Tokenized Traditional Assets: A Practical Guide for Asset Managers Part 2

Part 2

How to Get Started

Starting to invest in tokenized traditional assets as an asset manager requires a few key components from an asset manager's perspective. 

Crypto Custody and Wallet Infrastructure

Holding tokenized assets (which effectively means holding private keys) requires different technical abilities than holding traditional assets. To ensure the secure storage of these crypto assets, asset managers may engage specialized crypto custodians. Leading financial institutions are increasingly catering to this demand, either directly or via subsidiaries, to provide institutional-level crypto custody services.

Distinctly from traditional custody, the crypto world offers the choice of self-custody, meaning managers can retain private keys autonomously. However, as an institutional asset manager, attention should be paid to the clear separation of duties between managing assets and safekeeping assets. In traditional finance, these duties are clearly separated, i.e. an asset manager is in charge of managing assets, but the safekeeping, i.e. custody, of assets is provided by a separate, regulated custodian. Regardless of your choice between a custodial or self-custodial approach, the end result remains consistent: A digital wallet that facilitates blockchain interaction, akin to a conventional bank account.

Market Access and Connectivity

In order to buy and sell tokenized assets, access to the Digital Market infrastructure, such as the blockchains/protocols themselves, as well as marketplaces, providers, and counterparties, is needed.  This comprises two pivotal components:

• Technical connectivity: This includes connecting the wallet to blockchains and protocols as well as interacting with smart contracts, structuring blocks of transactions etc. In certain scenarios, this can also include connecting to e.g. a digital exchange or other counterparties via traditional FIX connectivity while the counterparty itself then executes through blockchain infrastructure.
• Regulatory onboarding: Many digital platforms necessitate rigorous KYC/AML procedures tailored for institutional clients prior to granting connectivity.

Providing infrastructure and connectivity to the Digital Asset markets is one of the core elements of Alloy. We have developed tools specifically designed for Asset Managers to not only connect to blockchains and decentralized finance protocols but also to interact with smart contracts and structure complex, multi-protocol transactions in an intuitive manner. For tokenized traditional assets, we have developed a dedicated execution management system (EMS) that combines various tokenized asset classes and markets into one single, simplified view. Thereby serving as an efficient connectivity layer for asset managers and investment system providers to easily connect to the fragmented market infrastructure in a standardized way. This allows users to remain with their existing investment systems and seamlessly execute and process tokenized bonds, equities, and funds alongside their traditional counterparts. All the connectivity and blockchain complexity is abstracted away and runs in the background.

System Readiness

Connecting to the market infrastructure is one important aspect of establishing the technical basis to trade tokenized traditional assets. The other important aspect is that the existing system is configured to handle digital assets from a data perspective. From a processing perspective (positions, exposures, durations, reconciliation, etc.), existing systems should have the capabilities to manage tokenized traditional assets given that they are generally equivalent to their traditional parts - whether tokenized or not. However, it should be ensured that the instrument types and data feeds are in place to ensure the tokenized equivalents of traditional assets are appropriately reflected in the system. This can largely be broken down into 4 main parts:

• Tokenized assets, i.e. bonds, shares, etc.: Tokenized assets should be set up with the right security and instrument type in order to represent and process them correctly within the system. It may make sense to establish tokenized bonds as a Bond security type but set up a new instrument type (e.g., called Digital Assets) to distinguish them from their traditional counterparts. 
• Stablecoins, i.e. tokenized cash and cash equivalents: In order to transact on the Digital Markets an asset manager will need stablecoins (in most cases). Since these represent cash it may be advisable to configure them as cash positions but mark them as stablecoins or Digital Assets again. 
• Position and transaction data: Transactions executed and positions held in the Digital Asset markets will need to be appropriately reflected in the system. This is where some of the benefits of using tokenized assets come into play again: Transactions are publicly available from blockchain data. Therefore data can be sourced from both blockchains and counterparties (custodians, marketplaces etc.) simultaneously and reconciled accordingly. In case a solution such as the Alloy EMS mentioned in the previous paragraph is used, the data sourced from each connection is consolidated and provided in a normalized format which ensures consistency and reliability for the investment management system (IMS).
• Price data: Finally, position keeping requires appropriate price data, which can be obtained through open-source price sources, dedicated data providers or again through a unified connectivity later, which ensures not only access and execution but also connectivity to as well as standardization of various price sources. 

In conclusion, tapping into tokenized assets demands both a foundational understanding of the digital realm and the strategic infrastructure to support it. With the right tools and strategies, however, asset managers can seamlessly integrate and leverage this new asset type alongside their traditional counterparts. Thereby opening up opportunities for considerable efficiency gains and new investment possibilities.

Legal and Regulatory Considerations

In our earlier discussion, we touch on the legal and regulatory perspective surrounding tokenized assets. It is interesting to shed some more light on what tokenization means from a legal and regulatory perspective to understand the potential significance for capital markets.

The Issuance Process (Primary Market)

To tokenize an asset or security, it must first exist or be created in the real world. For instance, shares meant for tokenization must either pre-exist or be legally issued.

In the case of issuance under Swiss law, on a high-level, three main steps have to be performed at a minimum: 

1. Modification of constitutional documents: The company's articles of association must be amended to allow the share issuance as ledger-based securities. This means that shares won't be conventionally dispatched as certificates but will be issued and tokenized digitally.
2. Board approval: The board must consent to tokenize the shares in alignment with the updated articles of association and the applicable tokenization standards. Notably, Switzerland has released regulatory guidelines for distinct token types and the requisite standards for smart contract designs, like those posited by the Capital Markets and Technology Association (CMTA). This ensures that tokenized assets are legally considered equal to their traditional counterparts.
3. Investor engagement and market onboarding: Depending on the nature of issuance, firms might need to draft investor communication materials and seek admission to a blockchain-regulated marketplace.

The Investment Process (Secondary Market)

Besides the technological aspects of investing in tokenized assets, there are pivotal legal and regulatory requirements to navigate.

• Prospectus adaptations: In order for a fund to invest into tokenized versions of traditional assets, there are likely changes to the prospectus that are required. Mainly the risk section of the prospectus should encapsulate particular wording that outlines the risks stemming from tokenized assets (such as blockchain-related risks). This prospectus change will require additional filing with the regulatory authorities and, therefore, additional time.
• Investor information and suitability: For tokenized assets or funds that invest in tokenized assets, appropriate investor disclosures should be made in accordance with local laws. In addition, for investment mandates (especially for global banks and wealth managers), individual investor suitability should be ensured, i.e. that it is in line with a client's risk and investment mandate.

Current Regulatory Landscape

Several countries, predominantly in Europe, have instituted frameworks that underpin a robust tokenized asset capital market. These frameworks encompass regulations related to custody, securities, technical standards, and stablecoins. Such regulations enable the issuance, safeguarding, and transaction processes within the Digital Asset markets.

Pioneers in this legislative realm include Switzerland, Germany, Luxembourg, and Singapore. A remarkable feat in some of these jurisdictions is the legal recognition of tokenized securities as synonymous with traditionally issued ones. This equivalency narrows the divide to primarily a technological one - more precisely to a difference in infrastructure: Even traditionally issued securities are mostly held in digital form (and therefore, some consider them “digital” already), however, based on a different underlying technology stack: They are held within Central Securities Depositories who keep records of ownerships (technically in whichever infrastructure they choose) and to which exchanges, custodians and clearinghouses have to connect to. In contrast, tokenized securities are blockchain-based, leveraging Distributed Ledger Technology (DLT). Here, ownership records are maintained across the network, eliminating central authorities and fostering a universally binding and reliant protocol.

A Brief Look Under the Hood: The Technical Side of Tokenization

Blockchains

A tokenized asset, inherently, is a token — fundamentally a smart contract — that exists within a blockchain's infrastructure. This mirrors the traditional finance world, where assets need registration with a CSD and exchange to be tradable. Choosing a blockchain essentially means choosing the basic infrastructure on which the asset, i.e., the token, should be transacted on. One key decision will be whether to issue a token on a private or a public blockchain, both with its pros and cons. From our recent conversations with market participants as well as from industry events, we see a preference for public blockchains, but in a permissioned setting, i.e., the token lives on a public blockchain but can only transact on a protocol or marketplace where participants have been KYC’ed. In choosing a blockchain it may help to think along similar lines as when choosing where to list or trade a share. As mentioned previously, tokenizing traditional assets can sometimes be compared to issuing ADR/GDRs. Currently, the most common blockchain used for issuing tokenized assets is Ethereum or blockchains that are based on Ethereum (so-called Layer 2, i.e., they are built with their own set of rules but ultimately settle back to Ethereum).

Token standards

Having a basic understanding of token standards is essential not just for issuers but also investors, ensuring asset transferability and regulatory alignment. Blockchains encompass diverse token standards that outline a token's fundamental attributes and functionalities. In the case of Ethereum, the most common standards are ERC-20 (fungible tokens) and ERC-721 (non-fungible token). For example, a company might use an ERC-20 smart contract to represent shares of its stock, while an art collector might use an ERC-721 smart contract to represent ownership of a unique piece of art.

Besides the token standard, which is a more technical view, tokenized assets in some jurisdictions should also follow a legal/regulatory token standard or framework (if available) which then enables the token to be seen as equivalent to the non-tokenized asset, i.e. the actual real-world asset. In Switzerland for example, this is the CMTA token standard which defines various attributes which the token, i.e. the smart contract, should follow on top of the purely technical (e.g. the ERC-20) standard. If it does, it is then seen as legally equivalent to e.g. any other regular bond or company share. 

The token issuance process

From a high-level perspective, on Ethereum, a token is created through a smart contract. Smart contracts are combinations of code and data that reside at a specific address on the blockchain. Smart contracts can interact with and send/receive data from other smart contracts. In order to execute a specific smart contract, it can be called via a message, i.e. a message is sent to the contract address, which then calls (i.e. executes) some of its functions. Smart contracts on Ethereum are “turing complete”, meaning they can represent any computationally feasible set of rules or logic. This vast range of possibilities allows developers to construct complex financial instruments, such as tokenized assets.

When it comes to tokenizing assets, a specific type of smart contract, often referred to as a “token contract,” is deployed. This contract contains rules and functions specific to the asset it represents. For instance, it can dictate the total supply of the tokens, ownership details, transfer mechanisms, restrictions, and even dividend distributions.

Once the smart contract is written, it needs to be deployed to the Ethereum blockchain by creating a message containing the smart contract code and broadcasting it to the network. When this message is included in a block, the code is deployed to the blockchain and functions within the contract can be called. Upon deployment, the contract gets its own unique address. This allows users to interact with it. Users can then send, receive, and hold the tokens created and managed by this contract in accordance with the rules and restrictions defined in the contract, all in a decentralized and transparent manner, and without the need for intermediaries.

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