Tokenization makes ETFs disappear

The tokenization of shares, i.e. the issue of a token that digitally represents a share – is in many ways similar to the traditional process of securitization or issuing of securities, for example certificates. The difference between securitization and tokenization lies in the introduction of smart contracts, i.e. programmability. Why tokenization is superior to conventional ETFs is explained by Prof. Dr. Ralf Wandmacher in his guest post.

The new world of asset management could already have started with the introduction of crypto assets and, in particular, with the tokenization of existing assets. The asset management of token assets is still quite small today compared to traditional asset management. However, token asset management can solve fundamental challenges of traditional asset management, for example in the rapidly growing part of passive asset management in the case of ETFs.

ETFs as an intermediary

ETFs are a classic intermediary in the capital market, which in the past made it easier for investors to invest in a basket of stocks, for example.

ETFs replicate the underlying indices on different bases, for example physically by holding the relevant index components, physically optimized by partially holding the relevant index components or by means of a swap. In the case of swaps, the ETFs receive the performance of the relevant index components through an exchange without holding them themselves.

One problem with ETFs is their structure, which leads to tracking errors compared to the benchmark. Attempts are made to reduce these tracking errors by lending securities, whereby not all income from securities lending always goes to the ETF, but rather to the asset management company in charge.

Another problem with a continued sharp increase in the volume of ETFs is that the high volume of ETFs can have an impact on the selection of stocks in the index and possibly impair the control function of the capital market when companies buy on the basis of their index membership but not on the basis of their profitability will. Initial research has shown that the growth in assets managed by ETFs leads to parallelism in stock returns while reducing the response to future stock returns. However, the authors of this study point out with some justification that ETFs have also brought many benefits. More research is needed here.

Another problem is the corporate governance function of passive index investors, which is still unclear in the case of ETFs. The proxy fight in the case of Procter & Gamble in 2017 proved that passive investors interpreted their fiduciary function differently: State Street Global Advisors and BlackRock voted against the management of Procter & Gamble, Vanguard voted in favor.

Transparent decisions and accountability are essential for the healthy development of capital markets. Likewise, the corporate governance function of trust assets must not be neglected.

Token Securities

The purchase of tokens according to the rules of an index can be fully automated and individual, only the signal with the relevant weightings of the index is necessary. An Oracle can transmit this signal and a robo-algorithm can then buy the individual tokens in fractions according to the transmitted weighting.

After buying the DAX, for example, the investor would then have 30 tokens from companies in his wallet, and there would be no tracking error.

The investor can choose to have access to the tokens in a self-managed wallet, in a wallet at a depositary or in a custody wallet at an exchange.

The self-administration of assets, i.e. the administration of the wallet with its private key by the investor, can lead to direct communication between the token asset or the token issuer and the investor’s wallet. The transparency or the identification option of the wallet address enables this communication option. This would have the advantage of direct corporate governance by the token investor with regard to the individual tokens, i.e. as it is today for shareholders. Even with custody solutions, individual wallets for each investor can ensure governance communication directly with the investor and end fiduciary issues.

The direct assignment of the tokens to the respective wallet of the investor would also be helpful for incoming distributions and further income from the tokens (e.g. dividends, staking income, farming income), so that all income is credited to the investor without any deduction by an intermediary.

The developing parallelism of stock returns in passive asset management cannot be solved by tokenizing stocks in passive index investments; instead, it would be possible for active asset managers to become an Oracle. These oracles of active fund managers would select stocks based on their profitability and growth prospects, which robo-algorithms would then buy and sell to investors’ wallets. This would restore the control function of the capital market.

Future of Asset Management

The tokenization of shares can solve several problems of passive asset management and thus trigger a classic disruption of an intermediary. Tokenization in conjunction with wallets will have an impact on many levels, for example ETFs, settlement, active asset management and custody. The scalability of large asset management companies can also be called into question by outsourcing active fund managers and using them as oracles.

About the author

Prof. Dr. Ralf Wandmacher is a member of the scientific advisory board of Boerse Stuttgart Digital Ventures GmbH.