Will ETFs Be Overtaken by Tokenization?

• Tokenization is poised to revolutionize the ETF landscape.
• While there may be hurdles to overcome, the potential benefits are quite compelling.
• Regulatory clarity will be crucial.

Exchange-traded funds (ETFs) have transformed the global markets in recent decades, broadening access to investment opportunities like never before.

An analysis from PwC suggests  that the total value of assets under management in ETFs worldwide stood at a staggering $11.5 trillion by the end of 2023, up 25% in 12 months.

And while it’s easy to assume that most ETFs simply track the world’s biggest indices, like the S&P 500 or the Nasdaq 100, there is much more to this burgeoning industry than meets the eye.

Funds based on Bitcoin’s (BTC) spot price have taken the U.S. by storm since launching in January, primarily because they allow investors to gain exposure to the world’s biggest cryptocurrency without taking on the risk of owning it directly.

According to SoSo Value, the total net assets within BTC ETFs have now surged  to $61.5 billion, just six months after their debut. The prospect of new exchange-traded funds tracking the price of Ether (ETH), the world’s second-largest digital asset, looms large.

There’s been no shortage of innovation among asset managers, who now offer ETFs devoted to the nichest of sectors. But another seismic technological shift is on the horizon: tokenization.

Tokenization opens up a world of possibilities

BlackRock is the largest asset manager on the planet, and when its CEO speaks to financial media, the market takes notice. Because of this, it was especially telling that Larry Fink believes  the natural evolution of ETFs is “the tokenization of every financial asset.”

Whereas old-fashioned stocks change hands on centralized stock exchanges, tokenization would see shares given a digital lease of life on blockchain. There are a multitude of benefits here.

Not only would transactions become more secure, but this would drive down inefficiencies and lower fees for investors. And while U.S. markets are only open during business hours, tokenization would drive liquidity by allowing trades to take place 24/7.

But this isn’t an opportunity that’s merely confined to stocks. Far from it.

A slew of other real-world assets—from gold to real estate, and from rare wines to fine art—can also have ownership reflected in the form of digital tokens.

While few of us could afford to splash out on a $100 million chunk of prime New York commercial property on our own, tokenization could split this opportunity into 100,000 smaller pieces worth $1,000 each. Holders would then enjoy partial ownership, and the ability to trade these tokens on secondary marketplaces.

Big players are now suiting up and investing tens of millions of dollars in building the infrastructure required to make this a reality. But what would this look like in practice? What are the hurdles standing in this nascent technology’s way? And could we really see tokenization fully replace ETFs over the next five years across investors’ portfolios?

A reality check

Tokenization is definitely the direction in which the financial sector is moving. But with trillions of dollars in value flowing through the markets every day through tried-and-tested rails, there’s a lot at stake—and that means the transition to digitized real-world assets will be more gradual.

Another elephant in the room concerns the current state of blockchain technology. Right now, this infrastructure simply isn’t mature enough to accommodate all ETFs in tokenized form.

There are scalability issues to contend with, and major networks often see transaction fees spike during times of peak congestion as it is. Proof-of-work blockchains also face uncomfortable questions about their electricity use and carbon emissions, but greener and cleaner proof-of-stake alternatives have helped assuage these fears.

Pragmatically, we’ll likely see traditional and tokenized ETFs complement each other in the years to come. Both can have a place in the market and serve different investor preferences and goals.

Old-fashioned exchange-traded funds undoubtedly offer much greater choice at the moment, but tokenized rivals have the opportunity to achieve greater global reach. The new era of finance will also be especially beneficial for entrepreneurs and startups around the world, who will find it a lot easier to secure capital.

The adoption of tokenized ETFs will grow as everyday investors begin to experience the benefits. Dividends can be paid on automated cycles with immediacy, trades made at speed, with artificial intelligence (AI) also playing a role in finessing strategies as the market adapts. As huge asset managers roll out funds atop of blockchain, smaller players will inevitably follow suit.

Regulatory clarity is another crucial roadblock to overcome—it’s heartening to see that the House Financial Services Committee in the U.S. recently held  a hearing to learn more about tokenization.

ETFs first started trading in 1993, but their rollout was slow at first. Sector-specific funds only launched five years later. By 2003, just 123  were in operation. Smartphones and the internet will mean tokenization achieves a much bigger impact more quickly, but innovation takes time, and it shouldn’t be rushed.