Tokenization Tumult: Navigating the Quirky Crossroads of Finance and Blockchain

Fund Tokenization: Where Blockchain Innovation Meets Traditional Finance, Charting a Course Through Uncharted Waters

The Tattle bot posted a message to my Discord server yesterday, which made me think: oh no, not again! It said: “BlackRock’s tokenised fund ‘brings legitimacy’ to public blockchains: Bernstein.” Legitimacy! The quality of being legal or acceptable. I suppose a big ‘thank you’ is in order to BlackRock for bestowing that gift and to Bernstein for singing praises. Or maybe not.

So what happened exactly? The news portal ‘The Block’ reported about BlackRock’s plans to tokenise a money market fund and this article references a client briefing from Bernstein Research (which I don’t have access to). This research firm prides itself on its ‘ability to cut through complexity with independent clarity’. Oh yeah! It does have a ring to it. So here is what such independent clarity can deliver:

• “BlackRock’s choice to use the public Ethereum blockchain instead of private chains, like JPMorgan’s Onyx, broadens interoperability and programmability...

But since Franklin Templeton already paved the road here, BlackRock’s move could encourage more to follow, we learn, and this would mean more institutions and investors would enjoy the benefit of less friction.

• “This would act as the first major test case for institutional holders to experience 24/7 instant settlement benefits of the blockchain with increased transparency and improved capital efficiency, at reduced operating costs,”

And they give an example:

• ‘For an institutional holder using liquid funds as margin/collateral, there are significant benefits to counterparties with increased transparency and capital efficiency from instant settlement.”

So as Bernstein lauds this pioneering stride towards frictionless finance, one can't help but wonder: are these conclusions an example of independent clarity, or are they as clear as mud?

And do people who write such things know anything about how money market funds operate, generally speaking, or the specific funds they talk about more specifically? Ok, my spell check bot is warning me about compromising my professional tone. Yeah, yeah, yeah! So, let’s look at the facts.

Franklin’s Tokenized Fund

When Franklin announced its use of Polygon in addition to Stellar, they had a press release with two noteworthy quotes: "It’s amazing to have a legacy institution like Franklin Templeton bringing transparency, interoperability, and secure, democratized access to their financial instruments, all things afforded with Polygon," said Colin Butler, Global Head of Institutional Capital at Polygon Labs.

And we read, “Extending the reach of the Franklin OnChain U.S. Government Money Fund to Polygon enables the Fund to be further compatible with the rest of the digital ecosystem, specifically through an Ethereum-based blockchain. This furthers our distribution reach through a Layer 2 (L2) blockchain […]” Keep that in mind.

Transparency and secure access:

So, what does such a tokenized fund look like? “The Fund’s transfer agent [TA] maintains the official record of share ownership via a proprietary blockchain-integrated system that utilizes features of traditional book-entry form and one or more public blockchain networks.” And this ensures that the TA “maintains controls to correct errors or unauthorized transactions on any blockchain utilized by its proprietary blockchain-integrated system.” And they say they would simply add a new instruction to the next block.

The fund’s investments are not recorded on the blockchain. What is recorded is the fund's transaction history without the identities of the investors. Why anyone would care to know how many fund units are exchanged or redeemed on a daily basis instead of what is actually in the fund is somewhat beyond me.

“Investors may not hold their shares in a wallet created by a third-party wallet provider, and the private key associated with an investor’s wallet will be held by the Fund’s transfer agent, subject to controls that are intended to reduce the likelihood of erroneous or impermissible transactions involving Fund shares.”

Interoperability and democratisation:

Retail investors can buy the fund only via a phone app, and an institutional one can also use a web portal, and this is the only way funds can be bought or redeemed. Only via their proprietary apps and only from and to Franklin. And unsurprisingly, access is only given after completing an onboarding process in “accordance with its anti-money laundering and know-your-customer policies and Procedures.”

So, what has this achieved so far? The fund strikes daily NAV, and investments or redemptions are thus processed - like for any other money market fund - daily at such price. You can submit your order request as instantaneously as you want; it does not make any difference to the investment whatsoever.

• There is additional system infrastructure.

• There are additional fees in the form of validation fees paid for by the fund.

• No peer-to-peer transaction.

• Proprietary access portal (if that’s the future, we will have an awful lot of apps on our phones) with a right to “modify, suspend, or terminate privileges via the App or Institutional Web Portal at any time.”

Net net? User experience - same or slightly negative? Costs presumably increase for the fund to pay for the additional infrastructure (assuming such costs get allocated straight away). And in some cases, the cost for investors significantly increases if they were to opt for one of the tokenized versions.

Archax Tokenising Abrdn funds

Take Archax for example; this half-dinosaur half-bird, which lived 150 million years ago in Germany until it became extinct and now resides as a digital asset company next door to one of my favourite hangout spots, the Ned, they have done something similar. They've tokenized an Abrdn fund, although not really because what they have is not a blockchain but an example of Directed Acyclic Graphs (DAG). And I know Archax will say ‘it has all the benefits of blockchain only better’ but that is not true; it defeats the purpose of tokenization, but I will leave it at that for now. So, let's say for argument's sake we call what they have done tokenization, what good does it do? Daily investment at the fund's cut-off time, so no change. The technical possibility of sending your stablecoin at midnight makes no difference other than giving an investor the opportunity to add a few more hours of uncollateralised exposure to their provider. And the website gives a few examples:

• Management fee: 0.20% or less

• Archax access fee: 0.20%

And an investor would now pay an extra 0.20% for the benefit of ‘?’. Yeah, I don’t know why anybody would do that. Actually, I do know!

Fireblocks kindly allowed me to attend one of their events last night, and there were discussions that in many cases these challenges are recognised, but it's a question of starting somewhere and building experience. So that I can fully subscribe to. But it's not yet a product that can be commercially successful without significant upgrades, and the ability to upgrade is perhaps a bit ‘unclear.’

And there are some market structural issues here to consider; hence why this ongoing hype around money market fund tokenization is getting annoying. The fund needs to be invested, and these investments can only be made when other counterparties are around to buy from. Running the TA records on chain has very limited potential to create efficiency benefits. Changing this dynamic would require that either the underlying investment markets are fully tokenized and operate 24/7, or somebody steps in and assumes the risks of building up an inventory of low-return assets so that your middle-of-the-night order could be settled immediately, they do that free of charge of course. And even if that could be achieved, it doesn’t change the fact that your interest entitlement would not begin from midnight but still run daily. Money market funds don’t have secondary markets; they are typically bought and sold against the fund. Tokenizing the TA’s books doesn’t enhance efficiency, liquidity, etc. I hope Bernstein reads this!

By the way, I am not saying Templeton made a bad choice. First of all, it's no different at Wisdom Tree or Archax/Abrdn here in the UK. Well, just because others say so doesn’t make it a good decision, but these constraints are a function of what the product is, and the fact is there is nothing in the toolkit of blockchain to fix it.

So therefore, to the Allied Guild of Independent Clarity (aka Bernstein), why don’t you do some fact-checking before you write this stuff?

Technical Definitions Need to Get Better

One more thing: it would be unfair, I think, not to share some advice with Franklin as well, in fact, I fear I may get complaints from them for leaving them out. So here we go. Can you do some fact-checking please on your blockchain-related info? This all reads a bit: meh!

Is Polygon a Layer 2 (L2) blockchain? No, it’s not, but it's on a pathway to get there. Does it matter? Oh yes, a lot, because it impacts how consensus is achieved and thus the safety of assets. So, I thought surely they must know the difference between a sidechain and an L2.

But then I read this in their documentation: “Arbitrum’s optimistic rollups are settled on a proprietary sidechain. A sidechain is a blockchain that is connected to a main chain; in this case, Ethereum.” But this is a bit muddled. The transactions in question do not settle on a "proprietary sidechain." Arbitrum utilizes optimistic rollups to handle transactions off the main Ethereum chain (layer 1) and then settles the transaction data on Ethereum.

At a time when regulated firms are contemplating how to facilitate access to digital assets for their clients, correct and unambiguous information is vital.

What would you say would happen if there was ever a problem and an investor would say:

"I was expecting the safety of an L2 but instead, I am getting sidechain risk."

Who is to blame? Good question. And what’s the answer?