The digitisation of the alternative funds industry has the potential to usher in a new investment paradigm; one that offers fund managers and investors a chance for capital preservation by investing in companies, real estate, infrastructure projects, and crypto currency-backed projects that are free of the influence of central bank intervention.
For hedge fund managers, this could open up new opportunities to invest in blockchain companies that eventually go public, and change the way they run their funds, not to mention cryptocurrencies, which are likely to continue to expand in number.
As we head towards 2020, there are signs that the digital asset space is beginning to become more institutional with more robust custodial solutions coming to market, institutional-focused exchanges, and myriad provenance tools developed by innovation labs and global financial institutions.
One of those innovation labs is Deloitte’s EMEA Blockchain lab in Dublin.
“At Deloitte, we collaborate globally with clients, across every industry, on how blockchain is changing the face of business and public services,” comments Amy Pugh, Manager, Strategy, Innovation and Ventures. “Right now, new ecosystems are developing blockchain solutions to create innovative business models and disrupt traditional ones. We help our clients understand the evolving momentum of blockchain use cases, prioritising blockchain initiatives, and managing the opportunities and pain points associated with blockchain adoption efforts.”
Both asset servicers and fund managers are looking at ways to use DLT technology to automate a range of operational activities, especially those in the back-office including trade reconciliation, regulatory reporting, investor onboarding to name but a few.
When asked how CFOs should be thinking about this technology, Pugh says it can be used to reengineer or innovate a wide range of finance processes: intercompany transactions (when there are multiple ERPs), rebates, warranties, financing (such as trade finance and letters of credit) in addition to upstream and downstream financial processes like:
• Post trade (clearing and settlement)
• Asset Servicing
Pugh outlines the following key steps for CFOs to consider:
• Assign a blockchain champion
Blockchain should be a business-led initiative, requiring strong sponsorship and leadership provided from the ranks of finance executives. They can start to envision how the various functions might benefit from implementing blockchain, identify value drivers, and build business case frameworks.
• Invest in talent
Pull together a focused cross-section team from supply chain, customer/channel operations, service, and finance to identify and prioritise pain points that could be targeted and develop a hypothesis around how the use of Blockchain will solve the business problem.
• Forget the technology
Focus on how blockchain will potentially disrupt or shift your operating model. The process involves understanding the transformative nature of blockchain, then talking with customers, suppliers, and C-suite peers to identify potential use cases. Given that blockchain’s value proposition relies on multiparty transactions, select external partners who share the business challenge you are focused on and are therefore likely to be receptive to participating sometime in the future.
• Think big, start small, and iterate often
Understanding the “art of the possible” is creating a lot of excitement, but where to start? Blockchain’s capabilities may be put to more efficient use in the external world, but as an introduction to the technology, it may be best to focus on an internal issue, such as intercompany transactions.
• Launch a pilot
Having identified finance / investment management pain points, select a use case where blockchain will likely produce a real return on investment (ROI). Track the results, especially transaction times and costs, to judge the technology’s suitability for larger scale iterative processes.
Deloitte’s EMEA Blockchain lab not only delivers value to clients via blockchain strategy design and technical implementation but also develops propriety solutions that are designed to accelerate its clients’ blockchain journey.
As Pugh adds: “Our multi-disciplinary team collaborate to develop solutions that solve complex commercial problems and transform the way our clients do business across all industry sectors. Such solutions include; a blockchain enabled qualification and certification platform, a Track and Trace platform portable for multiple industry sectors and a blockchain enabled regulatory reporting solution, plus more.”
This is certainly an exciting time for all key service providers within the hedge fund industry, including law firms. One of those is Eversheds Sutherland, which has built a leading practice covering the digital asset space.
“We advised on the first ICO in the UK and from there we’ve grown,” states Ben Watford, Partner, Financial Institutions. To clarify, an Initial Coin Offering (ICO) is a process for selling cryptocurrency “tokens” in exchange for conventional or “fiat” currency or other cryptocurrency.
“We’ve advised a range of firms in the FCA’s regulatory sandbox and we are advising everyone from crypto-funds to token developers, blockchain platforms, crypto-exchanges, crypto-custodians and crypto-brokers. We were also the first law firm to give evidence to the UK parliament on blockchain developments.”
The FCA’s sandbox launched in 2017 to provide businesses with a secure environment to test-run their new products and services. In April this year it confirmed that 29 new companies had been added into the fifth cohort of its sandbox, eight of which plan on using blockchain-enabled technology including Standard Chartered Bank.
James Burnie is a senior associate in Eversheds Sutherland’s financial institutions group specialising in financial services regulation, as well as fintech. He confirms that there are a wide variety of companies using different structures within the FCA’s sandbox. One such firm is 20|30, a start-up company that has investigated tokenisation of equity within a compliant legal framework.
“There are a lot of new concepts coming out, and we have coined a new concept of ‘Too Important To Fail’,” explains Burnie. “Some blockchain technologies are likely to become so important that we have to prevent certain entities from failing because the knock-on effect to global markets would be too great. The next stage of regulation in the UK is likely to be this recognition of certain entities being Too Important To Fail.”
Blockchain technology akin to first iteration of iPad
In Burnie’s view, we are only just at the start of understanding the true potential of blockchain and how it could be applied to the asset management industry, in particular for operational tasks. It’s a bit like the launch of the iPad: you get the first innovation and everyone gets excited by it.
“In terms of the application of blockchain to the asset management industry itself, it is clear that there is a role, in particular in relation to repetitive operational tasks, such as automation of distribution. In terms of where we are at in the development of this technology, at first there was the stage where it was a bit like the launch of the first iPad: there is the first major innovation and everyone gets excited by it.
“The next step is adapting blockchain technology so that it is used in a way that best works for a business and has proper commercial scale. This is roughly where we are at the moment, with businesses testing out ideas in a large professional setting: similar to when all the different applications were introduced to the 2nd and 3rd iterations of the iPad to improve the user experience.
“In 10 years, it’ll be more a case of constantly tweaking the blockchain technology,” says Burnie.
Banking was the first key focal point for blockchain developers but this is now starting to widen out to asset managers. Part of this, says Burnie, is because asset managers are looking at the value for money they are giving investors “and if they can introduce new technologies to generate greater value for money, and improve efficiencies, that is likely to play out well in the current climate”.
“Blockchain allows you to service clients in a way which is cheaper and easier. Take MiFID II for example. That legislation is based on the assumption that the technology would exist in order to enable entities to implement it. Transaction reporting creates an onerous et of obligations on firms. Blockchain enables firms to automate compliance with these obligations in a way that is much quicker and more efficient than previously,” comments Burnie.
According to Ben Marzouk, Counsel at Eversheds Sutherland, distributed ledger technology “has the potential to massively disrupt the traditional methods of clearance and settlement, matching buy and sell orders, and recording ownership through registered transfer agents – the “plumbing” underlying much of the US securities markets. We are excited to be advising these cutting edge investment products through various US securities regulatory hurdles.”
One area that has seen significant developments in the last couple of years is safeguarding the custody of crypto assets. From a technical perspective, there are now many options available to fund managers but it is not just a case of better security; it is also about third party risk.
“There are now third parties who will custody a Fund’s assets and in the process guarantee, with a registration and a balance sheet, the integrity of the whole process,” explains Manuel Anguita, co-founder of Silver 8 Capital, a US-based fund focused on financial technology. “Until recently we didn’t have these solutions.”
Anguita goes on to confirm that Silver 8 Capital does its own self-custody using a cold storage protocol that it designed early in 2015 when setting up the fund.
In its Guide to Crypto Custody report, Gemini, a next generation cryptocurrency exchange and custodian, points out that access to custodial infrastructure will be a growing need for hedge funds, high-net-worth individuals, and financial institutions as they expand their cryptocurrency holdings. Already, there are 150 active crypto hedge funds who collectively have USD1 billion assets under management (AuM), and 52 percent of those funds use an independent custodian.1
Gemini is able to provide investors with a qualified custodian solution, Gemini Custody™, and is one of several firms offering institutional-grade security.
At Copper Technology, for example, they have built a state-of-the-art infrastructure to protect fund managers when trading crypto assets across multiple exchanges, in addition to the Copper Unlimited custody application: an offline server-less, optically air-gapped application.
“Our custody application is part of the Walled Garden trading infrastructure we’ve built, which provides full protection of LPs assets,” says Boris Bohrer-Bilowitzki, Partner and Head of Business Development at Copper. “A fund manager might have their bitcoin custody address with Copper whitelisted on various exchanges and if they want to move assets away from one of the exchanges, and into custody, all they do is click a button.
“Therefore, you don’t have to physically log in to the individual exchange; everything is done on Copper. The Walled Garden removes the risk of someone being ransomed, and potentially losing their assets on an exchange.”
He believes that the usage of custody needs to be flexible but at the same time offer investors a high level of security. “If I have assets locked away, how quickly can I access them? And when it comes to the Walled Garden, how can I be sure that various security issues that arise when trading on exchanges can be mitigated? By combining these two aspects into our solution, I think we’ve gone some way to solving the problem,” adds Bohrer-Bilowitzki.
He says that currently, fund managers still have to physically hold assets on crypto-exchanges but plans are underway to move to a position where trading will become possible using a centralised book; at which point, managers will not need to physically hold assets on exchanges.
“It will be an out of custody trading environment, just as we see in the traditional fund space. Everything will be locked away in custody. I think we are three to six months away from this happening,” he says.
Such a development should help reduce the risk of asset misappropriation by hostile actors targeting the exchanges.
Digitalising fund distribution
Moreover, as crypto-custody becomes more institutional, fund managers wishing to launch digital asset funds could also reduce operational risks by availing of blockchain technology.
Take fund distribution, for example. Historically, this has often been a time-intensive manual process requiring compliance teams to ensure their funds are being marketed correctly to investors in different jurisdictions, all the while adhering to country-specific regulations.
Blockchain has the potential to radically improve how this distribution process is managed.
As Burnie outlines: “When distributing funds across multiple jurisdictions, some of our clients are looking to see if they could automate things like risk disclosures for investors in each jurisdiction, to make sure the right investors are coming in to the fund, etc, and the blockchain would tend to allow for that. The investor onboarding process still involves jumping through a lot of hoops, as shown by the fact that subscription documents can be 90 pages long. The more you can automate the process, the more it will make life much easier.
“The problem is that the initial set-up of the blockchain platform can be risky and expensive. The question then becomes whether, rather than funds individually setting up blockchain solutions, we will see new market entrants that specialise in these solutions being set up. I think this is one area we are going to see development, and it raises the further questions of how the funds using such platforms perform effective oversight over them.”
Another consideration is if a specialist third party entity stores investors’ details, for example, as a central validator to meet AML / KYC requirements, investors won’t have to provide each fund they invest in with personal information. Their details would only be shared once with the third party.
“The risk of a data breach becomes smaller because it means data is not being shared as much, and is being shared with entities which specialise in data protection. The FCA are quite supportive of this type of innovation, sometimes referred to as privacy enabling technologies, as it facilitates GDPR compliance,” adds Burnie.
Tokenisation of securities gathers steam
In other market developments, one trend catching people’s attention is the tokenisation of securities, with major institutions such as Goldman Sachs exploring the options of developing their own digital token. This is now a focus of R&D activity among many fintech start-ups.
At Deloitte, Pugh foresees tokenisation potentially having significant importance to the asset management industry enabling accessibility and affordability for all, “thereby unlocking trillions of euros in currently illiquid assets and vastly increasing the volumes of trades and investments”.
To clarify, a token is an object whose value is based on another object, either physical or virtual. The tokenisation of assets therefore refers to the process of issuing a blockchain token that digitally represents a real tradeable asset. It is, in many ways, similar to the traditional process of securitisation but with a modern twist.
Pugh outlines four key advantages that tokenisation provides for both investors and sellers:
• Greater liquidity
By tokenising assets – especially private securities or typically illiquid assets such as alternatives – these tokens can be then traded on a secondary market of the issuer’s choice. This access to a broader base of traders increases the liquidity, thereby capturing greater value from the underlying asset.
• Faster and cheaper transactions
Because the transaction of tokens is completed with smart contracts, certain parts of the exchange process are automated. This automation can reduce the administrative burden involved in buying and selling, with fewer intermediaries needed, leading to not only faster deal execution, but also lower transaction fees.
• More transparency
A security token-holders rights and legal responsibilities are embedded directly onto the token, along with an immutable record of ownership. These characteristics add transparency to transactions, allowing you to know with whom you are dealing with, what your and their rights are, and who has previously owned this token.
Tokens are highly divisible, meaning investors can purchase tokens that represent incredibly small percentages of the underlying assets. If each order is cheaper and easier to process, it will open the way for a significant reduction of minimum investment amounts.
A new digital asset secondary market?
The tokenisation of securities could potentially lead to the creation of a digital asset secondary market on which to trade tokens, which previously wasn’t practicable.
“If you take a private equity partnership structure, for example, it has Limited Partnership interests which could be tokenised,” explains Watford. “One could then establish a white label list and fractionalise units, meaning that we split them up so that a single token represents a 10th or a 1,000th of a unit and then we can trade these parts of a unit on a secondary market. This ability to split up fund units doesn’t exist with ordinary share classes but we aren’t there yet. However, it is worth bearing in mind that even if fractions of a unit can be traded, to have true liquidity there will still need to be active buyers and sellers of the tokens, which is dependent on market economics.”
This could help to democratise the funds industry and bring new investors and into the market. But it is worth stressing that even if securities are tokenised, this does not by itself guarantee liquidity. It still requires an active pool of buyers and sellers.
It is an exciting area of innovation. In July this year, Venturebeat reported that the SEC had officially cleared blockchain startup Blockstack to hold the first regulated security token offering under Reg A+ crowdfunding rules.
This is likely going to open the door to more start-ups seeking SEC approval to raise capital through the issuance of digital securities and give investors access to a plethora of new investment opportunities.
In the UK, the fintech company Globacap recently announced the launch of a fully regulated platform for digital security offering and administration. Globacap is tokenising digital securities including bonds, shares, and funds and according to the company, this is the first such exchange in the UK working under the regulatory guidelines of the FCA.
In August 2018, the company digitised its own shares while earlier this year it did the same for two UK-based companies and also offered regulated arranger and custodian services in each capital raise.
Myles Milston, CEO of Globacap, said: “The (FCA) sandbox programme has been a great experience, enabling us to come to market with a new application of an emerging technology in a controlled but quicker manner. From our groundbreaking proof of concept in August last year, to our product now coming to market, the support from the Innovate Team at the FCA was instrumental in the success of this journey.”
Precipice of change
The tokenisation of hedge fund ownership will allow added fractionalisation, enhancing tradability, and create a value-add for owners of the tokens.
Issuers of tokens, supported by blockchain platforms, will gain operational efficiencies and transparency in many categories, such as KYC/AML compliance and even regulatory and tax reporting.
In addition, tokenisation will enable streamlining of portfolio management, faster clearing and settlement of trades with blockchain-enabled real time reconciliation of information.
Investors will ultimately have more transparency on their holdings and hedge fund managers will be able to drastically reduce the time required to compile detailed investment and performance reports.
“The investment world sits on the precipice of change once again,” opines Deloitte’s Pugh.
“Blockchain is still waiting for that ‘break out’ moment as there are still significant unknowns related to the regulatory and legal environment. However, more and more players are experimenting and collaborating to leverage the benefits of blockchain technology, challenge traditional business models and re-invent industry value chains.
“The major risk for laggards is being left behind in the rise of digital platforms in the financial services industry.”