UK regulation is ‘technology neutral’ – but the asset management industry needs more clarity for the benefits of fund tokenisation to manifest, say Steven Lightstone and Robert Mailer of Morgan, Lewis & Bockius.
In recent years, technology has played a significant role as a driver of change in the funds industry, and this is set to continue at pace. The tokenisation of funds has the potential to transform how funds work.
A tokenised fund is a fund that issues digital tokens representing interests on a distributed ledger, meaning the tokens can be traded and recorded on the distributed ledger. A distributed ledger is broadly a decentralised database of transactions managed across a shared network, enabling investors to see holdings in real time with ledger updates occurring live as transactions occur on the network.
A tokenised fund could be structured as an open-ended or closed-ended fund, although tokens are freely tradable once issued, regardless of whether they are open-ended or closed-ended. With the exception of how the ownership of interests is represented, there is not much difference between investing directly in traditional fund interests and owning tokens representing interests.
Potential benefits of tokenised funds are:
Increased liquidity and accessibility: Tokens could potentially be traded more easily in secondary markets and enable investors to hold fractional interests in funds, allowing for invested amounts and holding periods to be reduced.
· Increased transparency: Tokens could store information on the ledger, such as information on investors’ identities, percentage holding, rights/obligations, and information on environmental, social, and governance risks to facilitate investor reporting.
More operational efficiencies and automation: Smart contracts could be embedded in a token to provide for more automation, e.g., to prevent it from being transferred to an individual not eligible for regulatory or other purposes and to automate the payment of distributions.
‘Technology neutral’ regulation
Regulation in the United Kingdom is technology neutral, meaning tokenised fund interests should generally be treated the same as traditional fund interests from a regulatory perspective. Tokenised fund interests would be “security tokens” under the UK Financial Conduct Authority’s (FCA’s) cryptoasset classification if they provide rights and obligations akin to traditional fund interests and, as such, would fall within the existing UK regulatory regime for fund interests.
However, while the FCA is technology neutral, it is keen to promote innovation, and the UK government last year announced plans to become a “global hub” for cryptoasset technology and investments, creating a new regulatory framework for cryptoasset businesses. It generally expects the continuation of the current treatment of cryptoassets that are security tokens already qualifying as “specified investments,” which would include tokenised fund interests, but expects there may be some amendments over time, such as updates to the custody obligations for security tokens.
Government call for evidence on DLT and tokenisation
The UK government has acknowledged that the tokenisation of traditional securities could have substantial implications for the manner in which assets are traded or capital is raised following its call for evidence in 2021 on tokenisation and distributed ledger technology (DLT).
Respondents considered that the existing legislation provides a good starting point but that regulatory certainty is needed through the provision of guidance and early amendment to rules where regulatory obstacles are identified.
The government said it would work closely with the Bank of England, the FCA, and the industry to consider what changes may be necessary and whether additional guidance or legislation is needed.
FCA Discussion Paper on Improving Asset Management
The FCA published a discussion paper in February 2023 on improving the UK asset management regime wherein it dedicated a section to fund tokenisation, which it understands as the ability to issue a fund’s rights of participation as digital tokens, usually by a distributed ledger.
The FCA is seeking to understand (1) the benefit of tokenised units in authorised funds for investors, (2) what regulatory changes are needed to enable the issue of tokenised units, and (3) the priority it should put on enabling the tokenisation of units. Responses were requested by May 22, 2023, and the FCA will publish a feedback statement later in 2023. Depending on the response, the FCA will consider whether rule changes are needed.
Legal certainty and the future
The UK Jurisdiction Taskforce of LawtechUK, a government-backed and industry-led group, helpfully recognises cryptoassets (such as tokens) as property and smart contracts (that can be embedded in tokens) as enforceable under English law. However, there are still issues in relation to the validity of smart contracts, available legal remedies if rendered defective due to error, and how the contracts are to be interpreted by the courts.
Further, the regulatory and legal framework for crypto assets is evolving quickly around the globe, and as such, there could be a lack of regulatory and legal certainty for tokenised funds in certain jurisdictions. Against this backdrop, it is naturally important to consider how contractual arrangements for tokens are to be documented. If trends continue, tokenised funds could become an increasing fixture of the investment funds landscape.
*Steven Lightstone and Robert Mailer are partners at law firm Morgan, Lewis & Bockius LLP.
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