Digital Assets: Tokenisation of investment funds

The UK leads the way, will others follow?

11 December 2023

8 min read

Asset Management in Focus - Edition 4

Welcome to Asset Management in Focus, a series which has been designed to give you an in-depth look into topics within the Asset Management sector. In our fourth edition, we will explore how transforming the investment management landscape will lead to a future of efficiency, transparency, and synergies.

The new Technology Working Group of the UK government's Asset Management Taskforce has said that UK funds have been given approval to develop tokenisation. The ‘Working Group’ established in 2023, published a roadmap for the adoption of distributed ledger technology in the UK funds industry.

Conor Moroney, a Director in KPMG’s Asset Management practice, summarises a vision of the future which the Working Group’s report – titled “UK Fund Tokenisation - A Blueprint for Implementation” – brings one small step closer. The report outlines a baseline model for the implementation of tokenisation that can be used within the existing legal and regulatory framework. It presents the initial phase of efforts to leverage innovative technologies within the UK asset management industry.

Overview of recent developments in the UK

In particular, the Working Group’s focus centres on the application of distributed ledger technology (DLT) through the tokenization of investment funds. This strategic initiative is poised to enhance efficiency, transparency, and the global competitiveness of the UK's investment management sector. The report articulates a shared vision for the future of the funds industry, envisioning a complete value chain operating on DLT. This entails utilizing digital forms of currency and identity, establishing synergies across the industry by seamlessly connecting individual investors with investible assets. The proposed model operates on a secure, trustworthy, and potentially decentralized settlement layer - a blockchain.

In close collaboration with HM Treasury (HMT) and the Financial Conduct Authority (FCA), the Working Group has crafted a blueprint for implementing the tokenization of UK investment funds. This blueprint harmonizes a shared vision with the practical challenges that must be addressed to bring it to fruition.

The recommended approach involves a phased implementation of fund tokenization, commencing with a foundational model that aligns with the existing legal and regulatory framework. Subsequent stages, evolving over time, may necessitate legislative or regulatory adjustments and could be influenced by broader technological advancements, such as the integration of digital currencies. The asset management industry is encouraged to contribute insights and perspectives to shape these subsequent stages, marking the second phase of their work scheduled for late 2023.

This collaborative effort between industry stakeholders and regulatory authorities signifies a transformative leap in investment fund innovation. By endorsing the tokenization of domestic funds, the UK demonstrates its openness to pioneering ideas. These developments increase the pressure on industry groups and regulators across other jurisdictions to progress their own local agenda, or risk being left behind.

Embracing Tokenization

Building upon the urgency and drivers identified by the Working Group, the report uncovers a realm of tangible benefits awaiting investment funds through tokenization. This section unveils the practical advantages, primarily centred around efficiency and speed.

Real-time Efficiency with Shared Record-Keeping

The envisioned transformation includes a real-time record-keeping system shared across all parties involved in servicing the fund. This innovative approach has the potential to eliminate the need for participants to reconcile fund data with a centralized register. Currently, the arduous task of daily and intra-day data reconciliation represents a significant level of activity and effort for each party, such as fund administrators. By removing this necessity, investors stand to benefit from the resulting cost and speed efficiencies realized by firms running and administering the fund through a digitally enabled back-office infrastructure.

Optimizing Settlement Profiles for Quicker Transactions

A crucial aspect of the benefits unfolds as tokenized funds optimize the settlement profile of underlying assets. This optimization promises quicker settlement capabilities for unit transactions. Currently, many open-ended funds operate on a settlement basis that is misaligned with the timing of underlying asset settlements. This misalignment, often presenting challenges with cashflows that require temporary funding, can be addressed through the flexibility offered by Distributed Ledger Technology (DLT). With DLT supporting settlement at various speeds, including near-immediate transactions, tokenized funds gain greater flexibility, reducing credit and operational risks amid increased pressures from reductions in capital market settlement timings.

Empowering Automation through Smart Contracts

The power of smart contracts takes centre stage in the future, enabling the scaling of automated processes such as distributions and corporate actions. These intelligent contracts operate via executable code driven by pre-defined and logic-based workflows. In the case of fund distributions, a pre-defined timetable provides the parameters for smart contracts to calculate and execute each investor's payment from or reinvestment into the fund. This not only streamlines processes but also issues customizable taxation and other reporting, marking a paradigm shift in fund servicing obligations.

Institutional Advantage - Token Collateral and Data Transparency

Some members of the Working Group underscore the benefits of allowing institutional investors to post their tokens as collateral. This strategic move proves particularly useful in thinly traded markets or times of stress, offering firms the option to temporarily post their interest in the fund to a counterparty rather than redeeming their position to raise cash. Recent transactions, such as the use of money market fund tokens as collateral between bilateral derivatives counterparties, exemplify the practical applications of this approach.

However, there are also several challenges that must be addressed for tokenisation to become a conventional feature of the asset management industry, which we have discussed in previous publications.

Unlocking greater transparency and future potential

Beyond immediate benefits, the Working Group highlights the potential for greater data transparency through embedding information within tokens themselves. This opens avenues for a direct route to investor information disclosure, including details about token holder rights and obligations, performance and voting data, or anti-money laundering information. The report hints at additional benefits and network effects that may emerge as the industry progresses. This could include real-time supervision and data reporting for regulators, easier ownership transfers between platforms, and engaged governance on portfolio assets through streamlined voting processes.

The Working Group has established a future state operating model for full fund tokenisation as a long-term goal. This ‘shared vision’ weighs up the varying options of tokenisation observed in other jurisdictions:

Opportunities	Description	Responsible party	Use case
Client Register	The register of end investors/beneficial owners	Investment platform/ distributor	Creating additional choice for investors when selecting digital funds marketplaces
Unit Register	The register of primary market investors/the platforms	Fund manager	Optimising fund inflows/outflows
Asset Register	The register of securities making up the fund’s portfolio	Custodian / Depositary	Optimising fund administration and potentially opening up new asset classes for investment

_{Source: UK Fund Tokenisation - A Blueprint for Implementation- Interim Report from the Technology Working Group to the Asset Management Taskforce}

The Working Group unanimously endorsed a collective long-term vision wherein each of these registers becomes accessible on a block-chain. This vision stands out as the optimal commercial use case, fostering synergies across the funds industry by seamlessly connecting individual investors with investible assets. This interconnected system operates on a robust settlement layer, ensuring security, trustworthiness, and the potential for decentralization.

While this shared vision represents the pinnacle of long-term aspirations, a consensus among most Working Group members acknowledged the necessity to align it with 'the art of the possible.' This pragmatic consideration arises from the recognition that the required investment and resources may be substantial. The prevailing sentiment within the Working Group leans towards a broad agreement that collaboration within the industry and with regulatory authorities is imperative to advance and reconcile these ambitions with practical realities. This collective approach is seen as fundamental for making tangible progress in the journey towards the envisioned future state.

Paving the future of investment fund innovation

The approval granted for the development of tokenization, coupled with the roadmap published by the Technology Working Group, marks the initiation of a transformative journey for the asset management industry in the UK.

The shared vision for the future of the funds industry, operating on a decentralized and secure blockchain, represents not just a technological advancement but a strategic imperative.

The tangible benefits awaiting investment funds through tokenization, as explored in the Working Group’s report, underline the potential for unprecedented efficiency, transparency, and global competitiveness. Real-time efficiency with shared record-keeping, optimized settlement profiles for quicker transactions, the empowerment of automation through smart contracts, and the institutional advantage of token collateral showcase the tangible advantages that lie ahead.

Beyond these immediate benefits, the Working Group’s foresight into unlocking greater transparency and future potential unveils a landscape where data transparency becomes paramount. The accessibility of registers on blockchain not only fosters synergies across the funds industry but also sets the stage for real-time supervision, streamlined governance, and enhanced investor information disclosure.

While the shared vision stands as the epitome of long-term aspirations, the acknowledgment of aligning with 'the art of the possible' underscores the need for collaboration within the industry and with regulatory authorities. A collective approach is not just a recommendation; it's fundamental for making tangible progress in the journey towards the envisioned future state which benefits the investor.

In endorsing the tokenization of domestic funds, the UK asserts its openness to pioneering ideas, setting a precedent that reverberates across European and US markets. The pressure on industry groups and regulators in other jurisdictions now grows, urging them not to lag but to lead in this transformative era of investment fund innovation.