Tokenisation, the process of converting rights to an asset into a digital token on a blockchain, is considered a transformative technology with the potential to revolutionise the financial industry. One of the most promising developments is the tokenisation of investment funds. Tokenised funds are investment funds whose shares or units are digitally represented and can be traded and recorded using distributed ledger technology (DLT). Asset or fund tokenisation is a topic of discussion as various global institutions attempt to improve market liquidity, fractional ownership, efficiency, and transparency. The growing adoption of tokenised funds has been driven mainly by the tokenisation of funds that have exposure and invest in securities such as bonds. This also allows for a more efficient capital raise mechanism. However, as with any technological innovation, it comes with risks and potential downsides, particularly in a developing market like South Africa.

Regulatory Uncertainty

Regulatory uncertainty is one of the most significant risks associated with tokenisation in South Africa. The South African financial regulatory framework is still grappling with the rapid evolution of blockchain technology and digital assets. While the Financial Sector Conduct Authority (FSCA) has shown interest in regulating crypto assets, clear guidelines on tokenised assets are still in progress. Establishing clear regulatory frameworks is crucial. The South African Reserve Bank (SARB) and the Financial Sector Conduct Authority (FSCA) need to collaborate with industry stakeholders to develop guidelines that ensure compliance and protect investors. In certain global jurisdictions, administrators have implemented parallel administrative processes to ensure regulators become comfortable with the DLT and the related track record of administrators, providing a smooth client experience when investing in tokenised funds.

Navigating regulatory uncertainty is crucial for the future of tokenised assets in South Africa.

Establishing a framework to ensure that regulators recognise tokenised assets as financial instruments is crucial. Without well-defined regulations, tokenised assets may not be acknowledged as legal securities, limiting their acceptance and use in the broader financial market. Asset managers in South Africa must navigate this uncertain terrain carefully, as any misstep could lead to significant economic and reputational damage.

Countries like the UK and Singapore have implemented regulatory sandboxes that allow fintech companies to test innovative products in a controlled environment. South Africa could adopt a similar approach to foster innovation while ensuring regulatory compliance.

Market Volatility and Liquidity Concerns

Tokenisation aims to improve liquidity by allowing fractional ownership and easier transferability of assets. However, the reality may be more complex, especially in the South African market. In areas where the use of blockchain technology is still in its early stages, the absence of a well-developed secondary market for tokenised assets can result in a lack of liquidity. This means that investors might have difficulty finding buyers for their tokens, which is especially worrying for assets that are typically less liquid, like real estate or fine art.

Though the tokenised funds will be less volatile due to the fund’s pricing mechanism, other digital assets, including tokens, are known for their volatility. Therefore, sudden price swings, often driven by speculation or external factors like regulatory news, can lead to significant losses for investors. This volatility challenges asset managers in portfolio management and risk assessment, as traditional models may not adequately capture the unique risks associated with tokenised assets.

Creating secondary markets and platforms for trading tokenised assets can improve liquidity. Encouraging institutional participation can also help increase market depth. DeFi platforms can enhance liquidity by enabling peer-to-peer trading and lending of tokenised assets. These platforms have gained traction globally and can be adapted to the South African market to improve liquidity and accessibility.

Cybersecurity and Technical Risks

Tokenisation relies heavily on blockchain technology, which, while secure, is not immune to cyber threats. Hacking incidents, smart contract vulnerabilities, and cyber theft pose significant risks to asset managers and investors, particularly in countries with less developed cybersecurity infrastructure. Beyond cyberattacks, tokenisation faces several technical challenges:

• ‍Smart Contract Risks: Vulnerabilities in smart contracts can be exploited, leading to financial loss or operational disruptions.
• Scalability and Interoperability: Blockchain's limitations in handling high transaction volumes and interacting seamlessly across different networks can hinder efficiency and liquidity.
• Oracle and Key Management Risks: Reliance on external data sources (oracles) and secure private key management introduce additional vulnerabilities.
• Technical issues in the tokenisation platform or blockchain network can cause asset loss or trading disruptions. These risks are heightened by blockchain technology's relative novelty and evolving nature.

Asset managers must invest in robust cybersecurity measures, conduct regular audits, and address these technical challenges proactively to ensure the security and reliability of tokenised assets.

Legal, Ownership Challenges and Tax

Tokenisation introduces new legal challenges related to ownership and asset transfer. In traditional finance, ownership rights are clearly defined and protected by law. However, in the digital world, these rights can become blurred. For example, the legal recourse available to investors in a dispute over tokenised assets is unclear. This lack of clarity can lead to protracted legal battles and potential investor losses.

These challenges are even more pronounced in markets where the legal system is still adapting to the digital age. Asset managers must be cautious in ensuring that the tokenisation process complies with local laws and that investors’ rights are adequately protected. Issues such as the classification of tokens, capital gains tax, and cross-border transactions need to be addressed. Without clear legal and tax frameworks, investors and fund managers may face unexpected liabilities and complications.

Limited Investor Understanding

Tokenisation and blockchain technology are relatively new concepts, and there is a general lack of understanding among South African investors. This limited knowledge can lead to scepticism and reluctance to invest in tokenised funds. Educating investors about the benefits and risks of tokenisation is crucial for its successful adoption, but this requires time and resources. Collaborating with financial advisors and institutions to offer training and workshops can also be beneficial.

Conclusion

While tokenisation offers exciting possibilities for asset managers and investors in South Africa, it is not without its risks. Regulatory uncertainty, market volatility, cybersecurity threats, technological barriers, legal and tax implications and limited investor understanding are significant concerns that must be addressed before tokenisation can be widely adopted. Asset managers must carefully weigh these risks against the potential benefits and take a cautious approach to integrating tokenisation into their investment strategies. By doing so, they can help ensure that the promise of tokenisation is realised without compromising the financial security of their clients.

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