How will tokenisation shape the future of the investment industry?

James Green, head of portfolio insights at NatWest Trustee and Depositary Services, dissects the tokenisation playing field in the financial services sector.

The introduction of digital assets and tokenisation promises to transform the way financial markets work – all the way through the capital raising, investment, trading and settlement processes.  

 The best-known digital asset is the cryptocurrency Bitcoin. Being the first major digital or crypto asset, it has encouraged a new class of investors to trade and store their wealth in pure digital form. Through tokenisation, the ownership of any kind of asset – real estate, fine art, stocks or bonds – can be recorded digitally with electronic trading and settlement coming at minimal frictional cost.  

If you follow the concept of tokenisation to its natural conclusion, it will be possible to replace traditional equity, bond and derivatives markets with safer, more efficient digital solutions.   

Progress at last  

The financial marketplace has evolved at roughly the same pace as technology, over the past 200 years. As technological progress is constantly accelerating, it should come as little surprise that financial market transformations are too and that we have reached another inflection point very similar to ‘dematerialisation’.  

A well-regulated digital ecosystem promises a much shorter, cheaper value chain, which should lower the cost of capital and investment, resulting in potentially higher returns to investors with no loss of safety or stability. Yet, while the technology to support such a system is increasingly accessible, realising its full potential relies on robust regulatory frameworks. An important step towards making this happen are the proposals recently announced by the UK Treasury to support the legislative process.  

Regulating cryptocurrency markets has been the subject of intense debate for several years and it seems that progress is finally being made. 

A new era of regulation 

In February this year, the UK Treasury unveiled proposals to strengthen rules for crypto lending and trading platforms, which will impact investors, asset managers and depositaries. Under the plans, crypto assets will be regulated in line with traditional finance regulation. 

This marks the beginning of a new era for UK crypto infrastructure, markets and businesses, as the digital asset industry is not currently regulated by the FCA to the extent that more traditional markets are; leaving consumers at greater risk. 

The prospect of bringing cryptocurrency under the umbrella of mainstream financial services regulation will be welcome among fund managers who are increasingly trying to understand how to apply digital currencies, tokenised assets and blockchain technology to their portfolios and operations.  

While most funds available to retail investors are currently prevented from taking direct exposure to volatile crypto markets, a rising number of Exchange Traded Products (ETPs) are enabling indirect access while still being exposed to the same risks. Meanwhile, globally significant financial institutions are investing in a growing number of products and services designed to facilitate institutional-scale access to the full range of digital assets.  

The opportunities to reduce costs, improve transparency and create more secure and efficient investment processes are enormous. A healthier digital asset ecosystem will facilitate disintermediation and give investment managers a safer, faster, cheaper investment ecosystem. 

In turn, this should enable portfolios to become customisable, as well as increase their transparency and enable more effective oversight, resulting in better customer outcomes.  

UK proposals  

Instead of creating a new set of rules, the UK Treasury intends to regulate digital assets using existing financial services legislation, tailoring the terms of the Financial Services and Markets Act 2000 to the needs of the crypto market. 

The proposals would introduce enhanced data-reporting requirements and implement new regulations to prevent so-called ‘pump and dump’, whereby a market participant artificially inflates the value of a crypto asset before selling it. They would also strengthen the rules around financial intermediaries and custodians, which have responsibilities for facilitating transactions and safely storing the ‘keys’ to a customer’s assets.  

One area of significance is the proposed regulations on crypto asset custody. When it comes to digital assets, custody is manifestly different to the traditional model because, where a Blockchain is deployed, the asset itself never leaves the ‘chain’. Only the ‘Key’ to the asset changes hands. Key management solutions are managed through a variety of technological mechanisms, including, but not limited to, hot (internet-connected) or cold (offline) wallets.  

Currently, there are no specific rules dictating what happens if access to these mechanisms is lost or if a custodian were to go bankrupt. The Treasury therefore proposes to extend and modify custody rules for traditional finance to protect investors’ digital assets and it is their intention to require custodians to provide access to assets in the event of their insolvency, as well as offering redress for lost digital assets.   

Looking forward 

The government’s public consultation on its proposals closed in April – now, ministers will lay secondary legislation and the FCA will conduct its own consultation before defining rules and regulations.  

Robust regulation will reduce the risks currently associated with crypto markets and make institutional investors more comfortable with experimentation. Ultimately, legislative proposals such as these promote a healthy, well-regulated digital asset ecosystem, which if formally legislated would be a good outcome for consumers and investors alike.