The Investment Association (IA) has published a report with a blueprint for implementing the tokenisation of UK investment funds.
The report recommends a phased approach to achieving the ultimate goal of the full investment value chain operating on distributed ledger technology (DLT) via a series of incremental stages.
The report is the product of the first stage of this work, and sets out a baseline model for fund tokenisation which could be used within the existing legal and regulatory framework. In this model, the only changes relative to a typical UK investment fund operating today are in the deployment of DLT in the registry and transaction functions. A private, permissioned chain would act as the master record for the fund unit register. In other words, the fund would be highly recognisable and consistent with mainstream funds that exist today, while utilising DLT for sales and redemption transactions and acting as the register of holders.
Future stages of work may require legislative or regulatory rule changes, which are considered below, along with some of the practical challenges to fund tokenisation.
Legal considerations
1. Digital assets
In the case of funds, the digital assets can be interests in the fund or assets held by the fund. Questions of ownership, title, delivery and categorisation follow from this status. The Law Commission has proposed legislation to affirm the current common law position, asserting that digital assets are subject to personal property rights.
There is also a need for clarity regarding the legal treatment of collateral arrangements concerning tokenised securities. The Law Commission recommends statutory amendments to the Financial Collateral Arrangements Regulations to provide explicit clarification in this regard.
2. Companies
The UK Companies Act 2006 (CA) does not inherently permit the existence of shares on a blockchain. In practice, tokenisation projects generally split legal and beneficial title, with the beneficial title held on-chain and the legal title held by a nominee.
The CA poses potential obstacles to tokenisation of shares and corporate securities, particularly in the maintenance of members' registers.
- Section 113 (formalities of registers of members) should be clarified such that references to a ‘register’ include digital or electronic form.
- Section 770 (instruments of transfer) should be modified such that any transfers via a financial market infrastructure in the Digital Securities Sandbox can be regarded as consisting of a proper instrument of transfer.
- Section 783 (title to securities) and other references to securities should be clarified to include securities issued/traded/settled/maintained inside the sandbox.
- Section 1134 (company records) requires modification to treat records ‘kept by a company’ as including those stored and maintained in digital or electronic form on a decentralised ledger within a financial market infrastructure.
Amendments to the CA, and related legislation, are necessary to formally acknowledge electronic ownership and title within DLT infrastructure. The Financial Services and Markets Act 2023 permits the alteration of legislative and regulatory frameworks by giving authority to HM Treasury to propose that temporary modifications permitted under Financial Market Infrastructure sandboxes, such as the Digital Securities Sandbox, become permanent.
3. Open-Ended Investment Companies (OEICs)
The OEIC Regulations pose potential obstacles to tokenisation. Like the CA, they do not inherently permit the existence of shares on a blockchain. In practice, OEICs have not to date been conventionally used in tokenisation projects.
- Clause 4(1) of Schedule 2 outlines provisions required in the Instrument of Incorporation, including in relation to "(c) the maximum and minimum sizes of the company's capital." This does not expressly require an OEIC to have traditional share capital.
- Article 46 sets out an obligation to issue share certificates. Article 47, however, exempts certain scenarios from this requirement, including cases where the company's instrument of incorporation explicitly states that share certificates will not be issued, and alternative procedures for verifying a person's entitlement to shares are outlined.
- Schedule 3 sets out expectations regarding the Ownership Register. Registration details must be administered at the network onboarding level, with the Transfer Agent serving as a recipient of data. If two Shareholder Registers are maintained (one conventional and one on DLT) it is necessary to establish and agree upon the contractual relationship to facilitate this process.
Regulatory considerations
1. Central Securities Depositories Regulation (CSDR)
All admittances to a trading venue require admission to a CSD per the UK Central Securities Depositories Regulation (CSDR). Adding a digital security to a non-digital CSD results in the digital representation being transitioned back to traditional structures. Consequently, consideration is needed on the extent which these requirements can be adapted to account for DLT. References to ‘accounts’, ‘book entries’, ‘credits’ and ‘debits’ in current legislation and regulation need fixing to refer to a digital medium in many DLT arrangements, e.g. where there is no legal operator capable of being authorised as a CSD.
2. FCA Handbook
Some language and terminology in the FCA Handbooks may require modification to accommodate tokenised securities. Regulations should indicate that books and records, encompassing both investor and asset holding records, can be stored on DLT infrastructure, given its capability to effectively segregate data and ensure data sovereignty for participants. There should be no requirement specifying that storage must be physically separate.
- COLL: Classes of units (3.3.2G) and Rights of unit classes (3.3.5R). Where tokenisation occurs at the share class level, firms must bear in mind requirements of these rules and should not provide advantages to holders of a tokenised class which prejudice other unit holders or avoid changing relative rights of holders.
Proposals for unit classes should:
(a) not provide advantages which prejudice other unit holders;
(b) be capable of being explained clearly to prospective investors in the prospectus; and
(c) should not appear to be contrary to the purpose of any part of COLL.
Rights of unit classes are not anticipated to change due to tokenising funds. Notably, the class of tokenised shares would need to be prescribed in the Instrument of Incorporation and Prospectus.
- COLL: Contents of the Prospectus (4.2.5.5(d)). At this stage it is unclear how a firm would describe within its Prospectus how it would cater for one-sided transactions such as mandatory redemption, cancellation or conversion of units from one class to another. Under DLT consensus mechanism, transactions are generally validated by both parties before being finalised.
- COLL: Approvals and notifications (4.3). When a firm decides to tokenise an existing share class or sub-fund, it would need to consider whether this would be substantial enough to be classified as a ‘significant’ change or other lesser classification. Expectations in this regard should be clarified.
- COLL: Sale and redemption (6.2.16) and Title and registers (6.4). If wholesale changes to regulation are required, these areas may be impacted. However, the rules do not conflict with a tokenisation model in which the transaction and registry functions would no longer be fully under the control of a centralised entity.
Practical considerations
1. Money Laundering Regulations (MLRs)
The report notes that the FCA is exploring whether it could more quickly determine MLR registration applications for firms already authorised by the regulator.
The registration process for the cryptoasset AML register takes approximately 9-12 months for established companies. While the FCA considers scenarios where an applicant is already authorised for other activities, it does not explicitly suggest a streamlined process for such applicants.
2. Availability of banking services
Regulated firms providing services related to tokenisation and DLT face challenges in accessing banking services from major UK banks. This impediment may hinder innovation in the UK and pose potential risks to consumers, forcing these firms to resort to lower-tier banks. The industry recommends the government to consider whether further action on access to business accounts is necessary.
3. Availability of digital cash solutions
Digital cash is more efficient and allows for settlement of securities transactions to occur on-chain, by directly linking the transfer of ownership of the token with payment. The UK has existing regulations for electronic money and payment services, and the prospect of a digital pound is under consideration. Phase 1 of the Future Financial Services Regulatory Regime for cryptoassets has adopted amendments to establish a stablecoin framework.
Industry will decide upon the optimal form of digital money for fund settlement and will explore the possibility of leveraging the Bank of England’s work on Synchronisation to engage wider industry access to the Real-Time Gross Settlement service and enable funds settlement in digital central bank money in the upcoming years.
4. Availability of digital identity
Secure identity data capabilities ensure a more efficient and digital solution for customer due diligence, which is currently documentation-heavy and fragmented. The Working Group recommends that government supports building awareness of the digital identity legal framework set out in the Data Protection and Digital Information Bill, including the trust framework. Industry adoption should be encouraged.
This article was first published in Thomson Reuters on 1 December 2023.
