

Tokenized funds are created, maintained, and traded on blockchain technology. Each token represents a real-world fund, enabling a person to own a digital token that is pinned to the asset.

This token is then stored in a digital wallet by the owner, who can also trade it on digital currency platforms like Binance and other networks.

Whenever a tokenized fund is purchased, the new owner receives a public key and a private key. The public key is linked to the owner’s network address, and the private key is secured in the digital wallet.

If you compare these keys to conventional fund ownership, the public key is a bit like the bank’s IBAN address, while the private key serves a similar role to the PIN number required to access the account.

Given that asset ownership records have been stored electronically for decades, lots of people question how tokenization of assets is any different.

Well, while asset ownership records are held on a centralized database managed by a trusted party, tokenized funds are held on a decentralized blockchain, enabling broader access and breaking down some of the traditional barriers to entry.

Simply, tokenized funds are much easier to buy, as they are not solely available to institutional investors with access to such funds. There are no high minimum purchase requirements, no long lock up periods, and no limited liquidity. As such, tokenized funds are much easier for regular people to access.

How does tokenization work in practice?

Funds, like other real-world financial assets, can be tokenized. The first step for anyone looking to tokenize funds is to choose a jurisdiction, noting that the regulatory and legal framework will differ from place to place. Then, the following steps are required:

Choosing a blockchain network

Public or private blockchains can be used to tokenize funds. The creator will also have to determine whether use of a permissionless or permissioned blockchain is the better option for the fund.

Deciding on the characteristics of the tokens

Next, the characteristics of the tokens will need to be determined. This will include things like a lock-up period, whether there should be investor qualification rules, and what the jurisdiction of the investors should be. Minimum investment amounts may also be considered.

The entity that provides the tokenization service

As lots of tokenization services exist, the fund creator will have to decide which service to use. They will also have to think about the information to be encoded within the token (including compliance requirements for token transfers). Authorized and regulated service providers should be considered.

Consideration of how the keys will be held

A decision then has to be made about whether a custodian will hold the private keys to the investors’ tokens, or whether the investors will hold private keys. Also, the way an investor interacts with the tokens and blockchain (i.e. via a mobile app) will have to be decided.

Code & oracles for real-world data

Finally, oracles need to be used to give real-world data about the fund to the blockchain. This provides information about the state of the assets and how it is performing in the real world. Also, the code for the smart contracts will need to be written to pay out the dividends to the token holders. This is only required if it is not already embedded in the blockchain code.

The pros and cons of fund tokenization

Tokenized funds break down many of the barriers attached to traditional investing, offering the following pros and cons to investors:

✅ Traditional funds tend to have high minimum investment amounts, restricting many potential investors. However, fractionalized fund tokens can be offered in more affordable trenches, increasing the potential market for the fund.

✅ Tokens can benefit from secondary market trading, increasing the liquidity of the fund and making them more attractive to would-be investors.

✅ Tokenized funds appeal to a much broader market of people, particularly those who are technologically savvy and have a working knowledge of smart contracts and Web3 services.

✅ There is increased transparency of tokenized fund transactions, particularly compared to traditional real estate AIFs.

On the flip side, here are some of the drawbacks of fund tokenization:

❌ There isn’t currently a comprehensive legal and regulatory framework for tokenized funds. However, several important jurisdictions – such as the UK and France – are currently working on a framework for tokenization.

❌ Tokenization is a new technology, and reviews, investigation, and approvals are required, which takes time, effort, and money.

❌ KYC protocols are likely to be required and additional fees may be levied against investors.

What does the future hold for tokenized funds?

The future for fund tokenization is bright. It has the potential to provide clear and transparent information relating to the creator and issuer of the token, as well as the asset characterization of the fund itself.

What’s more, the details of the buyer and seller, and the execution price of all transactions are immutable and shown on the blockchain. This has the potential to reduce asymmetries and is likely to improve price discovery in the long-term.

As it rolls out further, fund tokenization is likely to break down barriers to entry and encourage more people to invest in funds, particularly those who are restricted from more conventional fund investing.

Conclusion

Fund tokenization certainly has some management and regulatory challenges, but it has the potential to transform and reimagine the way that assets and funds are created and managed.

Fractional tokens mean lower or non-existent minimum investments, enabling investors to diversify their portfolios with funds that they previously wouldn’t have been able to access.

We’re seeing the tokenization of assets and minerals in numerous sectors, and fund tokenization is at an exciting point in its development, with lots more to come.

References

https://www.deloitte.com/lu/en/Industries/investment-management/blogs/breaking-down-barriers-with-new-building-blocks.html

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Tokenization as a cutting-edge technology that optimizes and simplifies the process of issuing corporate securities on the blockchain.

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