Will regulators and compliance drive tokenisation of assets in 2019?

Will regulators and compliance drive tokenisation of assets in 2019?

There are a number of organisations trying to convince investors of the merits of Tokenising different assets classes, on the basis that once it is possible to buy a fraction/share in a property or piece of art or a car etc, it will enable smaller investors to participate and create a pool of liquidity.

While this sounds very plausible in practice, illiquid assets such as art, property and classic cars tend to be the preserve of the very wealthy or institutional investors. These asset classes usually have little day to day liquidity, as these more sophisticated investors tend to buy and hold for the longer term. However, the jury is still out since by tokenising these illiquid assets, it will instead lead to other people actively buying and selling on a daily basis!!!

The Real Estate Investment Trusts (REITs) market started in the USA in September 1960, as a way of encouraging investors to participate in buying property in the USA. This REITs model has been subsequently copied by many other countries around the world.

The statistics below show it is estimated that 80 million people are exposed to USA REITs, which is valued to be over $3 trillionin size, with the majority REITs being quoted on a regulated stock exchange.

Source:www.reit.com/data-research/data/reits-numbers

It is possible to buy a USA REIT at a discount of its asset value and, indeed, at the end of 2018, the discount of the median RIET was as large as 18%.Therefore, one has to question if there are potentially 80 million investors exposed to over $3 trillion of assets, which one can buy at a potential discount of 18% – how will tokenisation help?

The other popular mis-nomer has been how Initial Coin Offerings (ICOs) and the tokens they created will democratise capital. To put this a different way, ICOs offered the promise to enable smaller investors to have access to smaller exciting tech start-ups. These have historically been the preserve of wealthy-sophisticated investors and institutions, like Venture Capital and Private Equity Funds.

In 2017 Naga, a German publicly quoted company, epitomised this by raising over $50 million from 63,000people. Unfortunately, apart from a handful of tokens, there is relatively little liquidity in the secondary markets and exchanges for many of the organisations that have issued a token.

According to Coinmarketcap.com, there are less than 100 tokens that had a volume of more than $1million, after which the volumes fall dramatically to a few thousand over most 24-hour periods. But this really ought not to be a surprise, as there are relatively few investors who buy even quoted smaller companies. In the UK, there are 481 companies on the Alternative Investment Market (AiM), that have a capitalisation of between £2+ million, but less than £100 million, and another 272 companies listed on the main London market valued under £100 million.

Just in the UK, we can see there is plenty of choice for investors but unfortunately it is almost impossible for even these publicly-quoted companies to raise fresh capital. There are multiple reasons for this – lack of information about these smaller companies, difficulty in valuing the company, few tangible assets being owned and lack of institutional interest etc. Often there is no liquidity to buy and sell these quoted smaller company shares. How familiar are these reasons cited as to why there are a lack of investors for tokens in the secondary market?

UK smaller companies have out-performed the FTSE 100 index –  in the 10 years to 6 November 2018, the FTSE Small Cap ex IT index has risen 266%, compared to a 140% increase for the FTSE 100. So, surely investors would be flocking to this asset class? Therefore, why will tokenising equities mean that these investments do any better??

This backdrop has not stopped The London Stock Exchange (LSE) from embracing tokenisation of equities and, in April 2019, it actually allowed a company called 20/30 to list its “tokens”on the LSE exchange- why? Strangely, this could be due to regulation and compliance pressure as, by tokenising/digitising a share/bond etc, it is possible to build-in greater controls from a compliance standpoint.

For example, an international mutual fund will have a maximum it is allowed to invest in the USA, say 10%, but the fund manager may go to buy another share and not realise that this will take the fund over the 10% limit. This results in a compliance breach which ought to be reported internally, and then potentially to the FCA. Alternatively, let us assume you are a high-risk investor and your portfolio manager decides to buy a low-risk investment, again causing a potential deviation from your portfolio strategy and the need for more compliance reporting.

These types of breaches are common, costly and time-consuming and totally avoidable if pre-trade checks have been automatically carried out prior to, not after, a trade is executed. These checks are not easy to carry out in today’s largely analogue manual systems, but eminently possible using automatic machine-run checks if a security is digitised.

Also, the amount of income payable to an investor can be calculated, based on the number of minutes the investor has held a share, bond or property. This is opposed to being paid the distribution, based on the investor owning the asset on the day that the share, bond or property makes its dividend, coupon or rent payment!

As compliance pays an increasingly important role in the financial services sector, and the constant need to be seen to be “treating customers fairly”, will we see quoted companies like Apple, Facebook, Microsoft, Shell, BMW Tesco being asked to create a digital/tokenised version of their shares?

This rather ironic state of affairs, where regulation drives the adoption of Crypto, is juxtaposed to the current situation where institutions shy away from tokens as they are seen to be akin to investing in the “wild west”, and concerns about the wrath of compliance officers abounds…….