Tokenization is proving money never sleeps and it’s likely that the always pioneering exchange traded funds (ETFs) industry will be fertile territory for tokenization advancements in the years ahead.
Forgive the over-simplification, but tokenization, helped by intersections with artificial intelligence (AI) pave the way for financial assets to trade in 24/7 fashion. Some digital-native brokerage and others are already experimenting with if not deploying the concept with individual stocks, indicating it could be just a matter of time before ETFs and tokenization meet.
As a pairing, ETFs and tokenization are practical because the creation and redemption process – already the bedrock of ETFs’ advantage over actively managed mutual funds – could gain new efficiencies by way of tokenization. Additionally, tokenization has the potential usher not only 24/7 market access for ETFs, but more rapid trade settlement as well.
Some issuers, including J.P. Morgan Asset Management, are already preparing for a day in which ETFs are tokenized in earnest. Advisors can bone up on tokenization of ETFs today, too.
Important Tokenization Topics
As J.P. Morgan Asset Management points out, tokenization of ETFs currently takes on one of two of forms. One of which is synthetic tokenized ETFs – a “clone” of an established ETF. In this case, the tokenized “copycat” is rooted in derivatives to replicated the parent ETF’s price action. Due to the derivatives foundation, a synthetic tokenized ETF may deliver performances that slightly deviate from those of the “real” fund. Then there are native tokenized ETFs.
“Here, the ETF’s share is issued directly on the blockchain; the on-chain token then becomes the security of record. This approach, which is still being piloted, could drive down costs by reducing operational friction and eliminating intermediary fees,” notes J.P. Morgan.
As Ciarán Fitzpatrick, global head of ETF Product, Securities Services at J.P. Morgan, observes, the ETF industry is likely still a couple of years away from ideal tokenization of use cases. That may signal that native and synthetic tokenization are more proofs of concept than what advisors and end users can expect three, five or 10 years out.
Interestingly, it’s the rise of active ETFs and associated technology demands that could spur the ETF tokenization evolution.
“Compared with passive ETFs, active ETFs change their holdings more often in response to market opportunities and risks,” adds J.P. Morgan. “They may also trade in underlying assets that are harder to price or source, and may have less transparent structures. As such, they typically require richer data, tighter controls and more automated workflows, prompting ETF providers to upgrade their technology suite accordingly.”
Speaking of Technology…
ETFs have long been rooted in technology with the creation/redemption process standing as a prime example. That history is relevant because as more unique active ETFs come to market, the need for fresh technology increases, potentially paving the way for tokenization use cases.
At the moment, it’s not a stretch to say ETFs and tokenization are “dating,” but it’s also likely the relationship will evolve over time.
“ETFs are forming a part of the new evolution of the financial industry. And I think the fact that we have capabilities in traditional markets, and now in the digitization and tokenization spaces,” concludes Fitzpatrick.
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