Investment Funds Tokenisation Transforms the Future of European Fund Distribution
- Tokenised investment funds are in no way different from their traditional analogue correspondents. That is for what concerns the financial and sustainable objectives that can be pursued with this type of investment products. The first stage of investment funds tokenisation affects investor participation, where title in the investment fund will be represented by a digital token.
- Investment funds tokenisation does not necessarily imply a qualification of the underlying investable assets. Tokenised investment funds are not defined as such because they exclusively invest in crypto or other digital assets. For the participation in a tokenised investment fund being represented by a token, there is a question as to whether they should be treated as digital assets themselves for regulatory purposes.
- The disintermediation inherent to DLTs/blockchain allows in principle for investors to trade their digital participation in a tokenised investment fund directly on the blockchain. This in principle has the potential to disrupt significantly fund distribution in Europe. Regulatory uncertainty as well as reliability risks for DLTs/blockchain are the most important hurdles to the widespread adoptions of these technologies.
Traditional investment funds will soon have an on-chain version thereof. A tokenised version. There is no real difference between what a tokenised investment fund can do compared to its traditional analogue correspondent. That is for what concerns financial or sustainable objectives expected from an investment product of that type. Both types of investment fund will be essentially vehicles for investors to gain access to the same asset classes, managed on their behalf in accordance with specific strategies.
Investment funds tokenisation does not mean tout-court exposure to cryptocurrencies or similar digital assets. In this context, tokenisation of investment funds refers to the use of advanced technologies to support, for instance, the performance of the registrar and transfer agent functions and even the function of distributors. According to this model, investment funds are tokenised in that investors will hold tokens as digital representation of their holding in an otherwise traditional or analogue investment fund.
With the progressive adoption of these advanced technologies across the spectrum of global financial markets, investment funds tokenisation will mean that more and more functions within the ecosystem and lifecycle of investment funds will be disrupted with the widespread adoption of these new technologies. Tokenisation comes also with the potential to disrupt the way investment funds are distributed in Europe. There will be inevitable benefits and at the same time unique threats and risks that will come with this revolution.
What is DLT and What Does It Do
Investment funds tokenisation and its benefits become understandable as we get acquainted with the distributed ledger technologies (DLTs). The easiest way to understand DLTs is to compare them to the more traditional – centralised ledger – approaches. In the traditional way, data and records related to ownership of assets or other information and identification – the so-called value – are stored at the level of an individual entity, part of a specific value chain. With the centralised ledger approach also comes a single point of failure. In case of disruptions or other failures of that centralised entity, data stored in that centralised ledger cannot be accessed or verified. As part of this approach, data and entries must also be reconciled periodically amongst the individual entities.
What changes with the DLTs is that interactions relevant to a specific value chain are first authorised and then recorded on distributed/multiple ledgers, represented by various independent computers. Distributed ledger means that these computers, each representing a ledger, are spread across different sites, geographies and institutions instead of being centralised at the level of each separate institution. These computers, also known as nodes, verify and authenticate related transactions on the distributed ledger system. The process of authenticating a transaction before it is recorded ensures that only valid and authorized transactions are permanently recorded. All DLTs have a specific software code that governs the systems used for the verification and authorisation of the transactions. The fact that the distributed ledger can be common to the various entities part of a specific value chain eliminates cost and time related to data reconciliation amongst the various entries.
The most common example of DLT is the blockchain. That is the same technology used for the bitcoin cryptocurrency. It derives its name from the fact that authenticated transactions are grouped in so called blocks.
What is a Token
A token is a digital representation of an asset made on a DLTs/blockchain system. A token can be representative of any type of asset, no matter whether tangible and real or exclusively digital.
We usually hear terms like on-chain and off-chain associated with tokens. On-chain is a term generally used to refer to assets created on a DLTs/blockchain system itself, which have no corresponding parallel representation off-chain. Off-chain is usually indicative of an environment where an asset can exist or be recorded outside of that specific DLT or blockchain.
Before looking into details at the benefits that will come with investment funds tokenisation, it makes sense to touch on the implications from a regulatory perspective of the phenomenon of investment funds tokenisation. Tokenised investment funds in essence provide their investors with a digital representation of their participation in the fund. That will usually come in the form of a token stored in a digital wallet. Where an investor does not have already a digital wallet as such, the administrator or transfer agent of the fund will presumably create such wallet for the investor as part of the subscription process. This is where the token representative of such participation will be stored and made accessible. The wallet is in essence a software application in no way different from the ones used to store other digital assets like crypto assets.
This approach begs the following legitimate question. Whilst being no different to traditional investment funds in the financial or even sustainable objective they pursue and the returns they can offer investors, should tokenised investment funds be nevertheless considered as crypto assets themselves? That is because the participation in the tokenised investment fund will be represented by a token, rather than a certificate issued under a traditional technology.
For the time being there seems to be consensus on that regulation of crypto assets, where it exists, should not capture crypto assets that are in essence instruments or investments that already exist off-chain and are specifically regulated. A tokenised UCITS, for instance, will remain a UCITS and shall continue to be regulated accordingly. The fact that investment funds tokenisation entails the use of DLTs/blockchain for certain of the functions within its value chain is a separate issue from its underlying investments. In other words, whilst a tokenised investment fund can invest in crypto assets, not all tokenised investment funds invest in crypto assets. And where a tokenised investment fund does invest in non-digital or crypto assets, it should continue to be treated and regulated as a traditional investment fund.
This seems at least to be the approach to be adopted by the UK authorities. In other European countries, where there are already examples of tokenised investment funds, the approach is similar. In the US, where the debate on the introduction of rules on crypto assets is still not as advanced as we would all want to see it, there is of course no other regulation than the traditional one applicable to tokenised investment funds.
Disrupting European Fund Distribution
For the time being, investment funds tokenisation is limited to certain specific aspects of the related value chain. More namely, the functions of registrar and transfer agent are now being carried out already on a blockchain/DLT for certain investment funds. That is a reality already and no longer a futuristic idea. Some big fund houses have already made the move and introduced tokenised investment funds. The move allowed these houses to capture a broader share of the market, especially in the younger generations. The ones that are more apt with this new technology and trustful of digital wallets. As the narrative on DLTs and blockchain regains momentum in the industry and the application of these technologies to the investment funds ecosystem continues to evolve, we expect that many more fund houses will consider issuing tokenised versions of their flagship investment funds.
The first phase of tokenisation of investment funds seems to have already received the blessing also by individual European authorities in the most respected member states. The ones with long-standing tradition and highest standards across the global fund industry. In one with reduction of certain administration costs, investment funds tokenisation at this stage already comes also with the potential to disrupt fund distribution in Europe.
Nowadays the centralised ledger approach still governs the dynamics related to subscribing and redeeming participations in investment funds. Distributors transfer agents and administrators are the entities involved in the process. The disintermediation effect that comes with the peer-to-peer formula ingrained in the blockchain/DLT ecosystem might offer new ways also to distribute investment funds. Distributors, administrators and transfer agents could all sit on the same blockchain, streamlining the process of fund distribution. In one with reducing the costs and the hurdles in this part of value chain, the adoption of the DLTs/blockchain comes with the potential of changing the way markets currently operate. Fund markets will function more efficiently because there will be no longer need for investors to recur to intermediaries to participate to these markets. Retail investors might not only be able to buy, but also sell and transfer their participation in a fund to other peers either on the DLTs/blockchain itself or on a secondary market. In one with the disintermediation effect there are other inevitable upsides. Certain investment opportunities might be made much easier to access by the masses due to fractionalisation of the related participations and the much lower minimums. This without having to even go through the hassle of the client classification imposed nowadays under applicable regulation in Europe.
A gift that could potentially keep on giving. Considering that these new distribution avenues could also solve some of the issues inherent to the lack of liquidity of long-term investment structures like the ELTIFs. Existing participations in these long-term structures could be traded more easily using the peer-to-peer formula. Investors would be allowed to cash out of a long-term opportunity in case it was not to work for them at a certain state before the maturity of the investment.
And the risks
Same as anything else, there are hurdles on the way to achieving the paradigm shift in the industry promised by the wider adoption of DLTs/blockchain in the life cycle of investment funds.
The first obstacle that comes into play is one of perception and trust. The blockchain remains the DLT of bitcoin. The immediate association of blockchain with crypto currencies in general and specifically with bitcoin has acted as a deterrent in the wider adoption of this new technology. However, starting with Europe and then with UK, we are witnessing a recent movement where the DLTs/blockchain narrative has been divorced from the bitcoin and cryptocurrencies narrative. Authorities are overtly supporting regulatory frameworks where these new technologies can be tested, with the introduction of sandboxes and pilot regimes. Where the approach from authorities remains one of technology neutrality, authorities created the conditions and the environment for the markets to be able to test these technologies and decide which one shall be adopted to support the broader functionality of financial markets.
There are other sets of risks involved with investment funds tokenisation, like regulatory risks. This industry is still relatively new and regulation is still in an embryonal stage. Whilst the technology neutral approach of European regulators bodes well for the best technology to win, there are also investors interest to protect. It is too early to say whether ancillary regulation on privacy matters, for instance, will be introduced and the impacts on the evolution of the application of DLTs/blockchain to the investment fund ecosystem.
In addition to regulation, better yet the uncertainties about regulation, we also have risks related to the operational and technical functioning of DLTs/blockchain technology. In other words, in addition to perception and trust risks we also have reliability risks.
The nature of the networks, with the possibility for new flaws arising, as well as the possibility of hacking of the DLTs/blockchains are some of the main risks relative to the broader adoption of these technologies in the fund industry. The potential for hacking events, in one with other breaches to the DLTs/blockchain, comes with the risk of the public generally losing trust in this technology with consequent reluctance both from the side of issuers and buyers of tokenised investment funds.
Lastly, for DLTs and blockchain networks having a nature of peer-to-peer open networks, most of the development of these structures depends on the continued support of unpaid developers. Its functionality, instead, relies on the effectiveness of the validators and the mechanisms of consensus on these networks to ensure that invalid transactions are purged off from the networks themselves. Whilst we it is unlikely that DLTs and blockchains could cease to exist, their continued development is not necessarily guaranteed.
The first stage of investment funds tokenisation comes with the promise of creating additional avenues of distribution and new secondary market opportunities. The second level tokenisation, relative to the adoption of DLTs/blockchain in the dynamics of acquisition of the underlying investments by the fund vehicles themselves, is set to take the fund industry to the next level. Starting with the increased efficiencies in the securities settlement cycle.