Tokenised ETFs: A glimpse of the future or just hype?

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• Reading duration: 6 minutes

ETFs have proven to be one of the great successes of modern investing: a low-cost, transparent, accessible product that’s transformed the ability of ordinary investors to benefit from the spoils of global growth. That stands in contrast to the other explosive growth story in finance: the crypto space. This technological frontier has acted like a digital Wild West - a world of hype, hope, speculation and even banditry. To outsiders, it can seem like an untamed place where fortunes can be made, and lost just as quickly. Yet, major financial institutions see this emerging digital finance ecosystem as a bubbling laboratory where they can experiment with the potential technologies of the future. That includes products like tokenised ETFs - an attempt to blend traditional investment funds with blockchain technology.

What is a tokenised ETF?

A tokenised ETF is a blockchain-enabled, digital representation of a real-world fund or financial contract. Investors own digital tokens which offer a stake in the profits (or losses) of the underlying asset. In this sense, buying tokens is no different to holding shares in a conventional MSCI World ETF, which provides you with exposure to the performance of the stocks tracked by the index. What’s different is a tokenised ETF exists on a blockchain, is issued and traded on crypto platforms, can offer access to the performance of US ETFs that are unavailable in Europe, and is subject to an entire zoo of risks that may be unfamiliar to mainstream ETF investors. Tokenised products may also benefit in the future from other features associated with DeFi or Web 3.0, although such developments remain largely in the realm of theory and conjecture for now. Counterintuitively, tokenised ETFs do not necessarily track cryptocurrencies like Bitcoin, but are instead an attempt to bridge traditional finance and blockchain. As such, tokenised financial products are highly experimental and aren’t governed by the raft of investor protections that have made UCITS ETFs a go-to for ordinary investors.

How tokenised ETFs work in practice

Two very different approaches are emerging: 1. Regulated tokenised ETFs:

• These are existing funds that issue shares as tokens on a blockchain.
• In this scenario, the tokens denote an investor’s share of an actual ETF. The tokens are traded on crypto platforms, while the ETF also trades on traditional stock exchanges, too.
• Bosera and Hashkey Group have launched tokenised ETFs that work this way in Hong Kong, approved by the local market regulator.

2. Synthetic tokenised ETFs

• Some products offer tokens that mimic the price of a particular ETF using a financial derivative contract.
• In this case, an investor gains exposure to the return of the derivative, not the actual ETF.
• The synthetic route also exposes you to counterparty risk: the chance that the derivative provider is not able to pay the return stipulated in the contract.
• Tokens do not grant investors the ownership rights or voting power that are normally associated with share ownership.
• A real-world example of this type is Robinhood’s Stock Tokens. This synthetic product is intended to mirror the price of various US-domiciled ETFs and stocks.

The distinction between the two categories of tokenised ETF matters. The first is a regulated ETF issued in a new form. The other is an ETF-branded derivative contract.

What are the benefits of tokenised ETFs?

The tokenisation of assets is being taken seriously by major financial institutions like BlackRock, Fidelity, WisdomTree, and J.P. Morgan who are seeking greater efficiency in their multi-trillion-dollar operations. Ordinary investors are not the primary drivers but could benefit from trickle-down effects such as:

• Global accessibility: Investors who can’t access certain products (e.g. US-listed ETFs) may be able to trade tokenised versions through a crypto platform. This matters much more if you live in a country with an unreliable or underdeveloped financial ecosystem than if you’re a European or UK investor able to access sophisticated and well-regulated financial services.
• 24/7 trading and faster settlement: Unlike stock exchanges with limited hours, tokenised ETFs can be traded around the clock if the crypto platform provides that facility. Settlement times can also be reduced to seconds.
• Infrastructure efficiencies: Blockchain technologies may reduce costs in the future by removing intermediaries, automating record-keeping, facilitating transparency, and accelerating processes that reduce friction in the plumbing of the financial system.
• Programmability: Tokenised ETFs could one day integrate with decentralised finance (DeFi) applications, allowing investors to pledge ETF holdings as collateral for a loan, or receive dividends through automated smart contracts.

Other reputed benefits such as fractional shares, low fees, €1 account balances and trades are already available to investors in conventional ETFs in Europe and the UK. Thus, tokenisation doesn’t yet solve a pressing problem for most mainstream investors.

The risks and trade-offs

You’re not alone if you don’t see the above list of potential benefits as particularly compelling right now. Moreover, tokenised ETFs are accompanied by a stack of new risks…

• Investor protections: Synthetic tokenised ETFs do not confer ownership rights of the underlying shares, and investors could find themselves exposed in ways they don’t expect. For example, investments in mainstream ETFs are protected by multiple tiers of investor safeguards - including compensation schemes - that are policed by the UK and European financial regulators. These measures do not apply to synthetic tokenised ETFs.
• Trust issues: A crypto exchange or fintech firm may issue tokens and claim to back them with actual assets. Investors must trust that those assets really exist and are properly safeguarded. At the same time, regulators are still shaping the rules for tokenised securities while innovation is charging ahead. Thus, investors in tokenised products face higher risks than those in plain-vanilla ETFs.
• Liquidity risk: Tokenised ETFs may not have the same trading volume or depth of buyers and sellers as a traditional ETF. That can mean higher spreads and worse trading conditions.
• 24/7 trading introduces new risks: Price gaps and wide bid-offer spreads can open up during extended hours trading. That’s because accurate pricing of underlying assets remains tied to traditional market hours activity. Participants who trade tokens during off-hours therefore run the risk of the on-chain price diverging significantly from the off-chain price while the stock exchange is closed. Thus, a trader can incur meaningful losses when the underlying asset falls sharply upon the market reopening - forcing a rapid and negative realignment in the token price.
• Crypto space risks: The crypto arena can be unforgiving and anything but user-friendly. Idiosyncratic risks include wallet security failures, smart contract bugs, hacking of exchanges, market manipulation, platform mismanagement and collapse, regulatory uncertainty, opaque governance, misleading disclosures, outright fraud and more. The industry’s lack of regulation and rapid pace of change make it both exciting and extremely risky.

Should investors care about tokenised ETFs today?

For now, tokenised ETFs are more of an intriguing industry side bet than a portfolio must-have. They’re a glimpse of how the financial system might look in ten years - faster, more digital, and more interoperable with new platforms. But today’s retail investor is unlikely to gain much by choosing a tokenised ETF. Currently, traditional ETFs remain the gold standard: cheap, simple, regulated, transparent, and easily accessible.