Series 7 Episode 8: Tokenisation: redefining the future of funds and financial markets

Transcript

Laura Talvitie: Welcome to Risk & Regulation Rundown, the podcast where we share our views on financial services, risk and regulatory hot topics. I'm Laura Talvitie, guest-hosting today's episode. I focus on digital assets of risk and regulation here at PwC. The topic today is tokenisation and we'll be talking about the FCA's recently published consultation on fund tokenisation, which builds on the blueprint and road map developed by the Investment Association and a group of industry leaders. I'm joined by Jonny Fry, a CEO of Team Blockchain and Digital Bytes, and Daniel Dzenkowski who leads PwC's work on the Cryptoasset Reporting Framework, or CARF. We'll talk about the impact of the consultation and how tokenisation could reshape financial services over the next few years. Jonny and Dan, welcome to the podcast.

Jonny Fry: Thank you for having me.

Daniel Dzenkowski: Thanks Laura, nice to be here.

Laura: Okay, let's get into it. The FCA recently put out a consultation on tokenised funds and looking how blockchain could be used to record and manage fund units. The idea is to let funds use blockchain for core tasks, like keeping digital registers, or running hybrid models which combine on and off chain records. The paper also looks ahead to what could come next, it explores future tokenised models including asset tokenisation where the investments themselves, such as bonds or real estate, could be issued or traded as tokens. Let's start with the basics. Why is the FCA looking into this now, Daniel if you go first?

Daniel: From my perspective Laura, they're acting now because the balance has finally tipped. The technology is proven, the industry is ready and the UK really can't sit and watch from the sidelines, especially as we think about things like the growth agenda.

Jonny: I think the other thing Laura is, you look at the UK market from the global perspective, it's the second biggest centre for funds under management, about £11 trillion sterling. It's the biggest of foreign exchange, we've got about a 40% market share, twice the number of dollars are traded out of London than are traded out of New York. And there's a growing understanding that the geographic advantage that we used to have by sitting between Asia and Americas, is becoming less and less relevant when you're dealing with assets that are trading 24 hours a day, seven days a week. If we don't do something we will lose potentially thousands of jobs and actually have negative growth. Which is juxtaposed to exactly what the government are trying to achieve.

Laura: Well indeed. Building up on that, the UK is often seen moving a bit behind other hubs in regulated digital assets and crypto. And how that is impacting the government's growth and competitiveness agenda. As you said, we're one of the world's biggest centres for asset management. How do you think these proposals will actually position the UK globally?

Jonny: Well, the trouble is, is the UK has taken a much more cautious stance than a number of other jurisdictions. We've seen a lot of noise and bluster coming out of the USA, so no surprise there with our cousins across the pond with the GENIUS Act being passed and now the CLARITY Act which is hoped to get through. Meanwhile in Europe, we've got MiCA, which is basically trying to give some regulatory guidance and structure as to what people can do. Whereas the UK have taken a very cautious approach, I think less than 12% of companies applying for registration or regulation in the UK have actually been successful. And there has still been a tremendous confusion, when you talk about digital assets, people immediately say, 'Oh, you're talking about Bitcoin.' Whereas, the crypto sector, we've discussed this many times Laura, it's about a $4 trillion market, which I know is a big number, but it's tiny compared to the $2.2 quadrillion of equities, bonds, funds, commodities and derivatives. And that's where the UK really can play, leveraging on the fact that English common law is used so extensively in many jurisdictions, not just here in the UK. And the UK is often seen as an arbiter for international arbitration cases like that. We need proper regulatory guidance which will foster innovation and put the UK, arguably, at the front of innovation, as opposed to, at the moment, we're seeing lots of companies, and I know you've been involved in some of these companies going to other jurisdictions. Whether it be Singapore, whether it be the UAE, and we have to stop that, because otherwise we're seeing an, in effect, a brain drain in this sector going overseas.

Daniel: Totally agree, Jonny. I look at this from the perspective, it's a statement of intent. The UK wants to lead in this space and it needs to do more and if I look at what's happening in the tech space, the Cryptoasset Reporting Framework, HM Treasury and HMRC are actually taking the lead in this. And so there's clear intent to do something and I think this crystallises that and makes the pathway a little bit clearer.

Laura: Looking ahead then, tokenisation is moving quickly. They say that we are only at the beginning of tokenising all assets. Right now the biggest commercial use cases are digital money, especially stablecoins. Where do you think we'll be in three to five years? Jonny, you often talk about this. More importantly, what should firms do now to prepare?

Jonny: I first of all think we need to bear in mind this isn't a binary choice. We're not saying get rid of cash, we're not saying get rid of the crazy paper-based trading systems we have. It was only a couple of years ago that 60% of fund managers still use a fax machine. I was chair of a fund administration business in Dublin, we have to send a fax on a daily basis reporting what we're doing and how we're doing it. Bits of paper, and as we see, the adoption of more and more AI. A recent study in the States, by Washington University of 800 businesses, found that 75% are seeing a real return on investment using AI. You can't use artificial intelligence if you've got bits of paper in a filing cabinet. What we're beginning to see, are various different technologies, all almost colliding at the same time. You've got things like internet of things, so a ship turns up in Southampton Docks on a Saturday morning and he has got a little thing called an internet of things. A little device which says, 'The ship has now arrived at Southampton.' So bang, immediately pay the harbour fees, pay the import duties, pay the shipping company, or whoever you've used to actually deliver these goods. And, so this automation is going to be required, but the trouble is, what we've seen, are these sandboxes, or sandpits, or, i.e. places where companies can play and experiment of tokenising assets. Which on the one hand is really welcomed, but they've put the cart before the horse. What they ought to have done is actually sort out the payments and the reason that you've already said, payments is we're seeing a lot of activity there.

Every business, regulated or not, has to pay money to buy things and it receives money when it sells goods and services. So you've got to get the payments right first, and interestingly there are numbers out saying that it's $3.2 trillion a year of income gets generated on payments. And, arguably it's this payments conundrum that has driven Fin Techs, and it comes back to the UK. The UK, second only to the USA, is the second biggest sector for Fin Techs, and that has been one of the powerhouses. I think it's over 360,000 jobs involving Fin Techs, and that's meant to actually double in the next couple of years. But if we don't act, you'll see centres like Amsterdam, you'll see centres like Frankfurt, again the Middle East. Talking to the Abu Dhabi regulatory authorities a couple of weeks ago, they've actually modelled the whole of their free zone on English law. They've taken one of our advantages, copied it, and now they're saying, 'Oh, but we're in the middle of', I think they said they were within seven hours of 80% of all the population in the world. We cannot be complacent but we've got some fantastic legal and accounting minds in this country. Half the money we manage in the asset management industry, is managed on behalf of overseas investors. We've got that global reach, but if we turn our back on innovation, we may struggle to get that, to get it back and wrestle control back off other people.

Daniel: Maybe just to build on a little bit of what you said there Jonny, and I agree with that. Is, for me there's something interesting about productivity, the blockchain kind of shows you what happened and AI explains why it matters. And if you think about operations across the business, tax, compliance, those kind of functions, you're going to see real growth in terms of the organisations that can put those two threads together.

Jonny: I totally agree, but what we're going to see, we're going to see a whole new ecosystem being developed, but that doesn't mean we get rid of the old traditional markets. If we take, for example, dark pools. Now, most people in financial markets know what a dark pool is. If you're not involved in financial markets you'll think it's something a bit dodgy, a bit iffy, 'What's going on in these dark pools? Is it a swimming pool with no lights or something?' Well, dark pools enable institutions to basically trade very large volumes of, typically, equities. Historically, they were started in the States, I think Bloomberg were Tradebook, was one of the first really extensively used ones. And what they enable them-, if you like, activity to happen without necessarily going on the direct stock market. If you want to go and buy $100 million of a well-known company's shares. Well, guess what? You're going to move the price, it's going to get more and more expensive. Or if you want to sell, the price is going to collapse because as you sell there are more and more coming through. So the equivalent in the DeFi sector, when you're dealing with digital assets, are things called DEXs, decentralised exchanges. Which are powered by automatic market makers, but these things trade 24 hours a day, seven days a week. And they're not just reliant on London, Paris, New York. They're actually global. A good example of this is hyperliquid, where you're seeing billions being traded through these automatic market makers, and these DEXs, on a daily basis. And providing real liquidity and actually bringing in smaller investors that are sitting on pools of liquidity. And so, this is real innovation, but it's no different really in many ways to the dark pools that we've already got. We shouldn't actually just assume one thing is better than the other. And, the other thing I think is interesting to note is, it has happened in the last couple of weeks. Nasdaq are moving a lot of their operations to Dallas and the Texas state is looking to set up its own stock exchange. And we're kind of going back in time. In this country a number of the major cities like Edinburgh and Birmingham had their own stock exchanges. Now, we just have one, the London Stock Exchange, but even the London Stock Exchange is actually reinventing itself and we're seeing the creation of the digital market infrastructure. The fact we're now seeing States, going back to the American example, of creating stock exchanges, and I can guarantee there won't be any bowler hats and umbrellas and quill pens down in Texas. It's likely to be digital, because they'll be looking to trade and trying to slash and cut through all the bureaucracy that we have, so that we can start seeing companies come out of the private market where there has been massive growth. And actually come more into the public arena, and that's great for democratisation, smaller investors can now get exposed to some of these exciting growth companies.

Laura: What about risks then? Strategic, commercial, operational?

Jonny: You're so an accountant.

Laura: I know, I know.

Jonny: It's always risk. Well, look risk is super important but the reality is very few of us really understand what the real risks are going on out there. And this is where I think AI is going to play a tremendous role, because you've actually got at the moment 60-ish percent of all trading in equities and bonds, and about 90% of all FX, is traded at by algorithms and bots. And, as we start to see AI being used more and more, and you see tokenised equities, tokenised bonds, tokenised commodities, tokenised real estate. Then you'll then be able to your bot will be able to start taking all that information and being able to look at private equity funds, private credit funds, Individual issuance from unquoted smaller companies and say, 'That actually isn't a great investment for you. This investment on a risk adjusted basis are.' You know, one of the things which just stagger me having run a fund management business for over twenty odd years, is very few people understand what a sharp ratio is. Sharp ratio being the risk adjusted returns, how much zig and zag have you had, have you been compensated for it. And I can remember back in the early '90s when we actually were managing a lot of funder funds, we sold one of the best known European fund managers, not because the performance wasn't very good, but the amount of volatility that that fund was taking. So most private clients don't understand sharp ratios, most advisors don't understand sharp ratios. But an AI bot can be programmed very easily to look at the best risk adjusted equity, bond, fund, whatever it may well be. So we can use technology to work and help us, as opposed to being frightened and say, 'Oh, it's just going to replace all our jobs.'

Daniel: From my perspective, I think this is where the basics matter a lot. There's the foundations of trust, governance and accountability, and if we think about consumer protections, that's a really important key. But there's also, wearing my tax hat, there's the tax base itself. And, you know, there's a real concern that this space becomes the next offshore tax haven. I think there's a risk of that, but the mitigation is again things like the Cryptoasset Reporting Framework that are meant to mitigate those risks. I think we're getting to the right place, but again the foundations I think are really important.

Laura: Both the UK and EU authorities have been concerned about dollarisation. So, especially linked to systemic stablecoins. So, Jonny, you've spoken before about the dollarisation of London. What do you see in your crystal ball? What's going to happen?

Jonny: Blimey, it's a bit foggy today, so I'll have to dust it up. You make me sound like Mystic Meg. Look, the reality is, in a cap-less environment money goes, capital flows where there's greatest liquidity. And, again, a huge problem that we have is over 90% of all the stablecoins currently in existence, are US dollar denominated. Why? Well, go and have a chat to the regulators. One regulator will tell you, 'Oh, you don't need to be VASP regulated, Virtual Asset Service Provider.' Or, the other one will say you do. One will say, 'We want you to do a stablecoin.' And then, you go back to them and they say, 'Oh, but not yet.' So, we've got this lack of clarity, if you like, using the crystal ball analysis. Whereby, it's very difficult for regulated companies to actually get heavily involved. And so, therefore, it has left this gap in the marketplace. Where we're beginning to see dollarisation we're working at the moment with a leading international estate agent, or a realtor. And they're saying, 'Can you help us put together a panel of lawyers that can actually buy, and help our clients buy and sell property using US stablecoins. We say, 'Well, why do you want that?' They say, 'Well, if you talk to the magic circle, the big fancy pants account lawyers, they understand the topic but they don't deal with private clients. And if you go and talk to the high street law firm, they've got loads of private clients but they don't understand stablecoin to know how it works.' So there's a sector in the middle of the mid-scale legal firms that are very knowledgeable and also have private clients.

We were talking to one only the other day, and they've already done $300 million worth of stablecoin transactions, of buying and selling prime residential property in London. Because you've got the global market, so you’ve got globally, people think, rightly or wrongly in terms of US dollars. US dollars accounts for in excess of 60-65% of all trading. So, if you're just going to buy and sell your property, and I think sterling accounts for around about 4-5% of global FX flows, why wouldn't you look at where the other, I don't know, say 60% market flows. You can then start going and attracting overseas buyers, particularly for real estate. And, I think this is something which we're seeing a growing trend, where people are saying, 'Well, I want to do it.' Now, let's go to another country. I was at a conference earlier this year and a Latin American, very large country, Central Bank was there. And, they said, 'Well, are you worried about dollarisation?' And, he said, 'Why?' And, the person that asked the question said, 'Well, because you're seeing your country effectively, it's handing over sovereignty to a third party.' He said, 'Have you ever had a 100% inflation?' And of course, in the middle of London, everyone sits there and goes, 'What's he talking about?' He said, 'A month.' He said, why wouldn't you want something that doesn't depreciate and you can then go and buy assets, just by doing nothing you become richer.' And, I think this is one of the reasons why we're seeing the US pushing so aggressively to actually say, 'We want to be the centre, because arguably the US dollar should no longer be the world reserved currency.'

These world reserved currencies, if you go back to 1445, without going through all the different countries. That's when they go back to, when the Portuguese real was actually the world reserved currency. And then became the Spanish peseta and then the Dutch guilder and then the French franc and then the pound sterling and then the US dollar. They have an average lifespan of about 94 years, the US is just over 103 years. So we should see another reserve currency coming through, if you look at historic records. But that wouldn't be very good for the US, who is going to buy their debt, if they're not the world reserve currency? What they want to do is to extend dollarisation and countries are just, with open arms. They want to actually use the dollar because it's actually a lot more stable than some of the currency they're used to dealing with.

Laura: What about London then?

Jonny: I think if London is not careful, it will get dollarised. Because large organisations look at London as a financial centre, we have more banks in London than any other city in the world. We've even seen new bank, fantastically successfully Brazilian bank, gone from nothing to over 110 million customers in the last eight years, locating its legal headquarters here in London. We're seeing great innovation and a lot of companies want to be here, and as a result of that, they're going to start saying, 'Well, actually, some of the other currencies are a bit of a rounding error.' If you take out arguably the Euro and you could say the Yen, most of the currencies are relatively smaller than overall transactions. And I suspect many of their suppliers would readily, happily accept dollars, if it was cheaper, if it was faster for them, and I think that's the key. If you're going to have a digital dollar, and you're going to pay in, say, ten working days as opposed to 30 days. I wouldn't be surprised if some of your overseas suppliers would accept dollars as opposed to the Yen, Sterling, or even dare I say the Swiss Franc.

Laura: Thank you, we're almost out of time. Any closing comments on the future of tokenisation, and what could the future look like?

Daniel: One of the strengths of the UK market is the asset wealth management sector, and it's really fascinating to see it reinventing itself, and we're moving, as you said Jonny, from sandboxes, or sandpits, into the real environment where things can be built. That can be put onto the market and so I think that it's a great time to be in the UK, but what they need to do is stay ahead of the pack. Because we don't want all the funds moving to Luxembourg, to Ireland, to UAE and to Singapore. And, that's probably the greatest risk, I think we just need to keep a real focus on it, and there's huge opportunity here. The market is ready for it, and it's nice to see some progress.

Jonny: Laura, I'll go back to your dreaded word risk and talking to a UK regulator a couple of weeks ago. And they concurred with my concern. Once you've let the genie out of the bottle, which arguably we have, why do we need funds? Because, we may well go back to our grandparents whereby, they did actually go and see an old, and typically, unfortunately, a man with a bowler hat, and he was their discretionary portfolio manager. He was their stockbroker, and we could well see, again, bots taking over and giving you your own 24 hour, seven day a week, managed discretionary portfolio, and strip away the level of costs and that layer within a fund. And therefore, asset managers need to be mindful of that, and historically what we're seeing is a shift out of individual discretionary portfolios, into funds. And I wonder whether we're going to see that actually go back the other way, and that'll get driven by compliance. Because from a risk point of view, why are you paying an extra half or maybe a full 1% for a fund wrapper. When actually, you can have your money managed very efficiently. Fractional ownership means that you don't necessarily need to be in a fund. Dan, you're the tax man, I'm sure you'll agree. There are obviously some tax advantages of having a fund. But when you put it into, say, some of the tax free shelters, or you've got money in trust, or a pension, or an ISA. Actually the tax is irrelevant and the closing comment is worth bearing in mind, and these are FCA figures not mine. 5% of individuals in the UK own equities directly, 12% own cryptocurrencies.

Laura: True.

Jonny: And we've got $124 trillion dollars worth of money that's going to be passed from the baby boomers down to the next generation. Now they want things now. They don't want to have to wait for an appointment to see their bank manager, or portfolio manager, if they even exist. If you can actually talk to them. They want to be able to do it on a Sunday afternoon and readjust their investments in their portfolio. Or maybe it's on the train on the way home. Or maybe it's when they're down at the gym. And, therefore, any company that can give the real user experience for the next generation coming through, they have a much bigger appetite for risk. They're much more interested in looking at alternative investments, hedge funds, private credit, private equity, commercial real estate. Those areas have historically been for the preserve of the so-called sophisticated high-net-worth individuals. But you're seeing a much broader base, and that's exemplified by some of the first asset classes have been tokenised, so has private equity. And going back to the London Stock Exchange, the first markets they're looking at are private equity and private credit. These are huge markets which the mass population hasn't been exposed to, but tokenisation will allow that. And, more importantly, because you've got tokenisation of those markets, they're providing liquidity for those private companies to be able to grow. Because 60-odd% of all people in the G7 economies work for an SME. 90% of all businesses in the world are SMEs. We need to get focused where the growth is, i.e. small companies, as opposed to worrying about what's happening in the FTSE 100.

Laura: Yes, that's a good place to stop and firms should really think about that. It's also good for the government, for getting money circling around.

Jonny: Very much so, well and your point there about money circling around. If you're paying your invoices, you're receiving money faster, guess what? The velocity of money increases, which is why interestingly the Bank of International Settlement have actually put out and said there's a correlation between use of digital money and economic growth.

Laura: Yes.

Jonny: 10% use of digital money, could actually lead to a 1% increase in growth. Now, if that's not a good enough reason to adopt tokenisation and have faster velocity money, therefore better economic growth, then I'm not sure what is.

Laura: Jonny, Daniel, thank you both for joining and sharing your insights. To our listeners, a thank you for listening as always, please subscribe to the series if you'd like to hear future episodes and write and review the series as it helps other listeners to find us. If you'd like to hear more from us on risk and regulation, please look out for our regular publications on our website, which will link in to the show notes. And we'll be back next month with our next episode, thank you.