Index and exchange-traded funds (ETFs) have transformed the landscape of investing over the past few decades. They have opened the markets to millions of investors, offering accessible investment solutions. In the past decades, technological and financial innovations have been greatly interlinked, and it seems that the next step in financial innovation is the tokenization of these funds.
Based on research, policy papers, and initiatives from leading international organizations and financial institutions, such as the World Economic Forum, Franklin Templeton, or Deutsche Börse, it is highly plausible that tokenization will be the next major development in the financial world, as Larry Fink (and other) envisioned.
“ETFs are step one in the technological revolution in the financial markets. Step two is going to be the tokenization of every financial asset.”
– Larry Fink, Chairman and CEO of BlackRock
In this article, we will explore the evolution of ETFs from their origins as index funds, analyze the factors contributing to their widespread popularity among investors, and discuss the potential advantages of transitioning ETFs into tokenized formats.
Index Funds and Exchange-Traded Funds: What Are They?
The rise of exchange-traded funds (ETFs) is closely connected with the history of index investing. Index investing allows investors to diversify and ultimately apply well-known portfolio investing strategies, minimizing their risks.
Back in the 1970s, the idea of index investing came around. Influential works like Burton Malkiel’s A Random Walk Down Wall Street (1973) argued that most investors would be better off with a low-cost, diversified portfolio that tracked a broad market index rather than attempting to beat the market. This concept laid the foundation for what would become a major shift in investment strategy.
Shortly after the book came out, in 1973, Wells Fargo and American National Bank launched the first index mutual funds for institutional customers. Just a few years later, Vanguard, led by John Bogle, introduced the First Index Investment Trust, a fund that tracked the S&P 500. Initially starting with only $11 million, this fund was met with skepticism and mockingly dubbed “Bogle’s folly.” However, the fund’s long-term success, now known as the Vanguard 500 Index Fund, proved its critics wrong and remains one of the largest and most successful mutual funds in history. This marked the beginning of a shift toward passive investing—investing in a portfolio that tracks market indices rather than actively trying to outperform them.
Innovation often finds its roots in financial crises, as seen with the emergence of Bitcoin following the 2007–2008 financial meltdown, the same was the case for the birth of ETFs after the 1987 stock market crash. During the 1987 crash, institutional investors identified a critical need to trade large stock volumes quickly and on an intraday basis. In response, a Los Angeles-based firm, Leland, O’Brien, and Rubinstein, proposed a novel idea in 1990: grouping stocks into a “basket” and placing it on an exchange to trade it as a single unit. This concept materialized as the SuperTrust fund. Despite its innovation, SuperTrust struggled due to high minimum investment requirements and fizzled out after a few years.
When ETFs were officially introduced in 1993, they debuted quietly, drawing little attention from average investors. For nearly a decade, trading activity remained minimal, with ETFs only surpassing 1% of fund trading volume by 2000, despite their growing recognition among major investors.
Today, ETFs are among the most popular investments for institutional and individual investors, usually accounting for between 26% to 30% of the daily trading volume in the U.S. in recent years.
With further DLT innovation, we see more and more affinity towards the tokenization of financial assets and, potentially, of ETFs.
Tokenization of ETFs vs Crypto ETFs
Tokenization of ETFs is not the same thing as the Crypto ETFs
In 2024, the US Securities and Exchange Commission (SEC) approved Bitcoin ETFs and ETPs and approved the sale of spot ETFs in the United States. The SEC combined proposals from the Nasdaq, NYSE, and CBOE exchanges, which requested changes to existing rules to allow the trading of Ethereum Exchange-Rraded Products (ETPs) and ETFs.
Spot Bitcoin ETFs are financial instruments tracking Bitcoin’s price by holding the actual cryptocurrency in reserve and backing each share of the ETF with real Bitcoin. These ETFs allow investors to invest in Bitcoin without the need to buy, store, or manage Bitcoin themselves in a specific crypto wallet. They function similarly to traditional ETFs but focus specifically on BTC as the underlying asset. As of December 2024, there were twelve spot Bitcoin ETFs available in the United States.
Within nine months of launch, these products accumulated over $49 billion in assets across the top providers, demonstrating strong market demand for regulated crypto investment vehicles. The SEC’s approval of options trading for BlackRock’s iShares Bitcoin Trust in September 2024 further legitimized this new asset class within traditional financial frameworks.
However, the tokenization of classical ETFs is different from Bitcoin ETFs.
Tokenization of ETFs changes not the underlying financial asset but the underlying technology. It promises to enhance their value by transforming them into decentralized digital assets that can be created more swiftly and cost-effectively.
Decentralizing enables instant trading without the need for traditional intermediaries, thereby reducing or eliminating associated institutional fees. Such advancements increase accessibility, improve liquidity, and streamline transactions for investors, but might be concerning from the perspective of investors’ protection and sufficient oversight and control over the trading.
Is Tokenization of ETFs the Next Step?
The financial industry is experiencing a transformative moment as it navigates the intersection between traditional financial systems and emerging blockchain technology. According to Franklin Templeton’s survey conducted in November 2024, financial institutions face significant challenges in their efforts to tokenize traditional assets such as equities, bonds, and funds. The existing technological infrastructure and deeply entrenched systems have proven resistant to wholesale replacement, requiring a more gradual approach to transformation. Rather than attempting an immediate transition to fully tokenized assets, the industry is adopting a staged evolution toward a digital financial ecosystem.
The ETF-First Approach
The initial phase of this transformation, commonly referred to as “ETF-ization,” is already gaining momentum across the financial sector. ETFs have emerged as the ideal vehicle to bridge traditional and digital finance, primarily due to their inherent flexibility and well-established regulatory framework. This strategic approach offers several significant advantages for the industry’s digital transformation.
ETFs excel at facilitating the efficient “bundling” of diverse assets, allowing for seamless integration of both traditional and alternative investments within a single instrument. This capability has proven particularly valuable as institutions seek ways to incorporate non-traditional assets into conventional portfolio structures. Furthermore, ETFs provide an excellent testing ground for new technological infrastructure, allowing financial institutions to experiment with digital innovations while operating within familiar regulatory boundaries.
Technical Infrastructure and Challenges
The transition toward tokenized ETFs presents complex technical challenges that require careful consideration and innovative solutions. The industry must develop robust systems that can reliably track ownershipand maintain secure custodyof assets across both traditional and digital platforms.
A fundamental requirement for tokenized ETFs is the implementation of sophisticated ownership tracking systems that can seamlessly integrate with both traditional financial infrastructure and blockchain networks, which is not an easy ask. These systems must maintain accurate asset ownership records while ensuring secure custody arrangements that meet regulatory requirements.
Financial institutions are developing new security protocols to protect against emerging threats unique to the digital asset space. One such threat is “dusting” attacks, where malicious actors send minimal amounts of cryptocurrency to wallet addresses in attempts to deanonymize their owners. Understanding and mitigating these new forms of security risks is crucial for the industry’s evolution.
Interoperability Requirements
The success of tokenized ETFs depends heavily on achieving seamless interoperability between traditional financial systems and blockchain networks. This requires the development of standardized data formats and communication protocols that can facilitate efficient information exchange across different platforms. Smart contract capabilities must be integrated thoughtfully to ensure automated processes maintain the same level of security and reliability as traditional methods.
Risk Considerations
The expansion of tokenized ETFs introduces several significant challenges, as outlined in the recent OECD Policy Paper on Tokenisation of Assets and DLT in Financial Markets, which must be carefully managed to ensure market stability and investor protection.
Market Structure Impacts
The introduction of tokenized ETFs could alter existing market-making models. Traditional market makers may need to adapt their strategies and systems to accommodate tokenized assets, which may temporarily affect market liquidity and price discovery mechanisms.
A particular concern is the potential fragmentation of liquidity between traditional and tokenized markets. When the same asset trades in both tokenized and traditional forms, there’s a risk of creating separate liquidity pools that could operate with different pricing dynamics. This bifurcation could be particularly pronounced during periods of market stress, potentially leading to pricing discrepancies and arbitrage opportunities.
Price discovery mechanisms may also evolve as tokenized ETFs gain prominence. While DLT offers enhanced transparency for transaction data and asset characteristics, the potential for trading across multiple platforms—both on-chain and off-chain—could create challenges for efficient price discovery. This is especially relevant for “real-world assets” that maintain both traditional and tokenized representations.
Operational Considerations
Financial institutions must develop robust cybersecurity frameworks specifically designed for tokenized assets. These frameworks need to address not only traditional security concerns but also blockchain-specific vulnerabilities. Regular security audits and updates will be crucial to maintaining system integrity.
Regulatory compliance presents another significant challenge, particularly given the global nature of digital assets. Institutions must navigate varying regulatory requirements across jurisdictions while ensuring their tokenized ETF offerings maintain compliance with all applicable rules. This may require sophisticated compliance monitoring systems and regular engagement with regulatory authorities,
Future Outlook
While the Financial Stability Board’s 2024 analysis indicates that tokenization currently poses minimal systemic risk, the growing adoption of tokenized ETFs could introduce new considerations for financial stability. The success of this transformation will largely depend on several key factors:
- The development of comprehensive regulatory frameworks will be crucial in providing clarity and confidence to market participants, balancing fostering innovation and maintaining market stability while ensuring adequate investor protection measures are in place.
- Technological infrastructure must continue to evolve to support the increasing complexity of tokenized products. This includes improvements in blockchain scalability, interoperability between different networks, and enhanced security measures.
- Industry collaboration will play a vital role in establishing common standards and best practices to tokenization, ensuring consistency and efficiency across the ecosystem.
- Solving operational challenges, particularly those related to custody and settlement, will be essential for widespread adoption. This includes developing solutions for asset verification, transfer mechanisms, and risk management.
Market acceptance and adoption will ultimately determine the success of tokenized ETFs.
The suggested pathway to full asset tokenization through ETFs represents a measured and pragmatic approach to modernizing financial markets. By starting with familiar investment vehicles like ETFs, the industry can build experience and confidence with tokenization while maintaining market stability and security. As market participants gain expertise with tokenized ETFs, they will establish the foundation for broader asset tokenization initiatives, potentially revolutionizing how financial assets are traded and managed in the future.
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