Let’s Automate Away the Middleman
Security tokenization is shaping up to be one of the most disruptive trends in finance. At its core, it is about ‘cutting’ real assets into regulated intelligent securities (‘tokens’) tradable in a pre-programmed way on blockchain. Real estate has been the obvious first use case. A luxury Manhattan condo development located on 436 & 442 E 13th St in the East Village was one of the first major assets to be tokenized on Ethereum. Investment funds will be next.
Tokenization makes just as much sense for alternative investment funds: VCs, private equity and hedge funds. A tokenized fund would be offered to investors as a security that they can resell as soon as a year later (in U.S., for example in acc. with SEC’s Rule 144). And it will be intelligent, so that it will know who & where can trade it, or how it should distribute returns. There are, of course, the obvious practical advantages. A pre-programmed security with rules encoded within, will remove tons of paperwork and the need for middlemen. And being on blockchain, it will be tradable instantly, globally and 24x7x365.
But, there are several other much more significant positive externalities that tokenization can bring to the funds industry. Removing the lock-up would open this space to a much larger audience of investors because they would not have their money ‘locked’ in the fund for many years; they could simply sell their token when they want to. Indeed, the age-old problem of Venture Capital (and the entire alternative investment funds industry, actually) is that the high minimum sign-up cheque and the 7–10 years lock-up restricts the access to invest to only a small group of investors.
Tokenized funds will also be tradable. Liquidity removes the urgency to achieve exits and return money within a certain period of time — investors can simply sell their stake in the fund if they want to. This gives the VC fund a freedom to be transparent about its investments; it also allows it to let its portfolio companies grow at a more natural pace, arguably building sustainable businesses for the long-term, not moonshots with a sacrificed moral core.
Indeed the lack of liquidity in the alternative funds industry in general (not just VCs) is somewhat puzzling because there is a clear need for it. The asymmetry in investment horizons between GPs and LPs, when the fund managers hit the wall of liquidity can lead to bad decisions. The illiquidity, it seems is an inefficiency driven by lack of any proven and easy-to-use methods. The massive growth of the secondary market for alternative funds in recent years (According to Preqin: approx. USD2B in 2002 -rising to approx. USD46B in 2016), a market which was more or less nonexistent a few years back, has been in no small part due to increased confidence in the process thanks to ease and legal clarity with more advisors and secondary market funds focused on this space.
However, perhaps the most profound improvement that tokenization can bring to the funds industry relates to the process of fundraising. For decades, the act of giving money by investor was a project in itself — a paperwork-heavy process with no easy in-and-out. This may have been fine until now when the sector was dominated by large funds closed to anyone but a few super-rich individuals and large institutional investors. This is changing.
The past several years have seen emergence of independent fund managers. This is for several reasons. The instantaneous access to knowledge brought about by internet has erased the information gap between institutions and individuals. It is this proliferation of knowledge that allowed Luca Lin, Christina Qi and Jonathan Wang to start a hedge fund from their dorm room.
There has also been a growth of funds run by influencers — investors that people can identify with and that they like to support. SoGal Ventures, a VC fund started and run by two millennial girls, are a prime example of this trend. And if indeed the bar to enter funds industry has been removed from below, then why should it remain closed top-down. Why couldn’t middle class also invest in a VC?
Well, with tokenization it will be able to do just that. The expectation is that tokenization will change the investing into a one-click process. When a potential investor comes to the website of a tokenized fund, he/she will undergo a number of on-boarding steps, including KYC and AML checks, but also whitelisting in relation to his/her investor status (retail, professional investor).
Tokenization can truly turn the funds industry on its head. It can be revolutionary for independent fund managers. Imagine that the access to alternative funds investment is as simple as lending on a P2P platform.
A number of ‘paperwork-heavy’ functions currently performed by middlemen can be automated away thanks to the use of smart contracts. Documents such as offering memorandum, subscription agreement, investor questionnaire, and other formation documents have to be reviewed multiple times by multiple middlemen. There are several layers of intermediation, when the middlemen have to perform checks, furnish further documents and leave behind additional paper trace. Each stage of intermediation requires reconciliation by a middleman with the previous stage leading to costly overhead, not to mention that each agent holds his/her own ledger of information. The programmability of the security tokens can automate this ‘away’ with the use of smart contracts, and also by sharing the same information on a distributed ledger. To put it simply, ultimately the process will no longer involve an issuer, lawyer, authority, investor, but merely issuer-investor.
The profoundness of the technological advantage that tokenization can bring has not gone unnoticed. Several tokenized funds have emerged, each of which has been domiciled in one of the exotic jurisdictions recognized for their flexible regulation. This was necessary because there was no legal framework to regulate the new technology.
But, since then, the countries that are perhaps most recognized for wealth management — Switzerland, Liechtenstein and Luxembourg — have embraced the new technology and began forming the necessary rules. They are on a path to pass their own versions of a ‘Blockchain act’ that will recognize representation and transfer of securities on blockchain without intermediaries.
Thanks to the progressive, if strict procedures in these countries, it is possible to tokenize a fund and attain legal certainty even now in a regulated manner compliant with the incoming framework. Progress favours first-movers.
For decades, alternative funds have been closed to anyone but a few super-rich individuals and institutional investors. Recent years have seen the emergence of independent fund managers thanks to reduced asymmetry in the access to knowledge at large, and the ability to gain public exposure and win followers through new media. Tokenization is set to further strengthen this trend by reducing the complexity and overhead associated with fundraising and running a fund in an unparalleled way.
bardicredit is a member of the Alternative Investment Management Association (AIMA), a global association of hedge funds, private equity and VC funds with more than $2 trillion under management.