Jersey's Approach to Digital Assets
Jersey has been host to an array of vibrant and respected digital assets businesses for a number of years. The Island’s world-class digital infrastructure, pragmatic approach to regulation and its broad range of corporate vehicles means that Jersey has naturally developed a pool of resident expertise in digital asset innovation – from the launch of the world’s first regulated Bitcoin investment fund almost ten years ago, to a more recent increase in players from across the spectrum of the industry.
From a regulatory point of view, the digital assets spectrum is broad, and jurisdictions have developed varying degrees of risk appetite. The Jersey Financial Services Commission (JFSC) has recognised that there is a middle ground, creating an environment for token-generating events with proper substance, and which are backed by a credible promoter.
It’s a middle ground that can offer a solution to a large part of the market. But nevertheless, it is important that as an industry we take a holistic view and understand the full picture. This report enables us to do just that.
About Tokenisation and Real Assets
Tokenisation is an important part of the digitalisation of assets. It is likely to offer new opportunities to both investors and asset managers, and it has already begun to impact real assets. Real estate has been an early adopter, along with infrastructure and precious metals like gold. Other illiquid asset classes are not that far behind, such as private equity and various sustainable investment sectors. Managers of real asset funds are being presented with the opportunity to access new investor categories because of it.
As well as opening up previously hard to access illiquid asset classes to new investors, tokenised investments are also effectively borderless. This might present the fund industry with a need to have a fundamental re-think on regulatory, governance and jurisdictional matters.
Distributed Ledger Technologies
Distributed ledger technologies, like blockchains, have no borders; they are available to anyone, anywhere in the world, with access to the Internet. Tokenised digital assets that share the features of traditional financial instruments could be considered security tokens, depending on their structuring and domiciliation, and could therefore already be within scope of the regulatory authorisation regime for financial services in many jurisdictions.
Asset tokenisation is the creation of tokens on a blockchain, thanks to the development of distributed ledger technologies (DLT). These tokens can be based on anything which has an exchange value. Most of the assets that have been tokenised to date are illiquid ones such as those on the private asset side of the business. Tokenisation, for example, can convert private equity funds into tradable digital securities. It is likely that all asset classes will eventually offer tokenised options to investors. Anything that can be put on a distributed ledger can be tokenised.
The distributed ledger technology, on which tokenisation is based, is developing in ways that go beyond cryptocurrency. Whilst most cryptocurrencies are on blockchains, not all blockchains are being developed for cryptocurrencies. It is likely that cryptocurrencies will represent a diminishing proportion of the assets on blockchains in future, as the investment management industry adopts this new technology for many different categories of its funds. The origins of asset tokenisation pre-date the emergence of cryptocurrencies, although the technology that has been developed for this new asset class, along with smart contracts, has given tokenisation a big boost.
Unlike securities, tokens can be traded in fractions, which offers investors holdings of any size. For example, a US$5 million fund can be divided into 100 tokens worth US$50,000 each, and then fractionalised and sold in smaller units. It is similar to an investor trading one-tenth of a cryptocurrency, like Bitcoin. The process could open up certain previously illiquid real asset classes to investors with small amounts of capital.
Tokenisation is frequently described as adding a digital wrapper to an existing asset which then can then be used, issued, stored and moved between owners, with everything recorded on a distributed ledger. For a valuable commodity such as gold, for example, this can be very helpful as the owner of the tokenised asset doesn’t have to worry about storage. It is also often called the democratisation of investment in real assets as it could be open to anyone. It represents a fractional share of an ownership stake in a real asset, one that is digitally owned and can be transferred.
However, almost all investors in tokenised real assets are, at least for the time being, professional. They include family offices and ultra-high-net-worth individuals, as well as institutional investors. When investing in commodities such as gold, tokenisation can give these investors more flexibility than they might otherwise have by accessing the asset through a more traditional means.
The Benefits of Asset Tokenisation
- Greater transaction speed
Many of the tokenised processes, including transactions and transfers, are automated. This speeds up the settlement and clearing of real assets.
It gets around the liquidity problem of investing in real assets. Assets like real estate are much more readily available to large groups of investors once they are tokenised. And then they could be freely traded. Greater liquidity often also means fairer pricing of assets too.
Distributed ledgers are often publicly available. Every transaction on it is stored and is retrievable. And the immutable nature of the underlying technology means that the transaction history is effectively tamper-proof.
The Challenges of Asset Tokenisation
1. Industry disruption
The fact that tokenised assets are accessible to anyone with access to the Internet could present the industry with significant regulatory challenges. And it could bring about a restructuring of the industry in the years ahead, especially on its private assets side. The industry might need to look again at its system of categorisation – both by investor and asset class – and tokenisation could facilitate the development of new alternative asset classes, particularly in otherwise hard-to-access specialist sustainable investment sectors.
Industry tech spend will almost certainly need to increase substantially as a result. This investment is likely to be continuous and it could be many years before it subsides. Also, there is still a lot work to be done in building blockchain scalability and developing global frameworks.
3. Regulation and legal disputes
Tokenisation and the broader decentralised finance (DeFi) industry will present the fund sector with a number of regulatory challenges. With or without more regulation, there could very well be some complex and expensive legal disputes ahead.
Contractual details on tokens are defined in smart contracts. Smart Contracts are one of the great innovations of the digital world, but they are only as reliable as the code that is used to create them. The digital world has attracted more than its fair share of bad actors.
5. Recapitalisation of real asset funds
It is not yet clear how tokenised funds, perhaps with many smaller investors, would be able to be recapitalised when needed. It might be that only certain real asset funds, those that give up on the recapitalised option, can be tokenised.
Scalability needs to improve before the tokenised opportunity for real asset funds can be fully realised. The CAIA points out that in the area of hedge funds, private equity and natural resources, a sizeable universe is needed to be able to create a portfolio of tokens for diversification.
The greater access to assets that were previously only available to professional investors will lead to some interesting governance questions. The protection for investors in tokenised funds is a key aspect of this.
8. Domiciliation of tokenised real asset funds
Tokenised real asset funds are global. It will be very difficult to say to investors in one country that they can access a tokenised investment vehicle but not in another. As a result, they are probably better off being domiciled in jurisdictions that are used to dealing with investors from all over the world and which are tax neutral.
Forecasts for Growth
Forecasts for the growth of asset tokenisation are universally bullish. A report published in 2022 by BCG and ADDX forecasts that asset tokenisation will grow into a US$16.1 trillion business by 2030. The report suggests that there will be growth in both real assets but also in other investment fund categories too, such as equities and bonds. It also expects to see asset tokenisation moving into new areas, such as car fleets and patents.
There may well also be a role for tokenisation in the many illiquid investment areas that are part of ESG’s sustainable sectors. Tokenisation could have a major impact on sustainable sectors such as renewables, forestry and water, for example.
Polaris Market Research reports that the global tokenisation market was valued at US$2.56 billion at the end of 2021 and is expected to grow at a CAGR of 18.9% to the end of the decade. Beyond the investment industry, it has been estimated that 10% of global GDP could be based upon tokenised processes by 2030.
Clearly, there are a number of challenges that need to be overcome before the tokenisation of real assets can reach its full potential. However, these are all teething problems that are being addressed. As a result, asset tokenisation will almost certainly grow very strongly over the next few years.
The impact of that growth may well be transformative upon the fund industry. Real assets, such as real estate and private equity, are the first to be tokenised. More liquid asset classes will not be far behind. Managers of real asset funds are, therefore, right at the cutting edge of the industry’s possible transformation over the coming years.