Yield-bearing assets like money market funds have long been a staple for investors seeking to manage their short-term liquidity needs. Particularly for larger corporate and institutional investors, like pension funds, which have limited options for managing cash needs due to constraints on unsecured exposure to bank deposits, money market funds offer an invaluable cash management vehicle, diversifying credit risk and achieving returns aligned with short-term money market rates. They are designed to be redeemed by investors for cash at short notice, typically offering daily redemptions with same-day settlement.
However, money market funds are not typically used as collateral, due to operational and in some regions regulatory barriers, they need to be converted to cash first. Indeed, around three quarters of collateral is posted as cash. But the process for doing so is hobbled by inefficiencies. Tokenisation can simplify it.
Right now, an investor holding units in a money market fund needs to redeem those units for cash and transfer the cash as collateral to a counterparty. The counterparty will eventually pass it back to the investor, who then needs to repurchase the money market fund units. The process is inefficient, uncertain, and highly manual, involving many different systems and intermediaries. What’s more, while this is happening, the investor no longer benefits from the yield of their asset.
If money market funds were tokenised, the investor could simply pledge their tokens to the counterparty as collateral without needing to redeem them for cash first. The assets could be posted to an account in the investors name for the benefit of the receiver of the collateral, meaning the investor retains the yield. When no longer required they are posted back to the main account of the investor – all executed on a single, efficient set of digital rails.
This offers significant benefits to both investors and the whole ecosystem. It makes operations more efficient, because tokenised assets can be transferred between accounts with full transparency to all parties in real time on distributed ledger technology (DLT) networks. It offers greater liquidity, because tokenised money market fund units can be transferred instantly, freeing up capital during clearing and reducing intraday exposure banking fees. The shortened settlement cycles also diminish counterparty credit risk, bankruptcy risk, and performance risk. Asset managers benefit from the increased stickiness of assets, as investors are no longer required to redeem their units for cash, thus keeping the assets within the fund. And, crucially, investors can continue earning returns on their assets while they are used as collateral.
It also benefits the wider financial system. The onset of Covid in March 2020 and the resulting economic turmoil highlighted the vulnerabilities in the current system. Money market funds experienced extreme outflows as investors redeemed their units for cash to meet margin calls, with sterling-denominated seeing outflows of approximately £25bn – 11% of their total assets. By eliminating the need to redeem holdings to raise cash for margin and repurchase agreement collateral, tokenisation could prevent such large outflows, stabilising the market in times of stress.
There are some operational and regulatory challenges to getting there. The acceptability of yield-bearing assets as collateral is not harmonised across jurisdictions, and regulatory regimes for tokenisation are still taking shape. Intraday trading and real-time redemption also require robust infrastructure which is still being developed.
However, significant progress is being made. As noted in the UK Treasury Technology Working Group’s latest report, this use case has already been successfully tested in other jurisdictions. The Group’s baseline model already supports the tokenisation of money market fund units, and the report calls for the use of tokenised money market fund units as collateral, particularly in the context of the UK’s regulatory framework for non-centrally cleared derivative contracts. This endorsement highlights the potential for tokenised assets to play a pivotal role in broader financial markets, influencing liquidity and collateral management practices.
Tokenising yield-bearing assets for collateral also serves as an entry point for the broader adoption of tokenisation and DLT into the financial world. It takes an existing, common use case and makes it more efficient and less risky for all stakeholders – the investor retains the yield and the asset manager retains the asset under management. This practical application builds trust in the finance world, paving the way for more complex use cases of tokenisation and DLT. Moreover, as digital asset markets evolve, tokenised yield-bearing assets may adapt further, especially with the development of reliable and secure on-chain currencies and clearer regulatory frameworks for stablecoins and central bank digital currencies. The Technology Working Group’s latest report also explores the use of digital money as the settlement mechanism, which underscores the movement towards a fully integrated digital financial ecosystem.
The future of collateral management lies in the tokenisation of yield-bearing assets. Overcoming the current challenges will lead to a more efficient and resilient financial system. As regulatory frameworks solidify and operational infrastructures mature, the benefits of tokenised collateral are becoming increasingly evident.
Calastone is committed to leading this transformation. Our money market fund services currently facilitate transaction movements, and we are extending our network to support multiple blockchains. This integration allows us to connect traditional fund processes with real-time tokenised asset movements, enhancing transparency and efficiency.
With our experience in building DLT systems and connecting funds, we are collaborating with clients to integrate traditional financial systems with innovative DLT solutions, creating systems that leverage the benefits of tokenisation. This is how this technology will find real purchase in asset management and markets – concrete, bounded use cases where the benefits of tokenisation are tangible, immediate and, crucially, achievable. We are actively building out a tokenised yield-bearing asset collateral system with asset managers, clients, and collateral providers, and we invite others to join us in this journey.
First published in Investment Week 08/24: https://www.investmentweek.co.uk/opinion/4350602/calastones-adam-belding-future-tokenised-yield-bearing-assets-collateral
