Private asset tokenization – Separating fact from fiction

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Kelsey Warkentin: Hi. You're listening to Market Matters, our market series here on J.P. Morgan's Making Sense Podcast. I'm Kelsey Warkentin, VP of Global Private Market Sales at J.P. Morgan. And today, I'm joined by Dennis Cristallo, Head of Wealth Management for Onyx by J.P. Morgan, and Nikhil Sharma, Head of Growth at Onyx Digital Assets by J.P. Morgan. Today we're here to have a round table discussion about privat asset tokenization. Nikhil, Dennis, thank you for joining the podcast today.

Nikhil Sharma: Kelsey, thanks for having us on the podcast.

Dennis Cristallo: Thanks for having me.

Kelsey Warkentin: Nikhil, maybe you can start off by giving us a brief overview of Onyx.

Nikhil Sharma: So Onyx by J.P. Morgan is essentially our blockchain business unit. We sit within the corporate investment bank within the payments unit within the firm, and what we do is essentially build traditional financial products on blockchain rails. We started on this journey about a decade ago when we started exploring blockchain and how it could be used to sort of solve issues within use cases within the firm. Since then, we've built out a number of applications, networks and platforms. And around 2020, we realized that a number of things that we've been building have legs for them to be commercialized. And we combined them into one business unit which we call Onyx by J.P. Morgan today. So our focus within Onyx is basically to streamline information, money and digital assets. And we do this creation of three private permission blockchain networks. And essentially what that means is we've created three blockchain networks on which we are building use cases that involve streamlining of information. This is a network called Liink, L double I-N-K. We are moving value on chain, and that's true a product called JPM Coin. And the third network where we've essentially created a unified ledger including assets and cash, and this is a network that we call Onyx Digital Assets. And through these networks, we are essentially moving information, money and digital assets in a streamlined form. That's basically what Onyx is today.

Kelsey Warkentin: Thank you. That's really helpful. And I know that tokenization will be important amid the rise of retail investors and private markets, especially around liquidity concerns. And it allows these investors to enter private markets and lets funds get a capital infusion from them. But before we go too far down the rabbit hole, can you just give us a brief primer on blockchain and tokenization? What are they and why are funds exploring how to leverage this technology?

Nikhil Sharma: That's a useful call-out. So all the networks that we've built within Onyx and everything that we are building within Onyx is sort of hinged on blockchain, so it's definitely worth calling it out as to why we use it. So think of blockchain as essentially an alternative record keeping system. That's it, [inaudible 00:02:51]. So from an external sort of participant perspective, it looks like any software that you have, the magic actually happens behind the scenes. So blockchain is essentially like, think of it as a shared ledger where everybody that's a stakeholder within a transaction is basically looking at one shared source of information. And this information can be represented in a pretty granular format. It can be standardized and you can write very simple logic around how the information needs to flow and how it's recorded and how ownerships and balances will be recorded. So there's an aspect called smart contracts when you speak about blockchain, and essentially what that means is when you're representing information in a granular format, you can write very granular code which says if a particular condition is satisfied, then a particular outcome needs to be reached. And when you're doing this within a shared ledge construct, what that means is for everybody that's looking at that ledger, those conditions work the exact same way. And that sort of enables mutualizing workflows between everybody that's actually acting off one source of information, and that's where you start to get benefits of reduced reconciliations between these parties, where I don't need to sort of explicitly reconcile my database with your view of the world, and then we agree on what the overall state of the world is at. And that's where the core constructs of blockchain start to help.

Kelsey Warkentin: That definitely makes sense in terms of blockchain and smart contracts, but how does tokenization fit in this context?

Nikhil Sharma: So when you think about smart contracts, I obviously spoke about the granular construct of smart contracts, when you start stacking up these smart contracts, you can build end to end complex financial uses cases. Now, when you think about this, representing assets and cash, which may be a part of those use cases, as programmable constructs becomes really useful, and that's where tokenization comes in. So very simply, tokenization is essentially representing the data, the identifiers, the properties and the rules governing how an asset is recorded or it moves into one single construct. That last part is important, because today, the way you record assets or any asset on a ledger is essentially as a ledger entry. Thereafter, you give instructions, there are intermediaries that step in and process how the asset is recorded and how it moves. Here what you're doing is you're combining all of that into one construct. So what that does is, when you move an asset thereafter, the rules that govern the asset on how it's held, how it moves, et cetera, those rules move along with the asset, which means a bunch of operational steps in terms of how an asset needs to be recorded, where it can move. Can it move from party A to part B? Is it authorized to do that? All that can be governed while the asset moves itself, and that makes the movement and recordation of an asset efficient, and that's where tokenization starts to come in. And when you take it one lever higher, in terms of putting all of this in one ledger, you start to create efficiencies in how assets move against each other and how they settle. Now, this has an implication and this has benefits when we look at multiparty workflows and cross-asset settlements. And that's where the segue to asset management comes in. Maybe this is a good time to bring Dennis into the conversation. He spent a good part of his career in asset management. Dennis, you wanna chime in on where this technology can help the space?

Dennis Cristallo: Yeah, sure. Thanks so much, Nikhil. I think as far as putting this in the context of alternative investments, I would highlight and just build upon two things that Nikhil said. The first is that by using this concept of a shared ledger, you can effectively ensure that all these parties are looking at the same data for their investors and investments. When you think about how this comes together today for alternative investments, you generally have a three party setup where you have a fund manager, you have a fund admin/transfer agent and you have a distributor. All of them have siloed systems and disparate data sets, and there's a tremendous amount of effort around reconciling this data and understanding the true state of what's going on with this particular investment and this particular investor. The second thing that I would highlight is that, as Nikhil mentioned, blockchains and smart contracts enable multiple assets to live on the same set of rails. And so when you have your cash sitting side by side with your assets on a unified ledger, you can do what we call atomic settlements. And so the interesting thing about that is that what this means is that when investor X sends their dollars to the relevant smart contract, they will be credited with having made that investment nearly instantly without the need to reconcile both legs of the trade because both are happening on the same set of infrastructure. And so instead of having to track hundreds of wires for your investors, reconcile lead payers, have everyone update their asset books, you can very clearly see at the source the status of all of your investors, cutting down a lot of the work which distributors and fund admins have to do today. And so for us, we think this is an incredibly powerful tool and technology when you think about the challenges of scaling up alternative investments to high net worth individuals who can be very numerous and writing much smaller tickets.

Kelsey Warkentin: Got it. That makes a lotta sense as far as streamlining some of the operational processes. But why should investors and fund managers care? And how does this technology help bridge the supply and demand gap? Dennis it's back to you.

Dennis Cristallo: Yeah, it's a great question. Who cares? So what? You mentioned the supply demand gap, and that's something that Nikhil and I wrote a lot about with our friends at Bain in a paper that we put out late last year. And so on the supply or, or manager side, I think it's pretty clear the main goal is to increase distribution and better penetrate that high net worth investor market. And we think that if the tech shows promise on that front, we'll start to see a lot of adoption from the fund managers coming into the fold. And so when we think about and when we look at some of the early initiatives within tokenized alternative funds, they were really attempting to get better distribution by reaching, I would say, a more crypto native audience that maybe hold stable coins or are more familiar with using things like crypto wallets. Our view within our Onyx is that we think this technology needs to effectively meet investors where they are. And so alts today are generally sold by wealth managers, RAs, wirehouses, and so we're trying to build solutions that make their lives easier and cheaper. And we think if we do that, distributors will start to demand these types of products and you'll see a feedback loop develop, hopefully, where more fund managers, again, come into the fold. And then on top of that, we think this tech is also going to enable some benefits for the end investors as well. And so this is things like making it easier for them to borrow against these assets, automating the capital call process, which is probably one of the biggest pain points in the industry, and making it easier to include alternatives in model portfolios which should produce better client outcomes. And so I think the key thing here is that it's early for this technology, and we need to demonstrate that it can add value at multiple levels. And we do see that path developing for both fund managers and distributors.

Kelsey Warkentin: Yeah, that all sounds great. And I know there's a ton of hype around these ideas like tokenization and real world assets right now, but sometimes it's hard to separate fact from fiction. So are there areas where your view differs with what's being said in the marketplace?

Dennis Cristallo: Yeah, totally agree, definitely a ton of hype, ton of excitement. There's announcements basically like multiple times a week at this point, which we love. But I think there are two areas where we talk about on the team that are being potentially heavily oversold right now. And so the first would be that tokenizing private funds or alternatives somehow improves access for general retail investors or quote unquote democratized assaults. I think you could argue successfully that because tokenized funds are more efficient that investment minimums could be lowered, and we have seen this with live examples out there. However, just taking an investment or anything and putting it on a blockchain doesn't really change the nature of what it is. And so if the investment offering was only suitable for qualified purchasers before, it's still only suitable for qualified purchasers. And QPs generally don't have a need for a 10,000 byte size, and so some of that is potentially a bit of window dressing. So the second idea is on the liquidity front, which is probably a bit of a more nuanced conversation. But again, just taking something and putting it on a blockchain does not make it in and of itself more liquid. You still need a robust marketplace of buyers and sellers to come together in order to get better secondary market liquidity. And frankly, this hasn't happened yet for a whole host of reasons. That said, we do think that this technology does lay the right groundwork for more efficient secondary markets in a few ways. The first would be that with tokenization it becomes a lot easier to update an investor register, process sales, approve transactions, et cetera. The second would be that within the token, as Nikhil described, we can effectively encode rules or an incentive for a fund manager to get them to the table for secondaries, which we know is a bit of a hurdle today. And so every time a fund sells in the secondary market, you could embed a rule that effectively pays the manager 50 basis points or 100 basis points on each of those sales to, again, get them to the table. The last is this concept of decentralize identity, and so being able to effectively have investors be able to port over their AML, KYC or different aspects of their identity could make it easier for them to participate in secondary sales and open up the supply and demand spigot, if you will. Admittedly, a lot of this is very future state, which I think is a bit of the point. But the question that's talked about a lot in the marketplace, we do think that this is a benefit of tokenization, but it's probably a bit further down the road than some of the other things that we're talking about. And so for us, tokenization isn't so much about democratizing alts, what we're really trying to do is liberate them. We're trying to free these assets up so investors can do more interesting things with them, get more utility out of them, and work with them in ways that really weren't previously possible.

Nikhil Sharma: Okay, great. Thanks for that, Dennis. Obviously agree with every point that you said, coming from the same side of the fence. Maybe this is a good time for us to turn the tables and get your perspective on this, Kelsey. So tokenization we do feel will be increasingly important as firms approach high net worth individuals in terms of getting investments in private markets. But before we go deep down that rabbit hole, what would you say is happening currently in terms of the mechanics of retail/high net worth individuals approaching alternative investment funds?

Kelsey Warkentin: Yeah. I can definitely cover that. So given the volatility in public markets lately, we've seen that retail investors are increasingly hungry for alts investments given their robust returns and the diversification they offer in comparison to the liquid side. So historically, huge check sizes have kind of been a barrier of entry for these retail investors, but recently, the barriers to entry have lowered for PE retail investors looking to tap into the asset class. So in 2020, the Securities and Exchange Commission expanded the definition of accredited investor beyond pure wealth and income based criteria to include those with adequate knowledge and expertise. To clear high fund minimums, this ruling by the SEC essentially makes it easier for retail investors to now pool their assets and invest directly in private market deals, and whether it's through private bank networks, RIAs or distributors in the marketplace.

Nikhil Sharma: Right. That's interesting. But we wouldn't say this is just investor motivated, right? There are private equity firms and alternative investment managers quoting or going off the high net worth individuals too?

Kelsey Warkentin: Absolutely, we see that all the time. So the scarcity of capital resulting from the popularity of private markets kinda means that PE firms looking for additional sources of capital are focusing less on institutional investors and more on individuals. And there's a really good reason for that. Almost half of global assets under management belong to retail investors, and that's at about 295 trillion. So as the institutional investors like pension funds, endowments, foundations, et cetera almost tap out for their allocations towards alternative investments, these PE fund managers have no choice but to get creative, invest in the retail market, launch different funds and strategies that allow them to be able to do so.

Nikhil Sharma: Right. And this seems like one side of the equation, like when you look at it from the behavioral side of things for investors for high net worth individuals, [inaudible 00:15:00] been convincing investors to lock up their funds in a closed ended structure for a decade or more, it can be tough. It's, I guess, all the more difficult when you add it with a lack of transparency of holdings within the fund, they don't really know what the fund is doing for over a period of time. So [inaudible 00:15:16] and diversification seem attractive in this asset class, would you say even from a structural perspective, B firms need to create like innovative fund structures, employ different techniques from an education point of view, to, like, stand out, differentiate themselves and, like, get in front of individual investors?

Kelsey Warkentin: Absolutely. So it's different for most retail investors to swallow locking up their funds or cash for 10 plus years. I know it makes me anxious just thinking about that. So in order to meet growing demands from these types of investors, private equity firms are structuring products that cater directly to them. There are a couple funds that we've seen in the marketplace. So in the US, two closed end mutual fund structures have emerged as a lure for retail investors. So they're interval funds and tender offer funds. And these funds usually have monthly subscriptions and quarterly redemptions, so not as often as your traditional open-ended mutual fund, but it gives retail investors a little bit of flexibility in terms of their liquidity being locked up. And then similar to the SEC ruling in 2020, the European ELTIF 2.0 regulation which went into effect January 2024 introduced wider marketing rules to raise capital from retail investors. And that allowed the increase and the emergence of three different structures. So you have the ELTIF or the European Long-Term Investment Fund, which emerged in 2015. And that allows individual investors access to private market investments. In the UK, long-term asset funds, or LTAPs, very original names, (laughs) have launched over the last year to allow more retail investors exposure to private assets with reduced blind pool risk. And then we've also seen the rise in the launches of UCI Part II vehicles, which modernize the Luxembourg fund structuring toolbox and target retail investors as well.

Dennis Cristallo: Kelsey, when you're saying retail investors, in that context, is that true retail or is that accredited investor, qualified purchaser equivalence? How should we think about that?

Kelsey Warkentin: So it would need the same definition as the SEC definition that I mentioned, so they do have to be accredited investors, but you can have high net worth retail that are considered to be accredited investors that are investing into the fund through a private bank chain, RIA or distributor. So there's multiple ways that retail can be discussed, but it's both.

Dennis Cristallo: Thanks, Kelsey.

Kelsey Warkentin: So now back to you, guys. As PE behemoths aspired to expand fee bearing AUM at double-digit rates, that will mean considerable new fundraising that requires them to market these new retail PE fund structures and manage the liquidity needs of a bevy of individual investors. So how can tokenization play a role in all of that?

Nikhil Sharma: So just going back to the framing that we mentioned earlier, right, Dennis mentioned the whole concept of a unified ledger, so what they're essentially doing here is representing a fund as a tokenized, a programmable structure on the same ledger where the cash that is used to settle or purchase units of a fund also exists. So it's basically a unified ledger of like assets and cash that's used to settle. Specially in the case of funds, by standardizing representation of fund shares, like LP interest, et cetera, what you can do is basically streamline the whole way how assets and cash are rerepresented on one single ledger. And that essentially streamlines how subscriptions can be put into the fund, distributions can be issued out of the fund. And that whole process can be not just streamlined, not just programmatically controlled, but also their tokenization, putting it on a blockchain brings in transparency across the lifecycle right from the time the fund is issued to the time distributions are given out and all the way down to liquidation. And where this helps the current ecosystem or the way the fund ecosystem's structured, you have different participants, different stakeholders within the whole process having their own siloed ledgers and reconciling with each other in terms of what the final state of ownerships and balances is. When you can work that into one shared ledger and start automating bits and parts and little bits of how information is moved and, like, settled, you start to see mitigation of reconciliation across all these parties. And that's where we believe efficiencies would come in, and that's where we believe efficiency will stack up and sort of help the catalyzation or catalysis of the entire process that you mentioned, Kelsey, earlier, in terms of like how do we bring funds in terms of like individual investors and make it easier from an access standpoint for individual investors to get in? Additionally, there are certain persistent frictions that exist within how investment into alternatives are structured today. So if you think about distribution channels as well, you do have to orchestrate a bunch of things from a distributor into the fund. There exist stringent timelines in terms of what is acceptable in terms of when subscriptions can be put in and when they will be processed, and that entire cycle. So we feel that tokenization can sort of play a role in terms of streamlining that whole cycle from the point at which an investor sort of approaches a distributor and like a- approaches a fund to the point at which they hold that value and start seeing how that is performing over the life cycle of the asset. That said, this is sort of foundational in terms of, like, synchronizing the data points that exist within a fund ecosystem and sort of building features on top of that. So Dennis and I have been working on what feature sets you can build on existing... once you tokenize a fund like LP interests, what can you build on top of that?

Dennis Cristallo: Yeah, I, I can jump in here. I mean, I totally agree with everything Nikhil just said. There're a whole host of ways that this technology makes the current BAU easier, and then there are a bunch of different ways where we think this kinda takes us into the future as far as alternative investments. So my favorite example here is, let's take a trip 10 years into the future or whatever where investors' entire portfolio is tokenized, and so imagine you have an investor with a liquid portfolio and they're making commitments to private equity funds. You could see a scenario where a capital call from a private equity fund could trigger a redemption on the liquid portfolio to automatically fund the capital call. And so in that scenario, which I think we would describe is kind of like a holy grail scenario for the industry, you have effectively killed one of the biggest pain points of investing in private equity funds today, which is dealing with capital calls and the phone calls and the reconciliations and the wires, and you've also not compromised the drawdown structure, which I think most investors agree is the superior structure as opposed to a fully funded upfront investment vehicle. And so for us, there are a lot of really exciting things around tokenization and what we could do in the future, and as Nikhil mentioned, what we're working on today is very much just the ground floor. As we solve these problems, we think this is how we and the industry could unlock what we've described with our friends at Bain as the 400 billion dollar annual revenue opportunity for using this technology to better sell alternative investments to individuals. Nikhil, anything you'd add to that?

Nikhil Sharma: No, I think you covered it all, Dennis. The one additional thing that we've done after that report that Dennis just alluded to is we've continued to sort of perform foundational experiments as to how this technology can sort of... little pieces, little components that form a part of a bigger solution. So one thing that we did late last year is we tokenized or we simulated tokenization of funds and we experimented how such a tokenized fund can sit in a model portfolio. So again, it sort of feeds back into that access point that was made in our conversation earlier, which was how do you meet investors where they are? So investors are using model portfolios today, can you tokenize funds and like include these funds in any way in model portfolios? So that makes the access point easier. There are multiple reasons why funds can be included in model portfolios today. Dennis alluded to a few. So what we did is a technical experiment proving how this can be done. Obviously, a bunch of things that need to be done before we can actually get to that point where this becomes a reality, but things need to start at some point.

Kelsey Warkentin: Well, I think this is a great place to wrap up today's podcast. We've given our listeners a lot to think about. So thank you Nikhil and Dennis for joining me on today's podcast.

Nikhil Sharma: It was great fun being here. Thanks for having us here, Kelsey.

Dennis Cristallo: Thanks, Kelsey. This was great.

Kelsey Warkentin: And thank you to our listeners for tuning in to Market Matters on JP Morgan's Making Sense Podcast. We hope you join us again next time.

Speaker 4: Thanks for listening to Market Matters. If you've enjoyed this conversation, we hope you'll review, rate and subscribe to J.P. Morgan's Making Sense to stay on top of the latest industry news and trends. Available on Apple Podcasts, Spotify, Google Podcasts and YouTube.

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