As an industry often seen as slow to adapt to change, innovation and asset management don’t usually go hand in hand. However, the Investment Association (IA) report ‘Investing for the future: three potential paths for a UK tech-enabled funds industry‘ seeks to break with traditional thinking and outlines how the industry can harness technology and innovation to deliver a new kind of investment fund to consumers.
Mainly concerned with the introduction and growing use of decentralized finance and tokenization, the report outlines three possibilities of what “Investment Fund 3.0” could look like and how it could work. This is set against the backdrop of broader industry trends, such as the transfer of wealth between generations and shifts in investor mindsets, particularly among those under 35 who are showing different priorities than previous generations.
To begin with, given the wealth of jargon, it may be helpful to clarify what we mean. Tokenization refers to the process of converting an underlying asset (tangible or intangible) into a digital “token” to act as its proxy. This can happen at the level of the fund itself (i.e. converting the shares of the fund into a digital token) or at the level of the underlying asset, such that the fund holds tokens representing investments . Decentralized finance (or “DeFi”) refers to the provision of financial services on distributed ledger technology (DLT), operating without centralized intermediaries or institutions. Blockchain is an example of DLT.
So what might the future look like?
- Release 1– The first vision of the report examines the improvements to the back-office infrastructure of investment funds that tokenization can bring, helping to improve efficiency and reduce costs for consumers. This falls under the “tokenization of fund units” compartment and involves structuring the operation of the fund using DLT. Here the benefits include:
- removal of the need for reconciliations given the decentralized and shared register;
- lower order fulfillment costs by eliminating messaging;
- potentially faster settlement;
- the ability to restrict investor access to those verified for anti-money laundering purposes, thereby reducing duplication of verifications; and
- embed fund details, such as ESG data, into the token itself.
Changes to the current UK fund regime may be needed to reflect the operational difference in a ‘chain fund’ if the UK is to keep pace with other jurisdictions that have already introduced share classes symbols of existing funds. Current AML registration requirements can also be a barrier.
The report also discusses the tokenization of the underlying assets of the fund’s portfolio. While the pace of these developments may be slow, the benefits could include faster settlement, improved transaction transparency, reduced counterparty risk, fractional ownership, and greater diversification and liquidity.
- Version 2 – the second possible scenario builds on the improvements of version 1 and envisages greater customization and the diversity of the “building blocks” that make up a portfolio, adapting more effectively to investors’ preferences. In this world, consumers (or their financial advisor or wealth manager) could group together mini baskets of stocks (of a similar market category or strategy type) to build a desired portfolio. The number of model portfolios available on the market may also increase or change significantly. In a context where the traditional roles of market players are beginning to evolve, the principle of “same activity, same regulation” will remain essential to guarantee a level playing field.
Voting is another area where new forms of technology such as DLT can have an impact. Good management and shareholder democracy are certainly on the agenda and can be improved thanks to the new solutions that technology can bring (ie.
Building further on the tokenization of underlying assets, the report examines the possibility of opening up the range of investable assets to consumers by tokenizing illiquid investments (building on the work of the Long Term Asset Fund or LTAF). This could offer consumers a lower entry point through smaller property values and potentially more liquidity by trading through a secondary token market.
- Variant 3 – the third possibility is defined by “hyper-personalization”, where risk and return exposure is tailored by clients at the individual stock and security level rather than at the fund level. In this context, the personalized wallet, constituted in the form of a non-fungible token (NFT), contains tokenized underlying asset classes in broad areas such as private companies, infrastructure and native digital assets. NFTs would be specially designed for the investor and non-transferable, with the underlying assets being hosted there. Here, the fund concept itself shifts from its large collective nature with limited customization to potentially small groups managing their money more locally through a decentralized autonomous organization (DAO).
Reflecting this change, the delegation and role of investment manager, wealth manager and financial adviser would take a different form (some more involved, some less). Whether this translates into tailored investment services for the masses is anyone’s guess, but the report notes that personalization of this ilk would provide a greater degree of consumer participation and control.
Products that are delivered direct to consumer (D2C) (via platforms or wealth managers) would also signal a shift from the decade-long trend of intermediated sales and although there are clear benefits to the model of hyper-personalization, the disadvantages of limited access to value-added services such as research, and the complexities that arise from investors directly owning underlying assets are also cited and should not be overlooked. Such a revolutionary change will require careful thought.
The report concludes that we are likely to see a combination of all three scenarios play out, with the industry’s center of gravity determined by the extent to which incumbents and new entrants drive innovation over the next decade. He notes that modernization of product and service delivery and capital market infrastructure is inevitable and will likely bring significant long-term benefits in terms of operational efficiency and cost reduction.
However, the broader regulatory and policy environment will be a significant factor determining the outcome here. The report therefore outlines a series of policy and regulatory actions aimed at creating an environment in which regulation can better support innovation, while ensuring consumer protection.
- establish the framework for token funds to operate in the UK;
- the creation of a DeFi task force to assess the overall policy implications for the UK funds industry;
- maintaining the “same business, same rules” position (including with respect to competing investment products and services in the retail market);
- consider establishing regulated pathways for exposure to native digital assets (including eligibility of crypto-assets within UCITS and national funds); and
- approach DeFi reforms with an open mind – recognizing that existing industry functional divisions may not be relevant if technology provides more efficient means of achieving the same results.
Concerning the regulatory scope:
- defining the “rules of the road” for crypto-assets to mitigate loss and harm to consumers;
- closely monitor the unregulated arena for emerging developments that could threaten financial stability; and
- ensure that investment firms are not exposed to the costs of the failure of stablecoins or other crypto businesses through the FSCS.
Concerning regulatory developments:
- bridging the advice gap by facilitating better consumer support;
- the completion of the implementation of the reform of the UK Funds Regime Task Force; and
- enabling the delivery and disclosure of next-generation digital information to investors.
While the focus on long-term use cases for crypto-assets and DLTs in financial services typically doesn’t make the headlines, it’s clear that industry players are increasingly turning their attention to more towards tokenization and blockchain technology as the next wave of innovation in an industry ripe for change. Offshore fund markets are also experiencing this development, so it is increasingly a global phenomenon.
Progress may not happen overnight, and the future of the industry remains unknown, but the growing interest we are seeing from customers and market players in this space – both in the development of symbolic proposals and the provision of services around it – is probably indicative of how the wind will blow.
“The way we regulate needs to be dynamic. We shouldn’t think of regulation as a static, rigid thing. Instead, we should think in terms of regulatory ‘code’, like computer code that we refine and rewrite when we need it. to; bespoke and proportionate, yes, but also nimble and technologically neutral” – John Glen, MP