Employing digital assets and tokenization for new avenues of growth

Authors: 

Brian Gelfand, Digital Assets and Financial Market Infrastructure Lead

Dave Inglis - Partner, Wealth & Asset Management

Contributors:

Tannor Pilatzke, Manager, Business Strategy & Transformation

Brandon Lapid, Senior Consultant, Business Transformation Architecture

Jigar Pathak, Senior Manager, Capital Markets Consulting

Vidur Channa, Consultant, Customer Strategy

Increasing investor interest, market developments and regulatory guidance in tokenized assets present a unique opportunity for asset managers.

In brief

• Institutional and high-net-worth investors show increasing interest in investing in tokenized assets, presenting revenue opportunities for asset managers.
• Tokenized assets offer both offensive and defensive strategic implications for asset managers, allowing them to tap into new markets and protect against potential disruptions in the industry.
• To navigate the tokenization landscape, asset managers must develop a digital transformation strategy, identify suitable asset classes for tokenization, build internal talent and resources, and stay up to date with regulatory evolutions.

Competition, regulatory changes and evolving service offerings in the digital asset space are creating a new wave of opportunities for Canadian asset management firms. Many institutions are now diversifying their portfolios with direct digital asset investments and implementing tokenization in their traditional asset holdings.

According to an EY-Parthenon survey, 37% of institutional investors and 61% of high-net-worth investors are planning on investing in the next wave of tokenized assets in either 2023 or 2024.1 Furthermore, high-net-worth investors are intending to allocate 6.3% of their portfolios to tokenized assets in 2024.

High-net-worth investors are also seeking better access to alternatives and are willing to pay higher fees for direct real estate equity. As such, tokenized assets are a prime opportunity for asset managers to offer direct or partial lines of ownership to real estate by offering a new premium asset class.

However, considerations surrounding institutional investors who expect lower fees for tokenized assets must be made, such as offering tokenized real estate assets without voting power to enable lower minimum investments. 

Source: EY-Parthenon Institutional Digital Assets Survey February 2023 (N=256) & Coinbase

The “crypto winter” that followed the collapse of high-profile crypto platforms has been a time of building infrastructure and capacity, and innovative asset managers are focusing on capitalizing on the changing landscape. Regulation is starting to catch up with the rapid technological advancements in blockchain infrastructure, both in Canada and globally. Understanding the allocation of funds in this new market, understanding and addressing the risks associated with digital assets, and uncovering the growing opportunities in tokenization are crucial next steps for Canadian asset managers.

There are two primary fields of play where these innovative asset managers have started to capture value.

First, they are offering ETFs and funds that provide exposure to cryptocurrencies. As of June 30, 2023, there were 21 public crypto asset funds in Canada.2 These funds collectively hold approximately CA$3.03 billion in net assets. Currently, these funds invest primarily in Bitcoin and/or Ether through direct holdings. Additionally, the approval of 11 direct Bitcoin tracking ETFs in the US has bolstered the expansion of further offerings by existing institutional asset managers.3

Second, firms are exploring tokenized investment funds and smart contract-based funds that cover diverse asset classes. These funds are represented as tokens held in digital wallets and transferred on the blockchain.

Asset managers have started to focus on the operational and cost efficiencies afforded by these new blockchain-based asset classes that programmatically govern underlying assets. These come with potential for error reductions, reduced reliance on intermediaries, and lower costs in the clearing and settlement process. The ultimate impact on financial markets should not be underestimated, with further potential for enhancements in transparency, security, efficiency and speed in executing and verifying transactions.

So, what is tokenization?

What is tokenization?

Tokenization is a transformative process that involves converting an asset or the ownership rights of an asset into digital form using blockchain technology. These digital tokens can represent various types of instruments, such as equity, notes or other financial assets with claims on real or financial assets. It is important to note that tokenization should not be confused with cryptocurrency. While cryptocurrencies operate within the digital realm, tokenization pertains to the digitization of real-world assets or ownership rights in those assets.

Tokenization can enhance liquidity, facilitate fractional ownership, enable faster and more efficient transactions, improve transferability, and enhance transparency and trust in asset ownership. Additionally, tokenization allows businesses to exploit efficiencies through process automation and smart contracts, leading to internal process efficiencies and cost reductions.

What are some of the value drivers and challenges facing tokenization?

Tokenization has several key value drivers, including operational efficiency through blockchain infrastructure, settlement efficiency with near real-time transactions, programmability via smart contracts for automation and cost reduction, diversified product development options with asset compositions, and increased liquidity by fractionalizing and trading illiquid assets. These value drivers streamline operations, reduce costs, improve transparency, bolster data security, spur innovation and broaden market access.

Challenges in tokenization include the evolving regulatory environment, developing distribution networks and interoperability, misconceptions about blockchain infrastructure, ongoing development of the ecosystem and supporting infrastructure, and the upfront investments and switching costs required. Overcoming these challenges is essential for successful implementation and widespread adoption of tokenization, and differing ways of dealing with them are already underway in various regions.

Regulation of digital assets continues to advance

To effectively navigate the market, Canadian asset managers must proactively stay abreast of regulatory developments to gain certainty and confidence in the future stability and credibility of the asset class. There are many ongoing efforts worldwide to regulate and supervise trading platforms for digital assets and tokenization.

Canada has taken a leading role in regulating not only public crypto funds but also crypto trading platforms and custodians. At present, 12 platforms are registered with securities regulators, and 9 crypto trading platforms operating under pre-registration undertakings. In response to recent insolvencies in the industry, Canadian regulators have strengthened requirements for pre-registration undertakings, specifically focusing on asset holdings, reserve requirements, margin operations, third-party guarantors, unregistered proprietary tokens and working capital assessment methodologies.

Globally, Europe has adopted the Markets in Crypto-Assets Regulation (MiCA), which is now in the implementation phase. The Hong Kong Monetary Authority has proposed to legislators that a regulatory regime should be implemented for virtual assets and stablecoins.

The US regulatory position is still evolving, with several bills in Congress proposing the regulatory oversight of crypto assets. However, there are still some differences between Canadian and US regulators on the treatment and legal classification of crypto assets.

Overall, there is a broad expectation of consolidation and streamlining of regulation across jurisdictions through a global regulatory standard in the next 12 to 24 months. The coordination of Canadian, US and European regulators will allow for the creation of strong guardrails that will provide asset managers and investors with confidence in the space. However, truly innovative asset managers will need to maintain rigorous internal safety mechanisms as well through risk management practices beyond regulation.

Risk management beyond regulation – operational, technology, resilience and third-party

There are incremental risks that must be managed in terms of custody of digital assets and security. Faster settlement and continuous trading require robust liquidity and processing capabilities. Additionally, challenges include identifying and addressing disruptive events, integrating with traditional systems, addressing vulnerabilities in smart contract code, ensuring reliable data sources, establishing standardized token standards, relying on emerging service providers, and lack of expertise in understanding digital asset risks.

To navigate the complex landscape of blockchain and digital assets, market participants can employ existing token standards with regulatory approval and consult risk and regulatory advisors. Developing parallel infrastructure with proofs of concept and maintaining traditional off-chain records can provide a short-term solution. Implementation can start on private blockchains with a plan to transition to public ones. It is important to gradually enhance capabilities for real-time transactions while conducting thorough assessments of distributed ledger technology options.

Implementing robust monitoring, security measures and redundancy in data sources is essential. Using open-source libraries, adhering to leading practices and conducting comprehensive smart contract reviews enable secure and efficient operations. Implementing enhanced frameworks and due diligence and acquiring blockchain expertise are crucial steps in successfully employing digital assets.

Next steps for Canadian asset managers

Canadian asset managers who want to capitalize on the tokenization opportunity face the imperative of addressing the evolving digital asset and tokenization landscape. Building for this future and making strategic investments is vital. To succeed, managers should focus on three key actions.

1. Developing a digital transformation strategy is crucial. Identifying critical technologies that boost competitiveness and drive performance is essential for staying ahead. This involves understanding strategic drivers of digital transformation, such as improving operational efficiency and enhancing distribution channels.

2. Identifying the tokenization strategy that aligns with their strategic goals — operational efficiency, defensive maneuvering, new revenue channels — is critical for success. This will inform the most suitable asset classes to tokenize and assess required operational capabilities to support tokenization.

3. Building internal talent and resources is vital through a people strategy. Managers must cultivate teams knowledgeable in digital transformation and tokenization. Acquiring talent or partnering with strategic advisors can bridge capability gaps, help navigate regulation and support growth.

As the industry continues to evolve, EY teams continue to help organizations navigate the complexities associated with formulating these strategies and bringing their vision to life. Bridging these gaps can be an effective tool for asset managers to seek out new avenues of growth in tumultuous times, but it requires collaboration and commitment across the board from operations, technology and business leaders.