The exploration of the synergies between cryptocurrencies and ETFs dates back to 2017 when the Securities and Exchange Commission (SEC) turned down the first petition to launch a bitcoin spot ETF, kicking off a battle that is yet to be won.
Since then, a plethora of crypto ETPs have emerged that provide access to a wide variety of cryptocurrencies. Now, after years of wrapping crypto into ETFs, the industry is trying a new trend on for size – namely, the tokenisation of ETFs.
Tokenised ETFs are crypto tokens that represent a traditional ETF and are traded on a blockchain. The development of tokenised ETFs has gained traction over the past year.
Several prominent ETF issuers, including WisdomTree and Franklin Templeton, have made forays into tokenisation. Earlier this year, the BlackRock’s iShares Core S&P 500 ETF (CSPX) was tokenised by Backed Finance, a decentralised finance (DeFi) platform. The ETF can now be traded on the ethereum blockchain via decentralised exchanges like Uniswap.
Yet while some industry heavyweights have described this as the next evolution of ETFs with the power to revolutionise the market, others are not so sure. Hector McNeil, co-founder and co-CEO of HANetf, is sceptical that tokenisation will make big waves in the ETF market amid a lack of market depth, counterparty risk and regulatory challenges.
The benefits of tokenisation
Proponents of tokenisation outline a plethora of advantages for crypto tokens over ETFs. Doug Schwenk, CEO of data provider Digital Asset Research, highlighted 24/7 trading, same-day settlement and access to broader global markets as key benefits.
“The ability to trade, settle, and reach investors in the always-on nature of crypto could bring greater liquidity, lower overall expenses, and a broader investor group to these vehicles,” Schwenk added.
ETF tokenisation could also generate cost advantages for the end investor. Unlike ETFs, tokens incur no operating costs and can be traded in fractions. In fact, the only fees associated with crypto tokens are the so-called “gas” fees – the cost of executing a transaction on a blockchain. Depending on the blockchain, these fees could be much lower than a TER on an ETF.
Finally, tokenisation can bring increased transparency to ETFs, with every transaction immutably recorded on the blockchain while also providing the token holder with voting rights – a frequently lamented limitation of passive funds.
Tokenising real assets
Keshava Shastry, global head of capital markets at DWS, said ETFs are just “version one” on the tokenisation journey as the industry seeks to get “the pipework and custody right”. Ironing out these details will pave the way for the tokenisation of real assets, such as US Treasuries, which would “democratise them and make them more retail friendly”.
This could open up access to markets traditionally inaccessible to retail investors including private equity and venture capital or even physical real estate and infrastructure, according to Andrew Prosser, head of investments at InvestEngine.
In fact, this type of innovation is already happening. As Stefan Rust, CEO of independent inflation data aggregator Truflation, said: “We are already seeing commodities moving on-chain, decentralised tokens, and decentralised commodity trading capability. These models are changing the system and enabling direct participation in the pricing of futures instead of going through middlemen to buy and hedge futures associated with commodities and metals.”
Still early days
Despite these potential advantages, the path to tokenisation is not smooth.
“While a number of ‘real world assets’ have been tokenised, it is still early days for this innovation. We do not yet know how the industry will evolve and how tokenisation will develop,” Schwenk said.
Not everyone agrees on the benefits of tokenising ETFs, either. McNeil conceded that tokenisation could be advantageous for illiquid assets, such as property, art, wine, or diamonds. However, he added liquid ETFs are, in essence, “already a token”.
In his view, the only tangible benefit could be the “lightweight regulatory arbitrage”, given the less strict regime governing crypto in some jurisdictions. However, he noted this regulatory grey zone for crypto is unlikely to last long, with policymakers across the globe racing to adopt legislation that brings the $1.1trn digital asset industry under their remit.
Challenges and barriers
Indeed, the uncertain regulatory landscape is one of the main roadblocks on the path to ETF tokenisation. In the US – traditionally a hotbed for ETF innovations – regulators continue to grapple with the complexities of blockchain technology. Notably, the SEC is yet to approve a spot bitcoin ETF, though BlackRock’s recent bid may emerge victorious.
Some providers circumvent this by choosing more supportive jurisdictions for their offerings. For example, in February DeFi platform Swarm, which is regulated by the German Federal Financial Supervisory Authority (BaFin), launched a pair of tokenised bond ETFs. Yet for tokenised ETFs to become mainstream, global regulatory frameworks governing cryptocurrencies must converge enough to allow for cross-border sales.
Prosser added that accessibility and crypto-specific risks could also hamper mainstream adoption.
“If tokenised ETFs are accessed via crypto-related protocols, then this could undermine access and confidence for some investors,” he continued. “The established risks associated with cryptocurrencies may [also] still apply, including the risks of investors losing access to their digital wallet, counterparty risks, liquidity risks, and irreversibility of transactions.”
Meanwhile, McNeil said that despite greater liquidity being touted as one of the greatest advantages of tokenisation, he is yet to see this in practice.
“Central counterparties and market making/liquidity providers are key features of the ETF market, and I do not see that in tokens,” he stressed.
Blazing a trail
Despite these challenges, several providers are dipping their toes into the brave new world of ETF tokens. WisdomTree was among the first to tokenise an ETF back in September 2022, when it made its WisdomTree Short-Term Treasury Digital Fund (WTSY) available on the stellar and ethereum blockchains.
Last December, the firm announced plans to bring nine more “digital funds” onto the blockchain, including the WisdomTree TIPS Digital fund and the WisdomTree S&P 500 Twitter Sentiment Digital fund. Now, WisdomTree is looking to launch an ETF-based crypto wallet to offer investors easy access to these products.
Schwenk also pointed to the Franklin OnChain U.S. Government Money Fund (FOBXX) as one of the most “promising early results”. Launched on the Polygon blockchain in April, the BENJI token represents one share in the fund and is available to investors through the Benji Investments app. Polygon is a Layer 2 scaling solution for the ethereum blockchain which boasts ultra-low transaction fees.
ETF giant State Street Global Advisors (SSGA) has also set its sights on tokenisation. Speaking at ETF Stream’s ETF Ecosystem Unwrapped 2023, Matteo Andreetto, head of SPDR EMEA at SSGA, said the firm will be exploring the tokenisation of ETFs and private assets, describing this innovation as a “game-changing” breakthrough for the industry.
Meanwhile, Yves Renno, head of trading at crypto payments platform Wirex, told ETF Stream that some investment bankers are starting to trade structured investments over-the-counter on the ethereum blockchain.
“Simple tokenised ETF transactions can also be written on the blockchain to offer a cheap alternative to centralised custody: namely, no custody at all,” he added.
Bringing ETFs to crypto
While traditional ETF issuers are seeking ways to incorporate tokenisation into their offerings, crypto-native firms are constructing ETFs on the blockchain – although they tend to call them “index tokens” or “pools”. One example of this is Moonrock, which has launched three products offering exposure to a selection of staked ETH tokens, a basket of NFTs and the US inflation index, respectively.
Joseph Knecht, founder of Moonrock, said his firm aims to “bring the benefits of indexing, including diversification, automated portfolio management and broad sector exposure, to the crypto ecosystem. There is a similar level of excitement and potential here to what the equity movement experienced in the 1970s.”
Rust argued that, in due course, these innovations could replace traditional ETFs: “In DeFi, we have vehicles that are so much more exciting than boring ETFs with their premiums and fees. These pools are not concerned about growing AUM for an asset manager – the people create them for the people and they are entirely decentralised.”
However, Knecht pointed out that such blockchain-based funds are not without their limitations. One of these is the substantial cost of rebalancing due to lower levels of liquidity in the decentralised crypto space compared to equities, which can significantly affect the price.
“In crypto, you have to rethink what you know about rebalancing and accept a rebalancing premium,” he said. “It is not optimal to rebalance on, say, a monthly basis, as it would be for an equity ETF.”
The future of tokenisation
Limitations aside, however, Knecht said he believes the “benefits of blockchain are so profound it will be difficult to put that genie back in the bottle”.
Meanwhile, Schwenk forecasted that tokenisation could disrupt the traditional creation-redemption, distribution, and settlement processes, and “become the standard, to the benefit of the end investor”.
However, experts agree it will take some time before tokenised ETFs and assets can enter the mainstream market. The journey will involve regulatory hurdles, volatility, and growing pains as the industry seeks to integrate this potentially revolutionary technology.
Only time will tell whether tokenisation can become the game-changer that some anticipate. One thing is clear, though – we will likely see fresh attempts before long as incumbents strive to bring a competitive edge to their product offerings.