bTF – Blockchain Traded Fund

Fintech

I have been spending a bit of time learning about Blockchain, I am trying to get an understanding of the inner workings of Blockchain technologies, first as a due diligence  (hype? ) and second as I think if the promises of this innovation will actually materialise, it will come down to its implementation, given the large paradigm shift on what it enables, this requires a complete re-engineering of products while keeping their “original intention”.

With that said, I am far from understanding its nuances, but I would like to get to a stage where I can run usage cases in my head (input and expected output) and understand what goes in the middle without being too far off.

To explain why I think re-engineering products will be key with this technology, we could use the example of the Web.  When it came along, WWW was an highway to transfer information when publishing companies were still “riding horses” to deliver newspapers door to door (figuratively). It took a long while for that industry to realise how fundamental the change was, and in the meantime they kept fighting against it while shrinking in relevance. In their intial attempts they tried to reproduce 1:1 their existing products using the web, instead of stripping down the legacy technology and physical constraints and re-engineer a new product starting from the web.

I think the first successful product of Blockchain will have to do the same, as this technology could very well be the highway for digital assets (digital files with rights and trust related properties associated with it) as Web was for the publishing industry. This time tho, I think the pace has changed quite a bit.

The below requires a little bit of knowledge on the blockchain – not all is explained in plain english – I will post an additional entry in the future going through my notes on the blockchain inner workings (or at least my own understanding of it) that will complement this example.

bTF – Blockchain Traded Fund

(I won’t go in the details of how we achieve the hypothetical future described below, this is more a brainstorm)

Today, an ETF – exchange traded fund – is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors. (Source)

Usually, investors use these products to get a diversified exposure to a basket of securities. (e.g. representing a specific market)

Let’s take a specific example of a passive physical ETF (like the SPDR) and work our way up to what it would look like with Blockchain:

Hypothetical features of a bTF:

A bTF behaves like a Decentralised Autonomous Organisation ( an aggregate of pre-defined business logics or smart contracts) sitting on the blockchain.
Tokens represent “shares” and give holders right to redeem in-kind the underlying basket of securities. Every token is unique and associated with “its own basket of securities”. Ownership is slightly different than in a traditional ETF, here we own the underlying through the bTF structure, in the traditional space, we own the share in the Investment Trust that owns (with a physical “unsampled” structure) the underlying basket of securities.

Features:

  •  Objective:
    • Invest in a basket of securities (e.g. shares of US public companies)
    • Following a pre-specified allocation (Asset weighted index – weighted by their Market capitalisation – where income is reinvested)
  • Standardisation (everybody that hold 1 unit of the ETF will have the same underlying portfolio)
    • Cost benefits driven by standardisation (economy of scale of aggregating AUM to manage the underlying portfolio)
  • Liquidity (can buy and sell token/share on an exchange)
  • Closed-end (Each token/share represent proportional interest in the portfolio of stocks of each of the underlying company)
  • No arbitrage (Price of the ETF must track the price of the portfolio replicating its underlying,  I can redeem the ETF in-kind and sell it – I will obtain the same $ amount less transactions costs)
  • Income events happen within the product wrapper (i.e. there is no look through from a tax perspective and I realise taxable gain or losses only by selling the ETF)
  • No counter-party risk (Exposure through physical allocation using a Decentralised Autonomous Organisation – DAO)
  • Transparency (Clients and other players will have a live look through of the holdings embedded in the bTF token)
  • Regulated with “live” read-only view by regulators and/or using pre-approved “regulatory templates” (UCITS guidelines could be hardcoded and be easy to verify to facilitate distribution)

The key takeaways here are: 

  1. The “Investment Management” in a passive ETF is a pre-defined business logic that can be automated and self-enforeced on the blockchain (including regulatory requirements)
  2. There is no need for an intermediary for this product (custody role of the Investment Trust in the traditional model can be disintermediated via blockchain)
  3. Offers more transparency and look through than a standard ETF,  while benefitting from the same regulatory status (i.e. tax wrapper)
  4. The construct is cheaper and should have – in its vanilla form – no counter-party risk.
  5. Allows for more applications as lateral development its easy once the infrastructure is in place (i.e. more pre-designed basket of securities)

Which would lead to this expected outcome:

  • Virtually zero tracking error by design (i.e. the Total return of Index and the ETF should differ only by the trading cost associated in replicating it)
  • No Investment Management fee
  • Removal of the Investment trust role and related counterparty risk and/or trust network cost

New business model:

The Investment Management cost  for this product should be = 0 bps – there is no discretion involved as the allocation strategy is pre-specified, hence there is no reason to charge for the ongoing investment management of the portfolio.

However, there are costs involved in creating the product, maintaining it and ensuring it reaches its costumers (especially integrating it with traditional exchanges): in order to be a viable business there needs to be (initially) a margin to incentivise players to join, grow and improve the technology. As other passive products, it will ultimately be a race to 0 , but as in other industries where that was the case, value can be found in other services on top of it.

Revenue:

A good assumption of what that margin could look might be in the interval between the cost of running it (see elements in the following paragraph) and the current market price of similar instruments (e.g. 10bps), which could evolve according to circumstances:

  • T=0: the cursor can be moved towards 0 initially via teaser rates to incentivise adoption
  • T=1: increased later as AUM increases and the underlying cost per share decreases, offsetting part of the increase (% increase of Total Expense Ratio < % increase Margin)
  • T=T: margin pressure as competitors join the market and start battling for market share
  • T=T+N: costs further reduced via technology advancements, converging towards winner takes all, high barrier to entry as margin too small

Once established, bTF companies could leverage their reach to offer services on top of their platform (e.g. SMAs) or more active and complex products, once they have a network, a potential revenue model could be partnering with established asset managers that want to take advantage of their platform and technology to implement their investment idea and leverage their distribution network. For these 2.0 products however, the structure might need to change quite a bit and the transparency of the product described above might need to be compromised to ensure to protect the IP of the managers, perhaps using differential privacy or less regular reporting to regulators.

Costs:
Costs are transparent and embedded in the bTF itself, players can access these information by “googling” the Blockchain network, among the costs we could imagine:

  • R&D costs (including smart contracts auditing – to prevent “theDAO” type of scenarios –  and all pre-launch costs) incurred to create the product could be pro-rated to share holders (token holders) and could decrease in time via a reverse exponential curve. Given every token is unique on the blockchain, we could envisage a model where the initial release of tokens is following a pre-defined R&D cost allocation even if the token changes hands, the following owner will benefit from the “vintage year” of the token. Following releases (i.e. new batch of tokens created) it will have the same reverse exponential pattern but with lower initial R&D allocation.
    This is just an example to show that given every digital asset is unique and can be followed from its inception to the current state in the blockchain, we could think of a better way to allocate costs across tokens and time.
  • Maintenance costs (e.g. smart contracts enhancements, integrating new technologies, increasing core capabilities and ensuring BAU operations) should be allocated across shareholders
  • Ad Hoc costs:
    • Compliance (Intelligence) costs incurred to comply with a specific jurisdiction should be allocated to the shareholders impacted.
      • This would re-align externalities of excessive/expensive regulatory requirement to the relevant jurisdiction, making investments less appealing for expensively regulated countries while not penalising countries where regulators have caught up with Blockchain compliance.

 

 

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