Transcript
Speaker: Welcome to HSBC Global Viewpoint, the podcast series that brings together business leaders and industry experts to explore the latest global insights, trends, and opportunities.
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Speaker: Thanks for listening.
Speaker: And now onto today's show.
Speaker: A very warm welcome to our listeners from myself, Barry Sandeman, Senior Product Manager for Trustee and Fugistry Services at HSBC Security Services.
Speaker: There's been much discussion of the uses of distributed ledger technology or DLT for crypto assets and asset tokenization.
Speaker: But today we're going to be discussing a very exciting innovation for the financial services industry, and that is fund tokenization.
Speaker: To help me explore this topic further, I'm delighted to be joined by John Allen, Head of the Innovation and Operations Unit at the UK's Investment Association, also known as the IA, and by my colleague, Rachel Rock, Senior Product Manager for Digital Data and Innovation at HSBC Security Services.
Speaker: John, thanks very much for joining Rachel and myself today.
Speaker: Could you firstly briefly explain to our listeners what fund tokenization is, please, and what benefits does it bring to the asset management industry and, importantly, to investors?
Speaker: Well, thanks for having me on, Vahri.
Speaker: Fund tokenisation can differ and there is no consistent definition, but it essentially applies distributed ledger technology to the administration functions of investment funds, such as the shareholder register, and transactions in the fund become DLT-based.
Speaker: Digital tokens are issued to investors that represent the ownership of a fund, and these tokens can be stored, transferred and traded on blockchain platforms, which can increase efficiency and transparency by enabling all the parties to the fund to see accurate fund data in real time.
Speaker: This is the model that I typically refer to as it is the one that is regulatory permissible in the UK and where fund managers benefit most.
Speaker: In other types of models, tokenization is not applied by the fund provider themselves, but instead by a third party, such as the investor themselves, or a platform or nominee who sits between the fund and the end investor.
Speaker: In this case, the fund share or unit is issued in conventional form, and the token created represents the investor's off-ledger interest in the fund.
Speaker: Here, the fund manager may benefit from a new distribution channel as the platform or the nominee might be able to reach investors that the fund manager otherwise could not.
Speaker: However, the operational efficiency benefits for the fund in this case are not as substantial as the accountant, custodian, depository and other parties still rely upon the central transfer agent and each other and have to reconcile against everybody else's record-keeping systems.
Speaker: In either or other models that exist, the benefits are to ensure that the fund is able to interact effectively with the increased use of DLT in the wider financial markets, utilising modern technology to streamline and automate fund administration functions, delivering an efficient way for multiple investors to access capital markets.
Speaker: the end client will likely not notice or even care particularly that DLT is being used.
Speaker: This is just simply a mechanism.
Speaker: But they certainly can benefit from reduced costs and in some cases, access to asset classes that they might otherwise not be able to reach.
Speaker: Thanks for explaining that, John.
Speaker: And there are some important benefits there.
Speaker: And John, you've been working extensively on this in your role at the IAE.
Speaker: What are we seeing in the UK in terms of developments?
Speaker: How much appetite is there to tokenise funds amongst asset managers and the wider industry?
Speaker: Well, fund tokenisation is a very exciting and innovative area that has the potential to transform the fund industry in the UK and globally.
Speaker: In the UK, a group of asset managers and digital asset firms took part in a government-convened working group to explore benefits and the barriers to fund tokenization.
Speaker: This produced a Financial Conduct Authority-approved way forward, and firms are now able to apply that model to their funds as of today.
Speaker: Many of our members already have tokenized funds in other fund domiciles across the world, and we are seeing lots of plans emerging.
Speaker: Several asset managers and service providers are participating in fund tokenization initiatives, such as creating tokenized funds that invest in money markets, private equity or infrastructure, and developing platforms that enable the issuance, distribution and administration of fund tokens.
Speaker: Complementarily to this, other developments such as the UK government's Digital Security Sandbox, which allows for testing on financial market infrastructure, utilizing DLT,
Speaker: the emerging regulatory framework for stable coins and wholesale central bank digital currency all help provide a direction of travel towards the wide-scale utilisation of tokenisation technology within financial services.
Speaker: And ultimately, we want to ensure the fund is able to interact effectively in this environment.
Speaker: Thanks very much, John.
Speaker: And Rachel, John referenced other fund domiciles there.
Speaker: Turning to Asia now, are we seeing equivalent developments there, for example, in Hong Kong and Singapore?
Speaker: Well, very interest in funds tokenization has definitely accelerated in Asia over the past year, partly due to increasing regulatory clarity, especially in Hong Kong and Singapore.
Speaker: So in November 2023, the Securities and Futures Commission, the SFC in Hong Kong, published a circular on tokenization of SFC-authorized investment products.
Speaker: And the SFC has stated that their principle of the regulatory approach is same business, same risks, same rules.
Speaker: So market participants in the digital assets space need to comply with the existing legal and regulatory requirements applicable to traditional securities.
Speaker: In addition, for tokenized assets, new risks, which are not typically associated with traditional securities, especially ownership risks and technology risks, such as blockchain network outages and cybersecurity risks, need to be managed as well.
Speaker: This clarity in the regulatory approach has spurred interest in fund tokenization from traditional asset managers.
Speaker: Several Hong Kong asset managers have started to explore fund tokenization, with one fund manager issuing a fixed income tokenized fund recently.
Speaker: In Singapore, the Monetary Authority of Singapore has launched Project Guardian, a collaborative initiative with the industry on tokenization and decentralized finance.
Speaker: In response to strong demand from the funds industry in Singapore, MAS launched a new funds workstream within the Project Guardian industry group that is focusing on the native issuance of variable capital company funds on digital asset networks.
Speaker: So a large asset manager has announced that they are exploring fund tokenization as a participant in Project Guardian.
Speaker: It's still early in the adoption curve in both Hong Kong and Singapore, but interest and adoption in the funds industry is definitely growing.
Speaker: Thanks.
Speaker: Obviously, a lot of activity in Asia too then.
Speaker: And Rachel, what impact would fund tokenization have on the fund management lifecycle and participants like asset managers, transfer agents and other security services providers?
Speaker: With fund tokenization, smart contracts can be used to automate many of the processes involved in the fund lifecycle by essentially capturing the rights and obligations of the participants in lines of code.
Speaker: This would help to increase efficiency and remove manual processing.
Speaker: For example, many of the fund administration functions, such as fund valuation and transfer agency, can be performed automatically via smart contracts.
Speaker: The participants involved in the end-to-end fund lifecycle would be similar to that of traditional funds.
Speaker: But the key difference here is how the services are being performed.
Speaker: For traditional funds, a transfer agent needs to receive orders from distributors, update the shareholder register that they maintain separately, and then update the fund manager on changes in asset holdings and cash flow.
Speaker: For a tokenized fund, the difference is that the distributors or exchanges should be directly connected to a shared distributed ledger.
Speaker: So all orders flow through to the network and result in an automated update to the fund unit holder register.
Speaker: And these updates should then be immediately visible to all the participants.
Speaker: So in this case, the transfer agent would either be the operator of the shared ledger or a participant with the main obligation of oversight and exception handling.
Speaker: Now let's look at the custodian role.
Speaker: Typically, a custodian is required to safe keep the underlying securities that the fund invests into.
Speaker: But for tokenized funds, there is an additional custodian role required for the fund unit tokens.
Speaker: function remains the same, new infrastructure would be required.
Speaker: And a custodian of a tokenized fund would need to provide wallet and key management infrastructure to be able to safe keep these assets.
Speaker: A number of traditional custodians, including HSBC, are currently developing capabilities to hold these tokenized assets in custody.
Speaker: Thanks very much, Rachel.
Speaker: And John, what does the future look like for fund tokenization?
Speaker: How quickly can we expect to see this commonplace in the industry?
Speaker: And are there any particular challenges that need to be overcome?
Speaker: Well, that's a really important question, Rari, as this concept has been discussed now for several years.
Speaker: And so clearly some challenges have slowed developments down.
Speaker: I'll cover three of them here.
Speaker: Firstly, international regulation.
Speaker: I mean, there is no clear or consistent legal framework for the issuance and trading of fund tokens across different jurisdictions.
Speaker: So this does create risks and barriers for market participants who need to comply with different rules and standards depending on where they operate.
Speaker: Domestically, HMRC have recently confirmed that fund tokens can be held in ISAs.
Speaker: But internationally, there is a need for more clarity and guidance on how fund tokens are taxed, how they fit into existing reporting and disclosure requirements, and how they are treated in the case of insolvency or fraud.
Speaker: Secondly, technical interoperability.
Speaker: There are many different platforms and protocols for creating and managing fund tokens, which may not all be compatible with each other, or with existing systems and infrastructure.
Speaker: This can limit the scalability and efficiency of fund tokenization as it requires more integration and coordination efforts among different stakeholders.
Speaker: There is also a need for more standardization and harmonization of technical specifications.
Speaker: and best practices for tokenization to ensure quality, security and reliability of the tokens and the underlying assets.
Speaker: And we're working with service providers and our members to avoid where possible a fragmented marketplace.
Speaker: And thirdly, and finally, market education and awareness.
Speaker: This would be a significant change and there is naturally a need for greater understanding and familiarity with fund tokenization among the many potential users and beneficiaries, especially in the traditional funds industry.
Speaker: There is also a need for more education and awareness campaigns to inform and educate the market about the advantages and opportunities of fund tokenization, as well as the risks and challenges involved.
Speaker: And this is a key plank of the work that we're doing here at PIA.
Speaker: So to sum up, I think that fund tokenization has a lot of potential to transform the funds industry and can certainly create value for all parties involved.
Speaker: And I expect to see more innovation in this field in the coming months, as well as more collaboration and dialogue among regulators, policymakers, industry players and investors to address the issues and pave the way for more widespread and mainstream usage in fund tokenization.
Speaker: John and Rachel, thank you both so much for joining me today to discuss fund tokenization.
Speaker: It's been absolutely fascinating to learn more about this and to consider the impact to the funds industry and investors.
Speaker: We hope clients have enjoyed the discussion.
Speaker: And if there are any questions on this, please follow up with your HSBC representative.
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