Tokenized Funds’ Rapid Growth Comes With Red Flags: Moody’s

Tokenization of funds is booming, but their rapid rise comes with serious risks that investors should not overlook, credit agency Moody’s Ratings said in a Wednesday report.

Several major financial institutions, including BlackRock and Franklin Templeton, have made their mark in the world of tokenization and inspired others to follow the latest trend. For example, tokenized money market funds grew roughly 350% in a year to a market capitalization of $5.2 billion, per rwa.xyz data.

“When assessing tokenized funds, investors have to weigh not only the benefits of accessibility and transparency, but also the risks tied to the underlying technology, security vulnerabilities, scalability limitations and evolving regulations,” said Cristiano Ventricelli, VP-senior analyst at Moody’s Ratings.

At the forefront of these risks is the limited experience of many fund managers in the still-developing tokenization market, Moody’s noted. With small teams and short track records, operators could face key-man risk where too much depends on a few individuals: If a crucial executive leaves or governance structures are thin, the stability of the fund could be shaken, the report said. Moody’s urged fund teams to distribute responsibilities and shore up risk management practices.

Blockchain disruptions, again resulting from the novelty of the technology, poses another risk. While smart contracts offer operational efficiencies like automating fund operations, they remain susceptible to coding flaws or malicious attacks, the report noted. Using public, permissionless blockchains increases accessibility but also raises exposure to potential exploits, it added. Moody’s recommended keeping off-chain backups and conducting rigorous smart contract audits to guard against disruptions.

Redemption mechanisms, which let investors cash out their holdings, are another fragile link. The report encouraged tokenized funds to allow redemptions in both stablecoins and fiat currency. This dual approach helps cushion against events like stablecoin depegs or blockchain outages.

Lastly, tokenized funds operate across jurisdictions with varying regulations, and this patchwork increases the risk that investor claims could face legal hurdles, the report said. While some funds use structures designed to give token holders direct claims on the underlying assets, enforceability still depends on local laws and the strength of fund documentation, the report added.