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Asset Fractionalisation — What, Why, and the Future was originally published in R3 Publication on Medium by Antony Lewis.
Digital assets and tokenisation: How relevant is fractionalisation and what are the benefits?
It’s the concept of splitting up ownership of something so that many people can receive benefits from it in a proportion to the amount they own. It’s a traditional concept which already exists today, as we discuss later. But why do people increasingly associate fractionalisation with digital assets recorded as tokens on blockchains, and what opportunities are being created?
When applied to financial securities, fractionalisation has been around for hundreds of years — when you buy a share of a company, you are buying a fraction of ownership of it. For many shares, the price of one unit is investible by an average retail investor, costing maybe only a few dollars. So ownership (and control) of a company can be, and often is, fractionalised. It’s worth remembering that even one share usually offers voting rights at company AGMs and most shares will pay a dividend based on company performance.
Another example of fractionalisation today is a Real Estate Investment Trust (REIT). Although the specifics differ around the world, typically a REIT is a fund or company that owns, operates, and manages real estate assets (buildings for residential, commercial or industrial use), and shares of that company are listed on a public exchange, bought by a mix of institutional and retail investors. Owning a REIT lets you participate in the income generated from the pool of properties as REITS are required to distribute at least 90 percent of their taxable income to shareholders annually in the form of dividends. Investors may also benefit in the potential upside from the buying & selling of portfolio assets. Yet a REIT is little more than a share of a specialised company, and owning a share of a REIT doesn’t give you legal ownership of a specific floor of a building or piece of land, but it does give you a share of the income generated by the assets.
Exchange Traded Funds (ETFs) also use a fractionalisation concept. A fund is created which owns some underlying assets, and shares of that the fund are listed on a public exchange, and multiple parties can own fractions of that fund. ETFs have been very successful and today manage over USD 5 trillion in assets offering investors exposure to mainstream indices and a whole range of thematic and specialised assets across equities, bonds, commodities and currencies.
Mutual funds operate on a similar basis — investors pool money into a fund, and the money is used to buy assets. Investors own a fraction on the fund.
REITs, ETFs, and mutual funds can be further fractionalised, just as any other stock can be, if the fund does a stock split where existing investors are each given more shares in some ratio (eg 2 new shares for 1 old share), and the share price immediately reduces to compensate (in this case dropping by 50% per share).
So we can already fractionalise. The way we do this, at a high level, is to create a vehicle — a company or other similar legal entity, have the vehicle own some assets, and have shares of the vehicle sold to investors — voila, fractionalisation.
So what’s new with tokens recorded on blockchains? Are having shares represented as tokens any better? Do they allow smaller fractions of assets to be created and traded? And would that matter? What about cost? Can we fractionalise more cheaply? What impact would that have? Could they provide exposure to new assets? And could value mean something different, maybe more than just a financial return?
Well, fractionalisation is just part of the story. It’s not just about fractionalisation in itself — we can already do that. It’s about reimagining the whole end-to-end process of finding and matching investors with investment opportunities, and the subsequent secondary market opportunities once an investment has been made. There are potentially new opportunities on both the supply and demand side.
The impact won’t be seen in the public markets — they are already fairly efficient and high-tech. It will be seen in the private markets which are manual, slow, opaque, and with high overheads.
The process of matching capital to investment opportunities involves a number of steps from finding and qualifying investors, finding and qualifying investment opportunities, through the initial capital allocation to the opportunities, to secondary trading of the assets, and the management of the assets which may have events associated with them throughout their lifecycle.
It’s not just a blockchain story: today, new and better technologies are being applied to the entire end-to-end investment process. For instance, new platforms with automated tools are making it easier to identify investors and qualify them as eligible, based on jurisdictional regulatory requirements. They combine technologies such as OCR (optical character recognition) or computer vision for data entry, with machine learning algorithms that can tell apart real documents from fakes (all part of the growing intelligent automation line-up). ID selfies taken with smartphones and sent over the internet are replacing physical “meet and greet” identity checks, and electronic signatures on pdf files are replacing wet-ink-on-dead-wood sent via courier. These processes are being built with regulatory compliance in mind, as opposed to added as separate steps.
The assets themselves are being created more cheaply, with standardised templates and contracts. Some are being recorded as tokens on blockchains, with smart contracts defining them, and determining what can and can’t happen to them. Automatic regulatory reporting is being built in instead of being expensively tacked on. Lifecycle events are becoming more automated and streamlined. This cheapens and reduces risks in processes and events that would otherwise be found in the small print of pdf files and managed in systems outside of the asset. (The pdf files are still important, but the parameters and key dates and events are becoming part of the definition or smart contract of the digital asset itself, which means that computers can act on them.)
In short, the entire cost structure of the end-to-end investment process is being driven lower by technology and it’s becoming more efficient. For the assets themselves, pdf files are being replaced by digital records containing structured data, which define what they are and how they are allowed to change. Tokens can be held in wallets on smartphones and sent frictionlessly to other investors, and traded on exchanges. This is a huge improvement to private markets today where assets exist as pdf files, which are complicated to split and re-sell.
For instance, a $50m loan to fund the building of some real estate might exist in the private markets as a series of bilateral pdf files between the issuer (borrower) and a small number of investors (lenders). Each bilateral contract has a cost in terms of time and administrative overhead for the issuer. Each investor holds a pdf file for say 6 months to two years until they get their money back.
These pdf files are hard to “re-sell” in whole or in part to a new investor because: either the new investor needs to trust the existing investor to pass on the return of capital (and trust that they haven’t already sold this asset to another investor); or the pdf files held by the original investor and the issuer need to be “re-papered” and replaced by new ones with the new investor’s name on it. If an investor needs to sell such an asset, no liquid secondary market exists so they will typically take big financial “haircut” if they need to sell in a hurry — and then only if they can find a buyer.
So, perhaps you can fractionalise a pdf file but it is complicated and troublesome for the investors and the issuer. The user experience is terrible.
Tokens, on the other hand, live on systems that are built to record the existence of assets, and guarantee that they can’t be spent twice, and guarantee that they can only change in accordance with their governing smart contract. Bitcoin has shown us the way, with wallets that can contain fungible tokens that have been issued, split up (fractionalised), and re-combined in a simple way that can be extended to other assets. This is a much better experience for both investors and issuers and offers a choice for investors to self-custody their assets or delegate this responsibility to professional custodians.
When costs are reduced and when the user experience improves, more investment opportunities can be created and more investors can participate. When more investors participate, financing becomes cheaper and easier, and capital can be deployed to where it is more productive, increasing opportunities for both investors and projects requiring capital. We already see live examples of fractionalised building loans, art and private companies. Classic cars, fine wine and many more are being discussed. These potentially offer access to new investable asset classes.
To date, most digital assets exist as an equivalent to traditional securities, but it doesn’t need to be this way. Coupons and dividends are traditionally paid quarterly or semi-annually but with automated systems and straight through processing of payments it is feasible that a digital asset can pay a daily or even hourly yield. With the rise in environmental, social & governance (collectively, ESG) screened assets, investors are now challenging the notion that value is simply a financial return. You can imagine an asset producing a combination of financial yield and environmental impact, for example a 2% yield and 10 trees planted a year. You could also imagine a yield and experience combination for investors (maybe an hour in classic car for every 3 months you hold a token). The potential is huge and very interesting. It challenges our concept of ownership: As a shareholder of Amazon, why don’t you get a discount at the store that you own a fraction of?
So fractionalisation in itself isn’t a particularly interesting driver of change. But it is just one small part of the bigger picture of the tokenisation of private market assets. REITs & ETFs have shown us the way for public markets, now there are ways of cheapening the process and making the investor and issuer experience richer and better in the private markets. Once the processes become standardised and generally accepted, tokenised assets with their respective smart contracts offer the potential to open up a whole new world of opportunities.
Please note that these opinions, whilst aligned with those of R3, represent my personal thinking on this topic. For more on what R3 is doing with digital assets on Corda, please visit https://www.r3.com/customers/digital-assets/
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December 18, 2019
December 18, 2019
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