Tokenization could transform the real estate and other non-listed asset markets, but trusted partners will be key.
As with all innovations that challenge the existing order, many complex issues still need to be fully resolved to allow the advent of tokenization. In the meantime, however, real-world initiatives are coming to market that demonstrate tokens’ potential, especially in the area of non-listed assets.
“Non-listed assets such as real estate and private equity are usually restricted to institutional investors given the high investment barriers”, says Karine Litou, Global Head of Products & Solutions, Private Capital, Real Estate at BNP Paribas Securities Services.
“But tokens could open up these kinds of asset classes, especially real estate in the first instance, to the mass market. Investor accessibility to unlisted assets becomes easier through a blockchain. And because each asset can be fractionalised into many tokens, minimum investment amounts are much lower.”
One of the main pain points for an asset manager creating a traditional fund is maintaining the registry and monitoring the different investors, with all the onboarding and AML/KYC processes that have to be completed before accepting any investor into the fund. Tokenization eases the onboarding and registry subscription because each investor is identified and validated into the blockchain one time and in a secure way. They can invest directly into the fund with fewer difficulties and in smaller amounts, while the funds can more easily meet their compliance obligations.
“Having an independent registry and digital exchange would also promote secondary market transactions and foster market liquidity”, says Karine Litou. “It is not really subscription and redemption, but transfers between investors on the blockchain. So the ability to dynamically monitor and fully dematerialise all the movements between different shareholders brings liquidity to the investor, who will be able to see who is willing to buy or sell at each moment, without impacting the liquidity of the underlying assets.”
Real estate tokenization would expand the retail distribution opportunities as well. “Retail investors can gain property exposure at present through Real Estate Investment Trusts (REITs), with asset managers typically distributing funds in their local market”, notes Karine Litou. “Blockchain unlocks the possibility of securely distributing a fund to retail investors in other countries. However, it raises issues around tax declarations and collection, and appropriate regulatory protections – such as what KYC documentary proof should be validated into the blockchain – that will need to be addressed.”
Patrick Rivière, Chairman of the Management Board of Groupe La Française, states: “I believe that Real Estate funds is one area of business that could benefit the most from tokenization technology, as it should impact not only the way we invest in properties, but also the way we manage secondary markets and client registration. I see it as both a very important potential operational leverage and a way to improve the client experience, but there is something that token is not going to change, which is the long term nature of Real Estate investment. Technology may help to ease and speed up Real Estate dealing process along the entire process, but at the end of day, it is not going to transform a Real Estate asset into a liquid asset, and it could be very dangerous for the industry to ignore this!”
Trusted partners on the blockchain
Real estate tokenization projects – which to date have focused on tokenising the shares of the holding company that owns the building, rather than the building itself – have come to market already. But maximising the potential that real estate tokenization offers will require all trusted partners at the different stages of the transaction to participate in the blockchain to create a secure end-to-end environment.
Along with validating investors on the blockchain, a key requirement will be to ensure certification of the real estate asset at the beginning of the process. “You need a trusted partner to validate a building’s existence, because otherwise you might be buying an empty field instead of a palace”, says Karine Litou.
In France, for example, the notary validates the building’s existence and value. “The notary registers all the transactions of the building, and its value at the time”, Karine Litou notes. “This expert needs to be on the blockchain to give investors confidence that a real asset exists behind the tokens.”
Custodians also have an important and evolving role to play as trustee of the registry and in monitoring the fund:
“Custodians for ordinary real estate funds need, at least once a year, to receive proof of a building’s existence from the notary, and that the fund is still proprietor of that building”, Karine Litou explains.
“In a blockchain environment, proof of the building’s existence and ownership, including any transaction on all or part of it, will be fully automated, secure and real time. So custodians will be able to provide investors with a real-time, transparent view of the evolution of the fund portfolio and a guarantee that the blockchain is secure. And because the process is fully dematerialised, it will reduce the different transaction costs.”
Provided there is a recognised local partner expert to provide the asset validation, real estate fund managers can invest in other countries and benefit from the same real time ease of portfolio monitoring as well, she adds. And if the transaction is standardised, with the necessary trusted actors operating on the blockchain, the final step potentially could be the creation of a UCITS-type tokenised real estate fund with pan-European distribution. “It could offer a way to distribute the fund on a very large scale with really small amounts, like in the UCITS world”, says Karine Litou.
ESG and blockchains
Yet, while blockchains offer efficiency improvements in the way markets function, they come with a drawback: their climate footprint.
Dematerialisation of the registry through blockchains removes the heavily paper-based processes that traditionally clog up the funds environment, bringing a positive environmental impact”, says Karine Litou. “But to develop and operate a blockchain requires significant computational resources. The level of energy consumption involved means it is not particularly eco-friendly. That eco-impact is a major consideration for asset managers, as it may not be aligned with their ESG policies and credentials. Some firms have opted not to launch blockchain projects as a result.”
The heavy computational demands and resulting energy drain are however more associated with mining cryptocurrencies than blockchain applications per se. Firms could also opt to offset the CO2 emissions from their blockchain activities through a carbon compensation scheme. “That could be a specific way to help asset managers be more confident about communicating with the market on their ESG policy”, notes Karine Litou.
Cost is a further deterrent. Developing a blockchain-based infrastructure takes considerable technology investment. And unless all the actors that need to participate in the blockchain buy-in to the process, it won’t succeed.
“To launch this kind of project requires progress on several fronts”, says Karine Litou.
“The outstanding regulatory issues need to be addressed. All the necessary actors have to be brought on board. Investments to develop and implement the technology will be required. Asset managers will need to tackle how they communicate their ESG policies to the market. And investors must have sufficient confidence in the blockchain, which will depend to a large degree on bringing in trusted trade partners with a strong reputation to give investors assurance at the user level.”
Much still has to happen before blockchain-based tokenised markets take off, but the same could be said for the early days of the Internet. The unfamiliarity, immaturity and concerns over security limited the number and type of transactions users would conduct. Now, it has become the global norm. “I think for blockchain it will be the same”, says Karine Litou.
The use cases to date show tokenization works, and that it has significant potential to redraw how investment markets operate, especially for unlisted and illiquid assets such as real estate. However, the argument has not yet been won, one way or the other. What happens in the next five years will be crucial to its ultimate success or failure.
With thanks to Patrick Rivière, Chairman of the Management Board, Groupe La Française and Karine Litou, Global Head of Products & Solutions Private Equity – Real Estate, BNP Paribas Securities Services.