Blockchain, digital assets and tokenization will provide new alternative investment opportunities, decentralized investment vehicles and provide greater transparency for investors and asset managers alike.

This article will focus on how the application of blockchain and NFTs will disrupt the asset management sector.

Article Outline:

• Industry Background
• Industry Challenges & Blockchain/NFT Solutions
• Real World Case Studies
• Risk Considerations
• Closing Remarks

Industry Background

According to Boston Consulting Group (“BCG”) the total global assets under management (“AUM”) are in excess of $100 trillion USD. Retail portfolios represent 41% of global assets at $42 trillion, while institutional investments are estimated to be worth $61 trillion, or 59% of the global market share.

According to Statista, AUM has grown by more than 400% since 2001, with double digit growth in the past year alone.

There has been persistent investor demand over the years, illustrated through continued net inflows, driven by increasing compound annual growth rates in assets from 6-11% over the past few decades:

Most assets are being managed in North America, with 49.5% of the market share:

The top 10 firms have $44 trillion USD of AUM, with BlackRock being the largest global manager. Seven out of the top 10 firms are based in the USA which is consistent with what we are seeing with the percentage of AUM managed in North America.

Typical services include establishing client risk appetite, developing an appropriate mix of investments and providing investment advice. The goal of asset management is to maximize the value of an investment portfolio over time, while maintaining an acceptable level of risk. Risk appetite and tolerance guides the types of investments a client is willing place funds in. Refer to the OriginsNFT portfolio allocation article for more information on this.

Management fees are typically charged as a percentage of AUM. Hedge funds also charge circa 20% on performance of the fund. This is known as 2 and 20 compensation structure, or a 20% carry fee. On average a fee of 1% is charged for management of a portfolio of around $1 million. This fee percentage typically reduces, on a sliding scale, as assets under management increase. There is a balance between an asset manager charging too much (thus deterring clients) and not charging enough to cover their costs. Technological advancements, such as blockchain, can help drive these costs down and aid managers to charge more competitive rates.

Investment custodians are appointed to safeguard a client property and accounts. This type of service typically falls under the asset management umbrella. The largest custodian is BNY Mellon who custodies $24 trillion of assets. In fact the top 10 custodians have more than $100 trillion assets under custody (“AUC”):

Quality data enables stronger performance within the asset management industry. Easily verifiable data enables a more reliable decision making process and cuts unnecessary costs from being incurred in the data integrity process.

The following looks at potential blockchain and NFT solutions that can support the wider asset management sector.

Industry Challenges & Blockchain/NFT Solutions

1/Digitizing Illiquid Assets

NFTs can be best used to digitize illiquid investment assets. The current transfer of ownership for these assets can be lengthy and inefficient, hence open to optimization.

Certificates of Deposit (“CD”) tend to have long maturity dates and hence attract a liquidity premium to compensate investors for locking up their funds for a longer period of time. A greater interest rate would be aligned with a longer term to maturity. The appropriate rate can be calculated based on yield curves derived from market interest rates as a basis for calculating their value. Attributing the CD as an NFT can then allow more active trading on a secondary market with transparency of all previous trades and the ability to verify its authenticity more easily than current processes.

Equities that trade over the counter (“OTC”) tend to be less liquid. This could be for companies that are not listed on an exchange. A private company could be launched as an NFT collection with the shares being attributable to a certain tier of NFTs. There could be preferred stock that are digitized as ‘Tier A’ NFT and common stock included as ‘Tier B’ NFTs within the collection. The meta data could then be updated to reflect the certain variables within the company. The properties of the NFT could define the specific details or rights backing each of the shares of the private company. Digitizing this type of asset will enable an immutable and transparent record of the past transactions which will better facilitate fair value for the stock.

We have already touched on real estate assets/investments and fractional ownership within a separate Origins article.

2/Opaque Funds

Verification of the underlying assets within a Fund of Fund (“FOF”) can be difficult. Typically fund reports are released quarterly and contain a breakdown of assets within a fund. These funds indirectly own portions of each of the underlying assets, but the assets can be transacted in between published reports, resulting in a lag in information or lack of transparency at a point in time.

Recording these funds as NFTs will allow for better transparency. The meta data can be updated for underlying transactions and so “NFTs of NFTs” can then replace FOF. The funds that invest in other funds can then see their underlying asset holdings on chain, in real time, or whenever the meta data is refreshed. This will have the added benefit of reducing the impact on other parties that rely on this information, such as auditors or regulators, therefore reducing compliance costs.

3/Operational Risk Management

Assembling, managing and collating investment data to support daily operations can carry a high level of risk when parts of the processes are manual. Human error can creep in, causing “fat fingered” mistakes that can impact decisions. As these companies acquire new firms, and incumbent asset management systems, integration of data can become less fluid and more cumbersome. Continual system upgrades and data migrations are required to ensure the completeness and accuracy of the data.

Blockchain offers an automated solution to recording transactions on chain. Client funds could eventually be converted to cryptocurrency and transactions eventually made using cryptocurrencies (Stablecoins) to buy and sell equity investments. The infrastructure is not established, but this is the direction the industry is heading and potentially sooner than we think.

Asset Managers currently take feeds direct from custodians but most will just maintain their own Investment Book of Record with the transactions entered into their Portfolio Management System (PMS) and maybe reconcile that daily to their custodians / counter parties. Blockchain’s automation and immutability reduces the risk of human error as client funds are recorded simultaneously when the payment is made. [This also helps to reduce the current settlement lag for both equities and FX, which can take up to two days.

4/Quality of Data and Data Integration

The quality of asset data can be suboptimal, especially as companies scale. Historical reconciliation differences or several data repositories cause disparities between systems. The reconciliation process can take a significant amount of time to reduce the differences to a reasonable level. A challenge is how the buy-side grapples with the need to consolidate, analyze and report on significant amounts of data.

Blockchain tech provides an immutable record of data, stored permanently on chain for all permissioned parties to view. This provides a single source of truth that can be used as a reliable data input into the decision making process. The automated nature means manual reconciliation processes may not be required as part of many existing processes. Investment managers and custodians can record all their assets on chain and digitize the transactions between parties, enhancing the reliability of the records.

5/Regulatory Reporting

Regulators require frequent reporting on corporate metrics for use in benchmarking industry performance and driving legislative change or government policy. This process can be resource intensive for businesses to comply with, particularly as the regulatory landscape has become more complex and requirements have become more comprehensive.

A permissioned blockchain can offer a transparent verified single source of truth for multiple parties within an ecosystem. Regulators and Auditors could have access to the same permissioned blockchain which would enable them to access real time data, rather than at a point in time. This would then allow regulators to access the information whenever required, therefore reducing the burden on companies to compile the current reports.

This would also enable issues to be identified and discussed directly with the regulator earlier, therefore fostering goodwill between the parties and preventing issues from being concealed. Auditors and regulators can perform analytical procedures on the verified data to identify anomalies and perform timely investigations into unusual activity. Historically there have been scandals with large adverse financial impacts that could have been prevented had the appropriate people been notified at an earlier stage. This tech can provide the transparency required to ensure these events do not repeat.

6/Compliance Systems

Robust compliance systems for breach and incident reporting is at the forefront of financial institutions. Significant breaches can result in serious penalties and fines for non-compliance with regulations as such accurate and reliable data is imperative.

Blockchain can offer a single source of truth and immutable data on compliance incidents. It helps those reviewing the breaches to ensure they are remediated in an appropriate and timely manner. Some centralized systems can be manually edited to make it seem like the problem has been addressed, only to resurface down the line. There are some audit trails built into existing desktop systems (Such as Thinkfolio, Charles River, BBG AIM) that prevent edits from going unnoticed, but having an immutable system would prevent this altogether. It ensures the incident/breach is actioned rather than “kicking the can down the road”.

7/ESG Agenda and Sustainability Ethos

Environmental, Social and Governance (“ESG”) agenda is a sustainable initiative that is front of mind for large corporations. There are now mandatory reporting requirements that need to be complied with to enable a more holistic view of the public company.

While digital assets such as Bitcoin have received bad press for their environmental impacts, there are other blockchain consensus mechanisms that are significantly more environmentally friendly. There are also sustainable initiatives that are enabled through blockchain tech, such as carbon credits traded as NFTs.

We covered carbon credits as part of the Origins insurance article.

8/Board Governance

Having a balanced board of directors has been a historical challenge in enabling an objective and informed decision making process. Governance frameworks have sought after diversity in ethnicity, gender and skill set to facilitate this. Humans are inherently biased, but on average if a decision is made by a large diverse group, then has the tendency to be more objective and informed.

Blockchain facilitates a decentralized governance model. Tokens can be distributed amongst an organization, with which voting rights can be attached. This can be in line with the current size of typical boards but has the benefit of being recorded immutably on chain. Alternatively a wider distribution of tokens could be made, thus enabling a more diverse voting system. Failing this a quasi mix of the two systems could be performed to understand decisions from those nominated to govern in the best interests of the clients and shareholders, or the shareholders themselves. A blend of the two systems could enable a better outcome.

Asset managers tend to vote by proxy on behalf of their clients.  Blackrock  have significant voting power for this reason. For instance their ETFs (e.g. iShares) contain mainly retail clients who do not get to vote. Tokenizing the governance process can offer a solution where these retail investors are able to be more active.

9/Changing Investor Preference and Evolving Customer Experiences

As new alternative investments enter the investable sphere, clients want exposure. Recently digital assets have hit mainstream adoption with several Bitcoin and Ethereum ETFs already being approved around the globe.

The learning curve is steep and requires a lot of infrastructure before many larger asset managers are able to adopt the wide range of digital assets. But as some funds offer digital assets as an alternative to traditional investments, it leads clients to move their funds away from incumbent managers in search of exposure.

Real World Case Studies

1/VanEck (NFT Collection)

Asset manager VanEck is launching an NFT collection aiming to create a community for crypto investors. The company has also launched several digital asset funds given the demand from investors for the new asset class.

In fact there are now several crypto ETFs. The following is a snapshot as at November 2021:

2/Dubai Land Department

Dubai Land Department deploys Blockchain based digital rental contracts. This is one of the earlier real world applications of real estate asset management. We have covered some additional real estate applications of blockchain and NFTs within another Origins article.

3/Magpie

Magpie (a fintech company) has been beta-testing a software-as-a-service (“SaaS”) platform that allows advisors to view the crypto and NFT assets of their clients and track and monitor their performance.

Similarly there will be a surge in NFT management tools as the sector matures. Origins will be launching its NFT trading terminal within the next few months which will act in a similar capacity to Bloomberg’s equities market terminal.

Risk Considerations

• There may be some complexities around how to account for NFTs that are used to represent shares of a private company. Currently, NFTs are seen as digital/intangible assets and are subject to impairment. However, most equities are recorded at fair value through profit and loss. If this method of issuing stock is used, then consultation with regulatory/accounting bodies would be required to provide clarity over the correct treatment, potentially using substance over form as a means of resolving the issue.
• The process for recording the data on chain will need to be robust. There is a risk of inaccurate records being input onto the blockchain. Once entered they cannot be altered so a transaction may need to be reversed - a “gas cost” would be incurred to do so. Typically this would be done by attributing an NFT to a real world asset (equities, real estate, bond) thus digitizing it and allowing it to be transacted on chain.
• There are limitations around the effectiveness and timeliness of Board decisions using DAOs. The governance process tends to be more lengthy than appointing skilled representatives, although as their use is tested an optimal mix of both and size can be refined.
• There are new risks associated with the tech, for example smart contract failure, that did not exist previously. Having an understanding on what this is and implementing appropriate insurance cover can help mitigate this. We touched on NFT insurance in another OriginsNFT article.
• Education on tech would be required given the lack of knowledge of this new industry. Hopefully in time the transition from Web2.0/Web3.0 will be seamless with familiar user interfaces so limited understanding will be required for end users. However, before this transition takes place, users would need to have a basic understanding of how to navigate typical crypto applications.
• There are also regulatory problems with viewing NFT's as a security (investment contract). The key benchmark for whether an NFT is (or is not) a security is the Howey test. Many NFT collections that have a fungible token attached may fail this test give the ability to earn a profit, with many claiming they are purely utility tokens. The Bitcoin network has managed to pass as not being a security for the time being, but many other more centralized protocols may struggle to follow the same path.
• There is a general lack of a legal framework in place for these digital assets and hence will take time for this to become established. Although progress being made in the courts with High Courts recently permitting service by NFT as a legal first.
• The adverse macro economic conditions will likely cut asset manager tech budgets, so innovation may be put on hold while strategies focus on the short term profit focused outcomes. This is likely to be the core services offered for larger key accounts. Those infrastructure investments with longer lead times may not be viable until market conditions shift to being more favorable.
• Competitive advantage needs to be considered with regards to data being on the blockchain shared with other entities within the supply chain. Establishing a means of harnessing this new verified data to inform those in positions of authority will also be required to maximize its use. Striking a balance between transparency and limiting loss of competitive advantage is key.

Closing Remarks

The asset management industry is evolving with crypto expanding the scope of available alternative investments. These exotic alternatives have caught the attention of clients, creating a demand for a new asset class. But the underlying blockchain tech also provides several operational solutions for managers to enhance their services to clients.

While some blockchain solutions are being realized, NFTs are yet to be considered fully. The infrastructure is taking time to implement. Regulation is slow to act, but with the current rate of adoption it will only be a matter of time before assets are digitized and managed fully on chain.

At OriginsNFT we leverage data-driven decision making, educational resources, and proprietary analytics to remain ahead of the curve with respect to blockchain tech and specifically NFTs. To find out more, please visit our website or Twitter.

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