Tokenization lurks as ESMA warns of liquidity issues facing alternative assets

Rick Steves

The report focuses on risks in real estate funds amid declining transaction volumes and falling prices in several areas. Liquidity mismatches are a significant concern, especially with open-ended real estate funds offering daily liquidity. This could be a systemic risk in areas where real estate funds dominate the real estate market.

The European Securities and Markets Authority (ESMA) has issued a warning about the potential liquidity risks in the alternative investment funds (AIFs) market, particularly in real estate funds.

Amid this cautionary stance, the concept of tokenization of real estate assets is gaining attention as a possible solution to these liquidity concerns.

Systemic vulnerabilities in alternative investment funds

ESMA’s report highlighted issues in the EU’s AIF market, focusing on the risks associated with real estate funds, especially those exposed to leverage and liquidity mismatches. The authority noted the systemic vulnerabilities in jurisdictions where these funds have significant market presence.

The report focuses on risks in real estate funds amid declining transaction volumes and falling prices in several areas. Liquidity mismatches are a significant concern, especially with open-ended real estate funds offering daily liquidity. This could be a systemic risk in areas where RE funds dominate the real estate market.

The overall size of the AIF sector decreased by 3% to EUR 6.8 trillion in 2022, representing 36% of the EU fund industry. The decline in value was largely due to valuation losses in funds invested in bonds and equities, impacted by adverse market conditions in 2022.

Real estate funds face risks related to leverage, market footprint, valuation discrepancies, and liquidity mismatches. Hedge funds continue to exhibit high leverage, potentially impacting the market. However, their significant cash reserves may mitigate the risk of forced sales.

National Competent Authorities (NCAs) have identified risks in Liability-Driven Investment (LDI) funds, especially those with leveraged exposure to the UK government bond market. The limits set post the severe stress of September 2022 remain relevant.

ESMA, along with NCAs, is taking measures to address these identified risks, aligning with its objective of financial stability. This involves a collaborative supervisory approach to the data reported under AIFMD, focusing on market development and key risk metrics like leverage and liquidity.

Tokenization could broaden the base of investors

In response to ESMA’s concerns, experts in the financial technology sector are pointing towards the tokenization of real estate assets. Tokenization involves converting physical assets into digital tokens on a blockchain, facilitating fractional ownership and trading.

Advocates argue that tokenization could significantly enhance liquidity by enabling a broader base of investors to engage in smaller, more affordable transactions. This increased market participation could, in turn, lead to more fluid buying and selling of real estate assets.

Despite its potential, tokenization faces regulatory and technical hurdles. The industry is still developing the necessary infrastructure and standards. However, recent partnerships and projects indicate growing interest and progress in the field of real estate asset tokenization.

The issue extends beyond the EU, with global markets closely watching the developments in tokenization as a potential template for addressing similar liquidity issues in their regions.

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