In a recent "Talking Investment Management" podcast titled, "Tokenization and Stablecoins: What Fund Managers Need to Know," Stradley Ronon partners Jamie Gershkow and Jesse Kanach "explore the fast-evolving world of tokenization and what it means for investors, fund sponsors and financial institutions." They "explore how blockchain is reshaping traditional investment instruments, such as money market funds, and enabling new innovations, such as stablecoins and interest-bearing digital assets." Gershkow tells us, "[In] today's episode, we'll discuss the rise of tokenization, which has gained significant traction in the asset management industry.... Jesse, let's start with the basics. When we say tokenization, can you break down what we mean and why tokenization is gaining momentum?" (Note: Thanks to those who attended our Money Fund Symposium in Boston earlier this week! Attendees and Crane Data Subscribers may access the recordings and MFS Conference Materials here.)
Kanach replies, "Starting way, way back, we've seen the evolution of holding assets physically like the old school treasure chest or the safe or the bank vault. Then over time, evidenced on paper like those embossed stock certificates that were passed around for hundreds of years up through the 1960s on into the computer age. The book entry, electronic books and records that we all looked to online now, and next you'll see blockchain and cryptographic developments often referred to as tokenization, where the evidence of ownership and transfer of your asset through near instantaneous unforgeable, self-verifiable mechanisms with your remaining and change holdings updated right away. So now, tokens are more than just an update of paper or electronic record keeping."
He explains, "One of these assets that's of critical importance to the US and even global markets is the US dollar, specifically either a $1 bill or an instrument that represents a $1 unit. So now it's been over four decades since $1 per share money market mutual funds were developed in the U.S., followed by some hefty regulation for good reason. So now I know I need to turn here to Jamie. You counsel and study money market funds. You're at the forefront of the regulatory developments impacting them, and now we've seen an uptick in interest around tokenized money market funds. What about the way these products are structured ... makes them attractive for tokenization?"
Gershkow replies, "Let's talk first about traditional money market funds. These are funds that invest in high-quality short-term debt instruments and, more specifically, the large majority of U.S. registered money market funds are government money market funds, which allows them to use theoretical cost method evaluation to maintain a stable dollar per share. These funds are popular cash management vehicles for a variety of reasons, including the stability of the $1 price per share while being able to earn some yield on your cash. In the meantime, all within a fund wrapper that is generally considered fairly low risk, tokenized money market funds or tokenized share classes of money market funds take that product and all of those features and benefits and essentially put it in a different file format whereby fund shares and investor ownership in the funds are represented by digital tokens on blockchain networks."
She continues, "Put another way, these are your traditional money market funds that have digitized fund ownership on different blockchain networks. The underlying assets held by the money fund don't differ from traditional money market funds, meaning these aren't the types of funds that are investing in crypto or anything like that. It is just that the digitized fund ownership is on different blockchain networks. So why money market funds for tokenization? I think these give investors a way to access the benefits of money market funds, coupled with the advantages and efficiencies of blockchain technology. They retain the low-risk benefits of a traditional money market fund with some really interesting use cases as cash management vehicles. We've seen different varieties of these products with different features that continue to evolve and innovate. One of these interesting features, for example, is peer-to-peer transfer, which is the ability to transfer fund shares from one shareholder wallet to another shareholder wallet within or between different approved blockchain networks."
Gershkow comments, "So, as an oversimplified example ... I could transfer my money market fund shares to your wallet, processed immediately at any time on any day. Tokenization and the use of blockchain have also allowed for the development of methods to distribute intraday yield based on the period of time each person holds transferred shares during an NAV cycle.... This all comes alongside the more general rise in decentralized finance, including stablecoins, for example. So now that we've discussed money market funds, let's shift over to stablecoins. Many have probably seen that stablecoin legislation is pending in Congress, and some have compared stablecoins to tokenized money market funds. But there are distinct differences."
Kanach says, "A stablecoin is a transferable token that represents a value of $1 or some other number. I'll just talk about $1 for this purpose; they're meant for token transactions or other instant digital transactions, basically, payments of some kind. They can be extremely efficient. And using a $1 coin rather than volatile Bitcoin or Ether, for example, can be reassuring by comparison. Wiring money is a bit like sort of printing an email that you receive and then mailing it back in an envelope. It does a job, but it's a lot less efficient. It doesn't track your records of having sent it. There's less assurance that the transaction has gone through or less immediacy. So that said, the efficiency of the transfer, which is indisputable, must be looked at alongside the question of why is the stablecoin worth a dollar?"
He tells us, "The stablecoin can say it is, a community can agree it is, but something needs to back it. And Jamie, you discussed regulated money market funds, which are backed by specific types of assets. There really is a tried and true methodology to maintaining a $1 price. The regulators and the markets have really tested this through many stress test-type market events. But based on all the lessons learned, it's way more complicated than, for example, just live streaming a shelf full of cash to prove the backing is there. Now, even assuming the stablecoins' $1 value will be respected perpetually, why place your hard-earned assets in a stablecoin?"
Kanach comments, "Every financial institution puts its cash to work ASAP. You hear about sweeping cash into interest-bearing accounts each day or at the end of each day and parking actual idle cash maybe in your pocketbook, your wallet or a cash register. That's about the only time someone would normally want to hold idle cash. And it's not just an interesting practice. There are class action lawsuits in the news as we speak, claiming that money managers didn't sweep their clients' idle cash into high-yielding accounts. So for stablecoins, there's not only the risk of holding the $1 asset, there's even a risk of loss.... So normally it's the oldest rule in finance that a person looks to be compensated for risk."
On new regulations, Kanach says, "Once the legislation and rules take effect, on the one hand, we can expect the role of stablecoins for payments to really surge. But that said, I'll mention that the legislation may be at odds with the newish concept of interest-bearing stablecoins since the permitted activities under the legislation or at least some of the legislation, are very narrowly defined. So keep your eyes open for developments for those. And Jamie, you may have thoughts on interest-bearing stablecoins in general."
Gershkow answers, "So let's dive in and talk about some of these regulatory considerations. One thing I'll note generally when I say money market funds in this discussion is that we've been talking about US money market funds registered under the 1940 Act. However, there are a handful of other liquidity vehicles that have been tokenized that are colloquially referred to as money market funds, but may not necessarily refer to us registered money market funds and are instead private liquidity pools not registered under the '40 Act that are limited to being offered to certain types of institutional qualified investors."
She explains, "A tokenized fund is an SEC-registered mutual fund registered under all of the same rules that exist in the US sold by prospectus. So, these tokenized products go through the regular SEC registration process that your more traditional mutual funds or money market funds would go through. But of course, there are special considerations to think through here. For example, does the issuance of tokens result in the issuance of separate securities? What happens if there's an outage on a blockchain that could impact the fund and its ability to meet redemptions? Are there any novel features of the funds that may require no-action relief or exemptive relief from the SEC? Are there different or enhanced KYC or ... procedures that are appropriate? These are some of the things that we’ve been thinking through as these products come to market."
Kanach adds, "That's an interesting transition to how these registered funds, SEC registered 1940 Act funds, operate as exchange-traded funds, or ETFs, in a normal stablecoin. Maintaining a $1 price could be tough. But if there was an ETF that that intended to maintain a stable price, there is a by now longstanding mechanism for arbitraging through creation and redemption of the ETF shares with authorized participants that are generally large investment banks, dealers and other large institutional parties, that really maintain, for many ETFs, the net asset value and for these funds could maintain a $1 stable value. `The funds that don't operate in the US as full-fledged ETFs may have additional challenges in maintaining the $1 price. Stablecoins that really seek to operate as non-funds and as non-issuers of securities also have additional issues to consider."
Finally, Gershkow comments, "I know broadly speaking, I think this is only picking up more momentum, and we're seeing the world of traditional finance and decentralized finance converge. And I think we're gonna continue to see increased tokenization of real-world assets, generally not just money market funds, but further democratizing access to these assets, more broadly speaking."
