blockchain technology

Blockchain Technology Meets Real-World Opportunity: Powering Direct Indices and Model Portfolios with Smart Contracts  

By Tyler Carter, Head of Digital Assets Strategy, and Manuel Rensink, Director, DeFi Strategy, Securrency 

The world of investment has undergone significant changes over recent years, with technological advancements creating new opportunities for investors. One such innovation that is quickly gaining momentum is Direct Indexing, which acts as both a complement and a competitor to traditional index investing through Exchange Traded Funds (ETFs). Direct Indexing has been growing faster than ETFs, with an annual growth rate of 12.4%, and a projected value of $1 trillion by 2025. Its popularity and potential have not gone unnoticed by major asset managers, who have made over 12 Direct Indexing acquisitions to date. 

Direct Indexing is a process that allows investors to own individual stocks or other securities that replicate the performance of a particular index, such as the S&P 500. Unlike ETFs which rigidly track an index, Direct Indexing offers investors significant benefits by providing more flexibility in creating a custom portfolio that meets their specific needs. Investors may add or drop specific equities to the base index that align with or don’t adhere to their investment ethos. They may also remove individual components that they hold elsewhere to avoid overweighting their overall portfolio and improve tax efficiency, for example through tax loss harvesting.  

However, Direct Indexing in its current form also has several drawbacks. The most obvious is the reliance on intermediaries, who act as fee layers that add to the costs of the investment. The early implementation of tokenization technologies has exposed first-generation Direct Indexing and Model Portfolios as static, meaning that they are limited to the single user creating them.  

New tokenization approaches can address these limitations by making Direct Indices, Model Portfolios, or Separately Managed Accounts (SMAs) investable, tradeable, and transportable. Tokenization involves converting real-world assets (RWAs) into digital tokens that can be traded on blockchain networks. In this way tokenization can be thought of as a technically evolved fund wrapper like ETFs or Mutual Funds, but with the unique ability to move at the speed of the internet. In addition to speed, tokenization also allows for the automation of front, middle, and back-office processes to provide significant cost savings. 

To achieve this, tokenization relies on smart contracts that enable automated data ingestion, portfolio rebalancing, individual exposure adjustments, and automated tax loss harvesting. This automation is what leads to more efficiency during the investment management process, thus reducing the cost and effort required for investors to manage their portfolios. 

Tokenization also offers integrated distribution through Decentralized Exchanges (DEXs), meaning that investors can access these model portfolios without intermediaries, further reducing costs. DEXs represent a secondary market for tokenized individual real-world assets, providing more flexibility and liquidity for investors. For institutions, DEXs can be thought of as a distribution channel with reduced fees when compared to traditional distribution. DEXs are also the markets in which a majority of tokenized assets are minted, meaning that users, volumes, and assets greatly outpace their centralized counterparts.  

Securrency is uniquely positioned to offer solutions for tokenizing Direct Indices and Model Portfolios. Composer, by Securrency, is an innovative platform that allows for the rapid composition of tokenized financial primitives that can be combined to create a variety of financial instruments, including index-like model portfolios consisting of RWAs and crypto, structured products, and fixed-income instruments. Additionally, Securrency’s core focus on compliance standards embedded within tokens ensures that they can move cross-ecosystem while adhering to regulatory requirements. Securrency’s technology already powers the first SEC-compliant tokenized indexed funds provided by WisdomTree. 

How does it work? Users can access a full suite of data-driven analytics tools and institutionally curated model portfolios. They can select a portfolio strategy and customize a curated portfolio or create a unique model portfolio. Once the portfolio is created, tokens can be minted as a Non-Fungible Token (NFT) which can include tokenized individual RWAs, crypto assets, or fixed-income tokens. Tokenized assets are replicated by traditional assets seamlessly and automatically via smart contract calls to the qualified custodian. 

Minted tokens can be held by the creator, traded through the integrated DEX, or transferred to external DEXs, CEXs, or wallets. Users can also mint additional share tokens using another user’s model portfolio, which creates an incentive for creation and participation within the ecosystem.   

The commercial opportunity presented by on-chain Direct Indexing is immense. Investors can access diversified portfolios based on their values, institutions can rapidly deploy model portfolios and structured products directly to their customers while accessing DeFi ecosystems as a distribution channel, all while reducing their costs and increasing revenue streams. Custodians can automate back-office functions for assets consumed through the platform, which can help them reduce their operational costs. Index providers can also eliminate sponsor fee layers by deploying model portfolios based on existing indices. 

The benefits of automation, efficiency, and cost-effectiveness are significant, and the combination of tokenized model portfolios and global on-chain liquidity is one of the most significant opportunities for innovation in the investment industry.