In recent weeks we have seen the launch of the first tokenised UK authorised fund. It is a significant milestone and one that brings both renewed interest in the potentials of tokenisation but also queries as to what a tokenised fund looks like in practice. 

Here we provide a high-level overview of the key operational mechanics and considerations for a tokenised UK authorised fund and its manager. 

Shares or Tokens

Compared to a traditional UK authorised fund that issues a conventional share (sometimes accompanied by a certificate), a tokenised fund issues “tokenised” shares (or Tokens) each of which is a digital representation of a conventional share. 

The Tokens are recorded in the register maintained by the registrar. However, instead of maintaining the register in traditional book-entry form, the register is maintained via a proprietary blockchain-integrated system that utilises features of traditional book-entry form and one or more public blockchain networks (e.g. the Ethereum Network). 

A blockchain is an open, distributed ledger that records transactions between two parties in a verifiable and append-only manner using cryptography. Transactions on the blockchain are verified and authenticated by computers on the network. The process of authenticating a transaction before it is recorded ensures that only valid and authorised transactions are permanently recorded on the blockchain in collections of transactions called “blocks.” 

The blockchain stores the complete transaction history from the dealings in the Tokens, and the data on the blockchain is available to the public. As a result, robust and transparent data, other than the personal information of the tokenholder, will be publicly available through one or more “block explorer” tools capable of displaying activity on the applicable blockchain network(s). Accordingly, the Tokens’ issuance and redemption data (but not a tokenholder’s personal information) will be exposed to the public. The personal information necessary to associate a given Token with the relevant tokenholder will be maintained by the transfer agent in a separate, traditional database that is not available to the public.

The authorised fund manager of a tokenised fund will need to choose a blockchain network to run the fund on. Ethereum appears to be the preference as a widely known blockchain network. The registrar appointed to a tokenised fund will need to have the capabilities to work on the chosen network. 

Digital wallets

To hold Tokens directly an investor must have a “digital wallet” on the same blockchain network as the tokenised fund. A digital wallet stores a user’s “private key” and related digital assets (including Tokens) and is used to facilitate the transfer of assets on a particular blockchain. Popular providers of digital wallets include Metamask and Coinbase and it is for each investor to be aware of and understand the advantages and disadvantages of each digital wallet. 

A private key is used by the owner of a digital wallet to send instructions to the blockchain to update the ownership records of the digital assets (including Tokens) and is private to the digital wallet owner, while a corresponding “public key” is public and allows other digital wallets on the applicable blockchain to transfer digital assets (including Tokens) to a digital wallet’s public key address when permitted. 

When a private key is stolen or lost, the digital wallet is compromised and the digital asset holdings linked to that digital wallet (which will include any Tokens in that digital wallet) could be inaccessible to the digital wallet holder and/or subject to the risk of misappropriation.

It is likely that Tokens will only be able to be transferred to “whitelisted” permissioned parties and with the underlying record of ownership, the risk of misappropriation is reduced if an investor has their digital wallet compromised. 

Investors who do not wish to hold Tokens in a digital wallet must appoint a third party digital asset custody provider who will hold the Tokens in their digital wallet on behalf of the investor. 

Registrar and transfer agent 

A specialist service provider for tokenisation, register maintenance and KYC/AML checks should be appointed as the registrar and transfer agent. It is possible that existing registrars/transfer agents will develop the necessary capabilities to handle tokenised funds and each authorised fund manager should carry out their own due diligence before selecting an appropriate service provider.

The transfer agent should maintain controls to correct errors or unauthorised transactions on any blockchain utilised by its proprietary blockchain-integrated system. In the event such a correction was warranted, the transfer agent would make the correction by adding an appropriate instruction to another subsequent block on the applicable blockchain (i.e., the prior activity on the blockchain would not be deleted, although the blockchain would be appended with the correct transactional history).

Dealing

It is possible that the chosen transfer agent can act as an intermediary for the tokenised fund with request for deals in Tokens being made through their online platform. As with conventional share purchases, investors should still have their cash for subscription in place in order for the transaction to be submitted. 

Investors will need to provide information to allow the transfer agent and the authorised fund manager to complete relevant anti-money laundering checks and may also be required to provide details of their digital wallets. 

Fees

Public blockchain networks require the payment of certain transaction fees to validate a transaction on the applicable network (known as “gas fees”). These fees are typically paid in the native digital asset for the operation of the blockchain network. Such transaction fees are intended to protect the blockchain from frivolous or malicious computational tasks and to remunerate those persons who act as validators to maintain the integrity and security of the blockchain network infrastructure. 

These transaction fees will typically be the responsibility of the authorised fund manager, however, the authorised fund manager may choose to meet these charges from the fund’s scheme property (albeit with appropriate disclosures to investors).

Risk factors

Whilst there are clear positives of a tokenised fund, there are risk factors that need to be considered and disclosed to investors if applicable to the tokenised fund. For example:

• distributed ledgers: the integrity and security of a blockchain network may be compromised by malfunctioning nodes or errors in the underlying source code, as well as by advancements in mathematics or technology (such as digital computing, algebraic geometry, or quantum computing). In extreme cases, such issues can lead to the complete failure of the blockchain network, and loss of information and assets (including Tokens);
• public permissioned blockchain: while personal data will not be available for public view on the network, investors should be aware that transactions are visible. If an investor discloses their address to anyone, they should be aware that people may ascertain their investment transactions and positions; 
• emerging technology: while distributed ledger technology (DLT) and blockchains are well established, there is a risk that use of DLT systems and blockchain technology may not be widely adapted in the future. This may mean that Tokens on a blockchain may be difficult to transfer to another person, as they would need to hold a digital wallet with access to the appropriate blockchain. 
• security breaches and faults: malicious actors may manipulate blockchain networks and smart contract technology, creating similar disruptions and potentially resulting in losses for investors; 
• malfunctions, technology failures and updates: malfunction of the transfer agent’s platform may have adverse consequences on the settlement, registration and transfer of Tokens;
• control of digital wallets and private keys: the ownership and transfer of digital securities, including Tokens, relies on safeguarding private keys to digital wallets to prevent unauthorised transfers. Only the owner of the private key will have access to and control over the Tokens. The loss, theft, or destruction of the private keys may be irreversible; 
• legal uncertainty: while English law applicable to securities is well-established, the issuance and transfer of digital securities (such as Tokens) and the legal aspects of the tokenisation of funds remain somewhat uncertain, and no court decision has yet been published on the topic. Disputes regarding certain aspects of the acquisition and transfer of tokenised securities in the form of Tokens, for example, the validity of transfers, cannot therefore be excluded. If a court were to decide that a transfer on the relevant DLT is not sufficient to transfer the rights and obligations associated with tokenised securities, the validity of transfers of the Tokens effected by transferring the relevant tokens on a DLT may be challenged; 
• regulatory risk: the integration of DLT into financial products is a recent development, and the regulatory frameworks governing its use in the financial sector are evolving. Regulatory changes at both national and international level are anticipated, and actions restricting the authorised fund manager’s use of the technology cannot be ruled out; and
• environmental impact of DLT systems: there is a perception that DLT systems are not an environmentally sustainable technology by being energy intensive. 

We hope this has been a helpful overview of the key operational mechanics and wider considerations when launching or converting to a tokenised fund. We would be delighted to discuss further with any clients the specifics of tokenising a fund, including approaches to the FCA and the requisite documentation to put in place.