More than a token approach to blockchain

How DLT and tokenization will reshape the fund distribution value chain and the role of the Transfer Agent.

Paul Daly, Head of Distribution Products and Solutions and Carole Michel, Fund Distribution Senior Global Product Manager at BNP Paribas Securities Services look at how DLT (Distributed Ledger Technology) and tokenization will reshape the fund distribution value chain.

The last decade has seen strong growth of the funds industry, both in terms of the number of funds and total assets under management. This has enabled fund houses to maintain revenues despite fee pressure, stricter regulation and an ever-changing technological landscape.

From a technology evolution perspective and in light of growing interest in digital assets, blockchain has the potential to be the most transformative technology in the fund industry by enabling digitization and tokenization of fund shares, reducing inefficiencies in fund distribution.

Fund houses rely on long and complex chains of distribution which make it difficult to build investor relationships and control distribution costs. Blockchain use cases represent an opportunity for fund houses to go direct to investors and expand their distribution network.

Investors can now subscribe to a native digital or tokenized asset via a distributed ledger online and hold these fund tokens in electronic wallets that they own and operate, moving the industry closer to a self-service model.

In addition to lower transaction costs, real time visibility, automation, and enhanced reporting with sharing of golden data are just some of the features that appeal to the buy and sell-sides. A shorter settlement cycle will increase liquidity and cash on chain will enable true delivery versus payment (DVP) between cash tokens and shares tokens, enhancing operational efficiency by eliminating cash reconciliation processes and chasing of payment.

Blockchain will also streamline AML/ KYC processes as ownership of tokens can be tied to the digital identity of the investor, building proof of beneficial ownership with AML/KYC controls integrated into the smart contract.

Today, investors are onboarded and protected from identity information leaks through an off-chain decentralised AML/KYC process. When the ownership of tokens can be tied to the digital identity of the investor, ownership changes will be registered automatically – eliminating the need for manual processes.

Developing digital ecosystem

We expect the digital asset ecosystem to grow significantly over the next few years, driven by changing investor behaviour. In the short to medium term we expect the fund industry to adopt a hybrid model with established players giving investors the option of subscribing via blockchain platforms or traditional channels.

Existing providers will continue to play a role in the market, but will need to adapt to new types of services, which is why we are supporting and working closely with our clients.

This technology will give birth to new types of services such as consolidation in case of interoperability between blockchain platforms, storage of private keys, signature of orders to validate the value on the chain, and structuration of data in the security token.

In addition, given that fund houses are not yet prepared for the extra costs and complexity that come with the move to a truly decentralized ecosystem, they will need some time to adapt if they want to bypass trusted third parties and issue native digital assets directly into the electronic wallets of investors.

Many of the fund houses we have spoken with are working on the basis of digitizing existing assets by converting them into digital tokens, but others are looking to offer natively issued digital assets.

As well as identifying the potential cost savings from further digitizing operations, we see the potential of blockchain as an opportunity to revise our business model and develop new services that add value to our clients.

We have made a considerable investment in blockchain technology over recent years, in collaboration with Allfunds Blockchain and strategic asset manager clients. This enabled us to deliver a proof of concept on tokenization of a UCITS fund in February 2021, improving our understanding of issues around digital assets.

Blockchain model options

Institutional clients are slowly but steadily moving from proof of concepts to investments. BNP Paribas Securities Services supports these clients through two models:

Firstly, where a blockchain platform is a financial intermediary or a distributor is using blockchain technology. In Luxembourg, we collect the blockchain orders and manage them like orders coming from any other distribution channel with the same level of service. A fund opens a register under the name of the blockchain platform or the client/distributor which is managed through our standard distributor onboarding process. We are already collecting orders for Luxembourgish funds from the IZNES investment platform based in France and FundsDLT based in Luxembourg.

Secondly, where some share liabilities are partially issued on a blockchain platform through our DLT integration service, we provide fund managers with an aggregated view including cash flow forecasts and other reports such as positions. We can also confirm the aggregated number of shares in circulation and provide all orders on blockchain and traditional shares to the fund accountant to compute the net asset value and to the depositary to operate the required controls. With this model we can also manage the cash settlement of blockchain orders between the main cash account of the fund and the fund’s cash collection account. We are already connected for French funds to the IZNES investment platform located in France and plan to connect to other existing market infrastructures deploying blockchain solutions.

To ensure that we continue to play a leading role in the development of market infrastructure, we are exploring the potential opportunity to be a direct participant in the blockchain in order to further streamline the process between investors and fund houses.

In this respect, BNP Paribas Securities Services is participating in initiatives driven by Allfunds Blockchain in Luxembourg, Italy, Spain and France and we are working on several use cases (including tokenization of fund shares). We believe that an integrated approach where distribution and transfer agent activities are operated within the same network will realise the full benefits of the technology.

The evolving future

From a regulatory perspective, we recognise that regulation on digital assets is fragmented and we are working closely with clients to help them navigate national requirements and provide services that comply with local rules.

These disparities in the regulatory framework across different aspects of the market are not helpful, but there is a conscious effort across all of the main fund markets to have a framework in place that will benefit the end investor and the fund house.

It is important to note that we only focus on digital assets with a clear legal framework, allowing us to provide services to our clients with the requisite level of safety and protection.

Looking further ahead, tokenization should enable the fund distribution industry to develop a secondary market where the value encapsulated in a token can be transferred almost instantly in a traceable process that can handle smaller amounts of value.

This would be of value to clients with illiquid funds – where the assets they hold are in private capital or infrastructure funds – by allowing them to offload their investments to another investor outside of the dealing cycle, creating more liquidity and more ease of transfer than currently exists in the market.

In conclusion, we strongly believe there is a need for tokenization of shares/ funds in a global solution for the fund distribution value chain, to ensure reduced cost, quality, safety and real time data as well as simplifying operations and introducing efficiencies for clients.