Missed opportunity of 4 June's correction: The case for tokenising mutual funds

However, much to their dismay, investors were allotted mutual fund units on the next day, 5 June’s prices, when markets had recovered around 3-4 percent.

As per norms, mutual fund units are usually allotted to investors at the NAV of the day on which the funds are received, before the applicable cut-off time. Reportedly, the delay on 4 June was due to heavy trade volumes and consequently, the delay in movement of funds between banks, exchanges and fund houses.

Though this problem reportedly affected only 2% of the total transactions, it nevertheless warrants a discussion on the tokenization of mutual funds, which would allow for instant allotment of mutual fund units at the desired prices to the investors.

To achieve this, mutual fund houses would need to select a blockchain platform and create digital tokens representing ownership of the units of the mutual fund scheme.

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Once investors provide the required funds, they will be instantly allotted mutual fund tokens on the distributed ledger technology. This DLT allows peer-to-peer transactions—eliminating the requirement of traditional intermediaries such as banks, clearing corporations, etc.—thereby speeding up transactions and reducing costs.

Blockchain transactions are verified and authenticated by computers connected to the network, which ensures only valid and authorized transactions are permanently recorded.

A blockchain contains a digital record or ledger of transaction data that is permanently recorded in files called “blocks." In the event of a conflict between the blockchain record and the record held by the transfer agent, the transfer agent’s record will be determinative.

Tokenisation versus dematerialisation

Many question how tokenisation differs from dematerialisation—that has existed for long. While dematerialized papers are held by depositories, tokens are held on blockchains forming part of a decentralized ledger technology (DLT).

The ownership and transfer of tokenized assets are streamlined due to the blockchain’s inherent features. Unlike traditional dematerialized records that might still involve cumbersome manual processes, tokenized assets can be transferred with ease, reflecting changes in real-time across the decentralized ledger.

International experience

The US-based Depository Trust and Clearing Corporation’s (DTCC) smart NAV pilot has sparked discussions about mutual fund tokenization using blockchain technology.

The project aimed to create a standardized method for disseminating NAV data of funds across blockchains using Chainlink's Cross-Chain Interoperability Protocol (CCIP). Chainlink is a decentralised blockchain.

The pilot is an extension of DTCC’s Mutual Fund Profile Service I (MFPS I), which is the industry standard for transmitting net asset value (NAV) data. DTCC acted as the data provider and overseer of the on-chain solution, while Chainlink’s CCIP facilitated interoperability.

This initiative involved collaboration with ten of the world's largest financial institutions, such as BNY Mellon, Franklin Templeton, and J.P. Morgan, among others.

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The pilot showed that trusted, verifiable NAV data sourced by DTCC could be securely delivered onto blockchains, potentially powering a broad range of future use cases.

Key outcomes indicated significant advancements in automated and real-time data management, reducing the need for manual data recording and broadening of API accessibility for price information.

Franklin Templeton has also made a notable advancement with blockchain by developing the world’s first digital asset security to run on a public blockchain. The  Franklin OnChain U.S. Government Money Fund (FOBXX) , introduced in 2021, is the world’s first mutual fund to use blockchain technology for processing transactions and recording share ownership.

Although the fund’s transfer agent maintains the official record of share ownership in book-entry form, the ownership of the fund’s shares are recorded on the blockchain.

According to its prospectus, “The use of distributed ledger technology is untested for mutual funds, but it is believed that blockchain-based shares will provide increased transparency to fund shareholders and may, in the future, permit reduced settlement times and provide other benefits to Fund shareholders".

Potential impact and future application

The pilot’s findings indicate that delivering structured data on-chain and establishing standard roles and processes can support a wide range of downstream application, including brokerage portfolio applications and other business workflows.

These benefits stem from automated data dissemination and access to historical data in real-time. The initiative could also foster more extensive use cases beyond just price and rate data and across more blockchain networks.

Encouraging further industry exploration, the Smart NAV pilot sets the stage for potentially expanding these technological applications, aiming to improve operational efficiencies across the financial landscape.

Implications for Indian mutual funds

Could this pilot lead to a paradigm shift in how mutual funds are managed and traded in India? Most Indian mutual fund schemes are bought from statement of units rather than dematerialization.

So here, the shift would be from statement of units to tokenized assets, not from dematerialized to decentralized tokenized assets.

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In India, a mutual fund’s NAV​ is usually calculated by a fund accounting firm hired by the mutual fund, or the mutual fund house itself. We could perhaps try Franklin’s model discussed above.

The transparency provided by blockchains, coupled with the efficiency and security of smart contracts, could lead to lower costs for investors and broader accessibility, leading to a more inclusive financial landscape.

The way ahead

Tokenization currently lacks a fully developed and comprehensive legal and regulatory framework. However, jurisdictions like Singapore, France, Germany, and the United Kingdom are making significant strides in developing such frameworks.

The securities market regulations would need significant amendments to make provisions for tokenization, which in turn will support other reforms in Indian securities markets, such as fractionalisation.

However, clues can be taken from the IFSC Gift City, which has taken a bold step in embracing tokenization and putting in the necessary framework.

Cues can also be taken from the RBI, which has adopted this technology to enhance the security of card transactions and reduce fraud by replacing actual card details with a unique code or token, to ensure the security of transactions.

Kohli is Assistant General Manager (AGM) at National Institute of Securities Markets (NISM), and Panda is Assistant Professor at Indian Institute of Management (IIM), Raipur.