The Evolution of Funds and the Potential of Tokenization

Written by Christiana Aristidou, Alexis Nicolaou

The first modern mutual fund dates back almost a century ago, in 1924 in the USA. Since then, the use of regulated funds has been a popular option for funding an investment project. A variety of funds exist catering to different investment objectives and strategies, each having different financial, management and reporting requirements.

An independent public supervisory Authority is usually responsible for the supervision of these investment vehicles. In Cyprus, this is the role of CYSEC (Cyprus Securities and Exchange Commission), which is responsible for the supervision of the investment services market, transactions in transferable securities carried out in the Republic and the collective investment and asset management sector.

Over the last decade, Cyprus has introduced and significantly developed attractive legislation on funds which is constantly being modernized offering ideal tools for building sophisticated fund structures.

There is an array of benefits to be reaped ranging from tax efficiency, cost efficiency, transparency, collective investment planning, pooling of investments, building economies of scale, professional management and administration, compartmentalization, and umbrella structures.

Types of Funds in Cyprus

The two types of funds used in Cyprus are Open Ended Undertakings for Collective Investments – the so called “UCITS” – and Alternative Investment Funds – the so called “AIFs”, with further subtypes (“AIFLNP”, “RAIFs”).

The formation and operation of these is based on the following legislation: (a) The Open-Ended Undertakings for Collective Investment (UCI) Law and (b) The Alternative Investment Funds Law, both as amended from time to time.

As mentioned previously, both types of funds have different management, administration, marketing, and reporting requirements. It is not the scope of this article to get into the detail of these requirements, but depending on the type of vehicle chosen, a decision will need to be taken on some or all of the following:

  1. Internally or externally managed
  2. Legal form of investment vehicle
  3. Hiring of qualified personnel
  4. Engagement of manager
  5. Engagement of Administrator
  6. Engagement of depositary
  7. Number and type of investors to target
  8. Marketing of Units
  9. Initial capital requirement

The Potential of Tokenization

Recent technological advancements have introduced new methods of fund raising, offering fund raisers and investors alike, increased options. Asset tokenization is a modern way of investing in real world assets. This revolutionary concept, made possible because of blockchain technology and smart contracts, has disrupted real estate and other traditional industries by offering investors access to fractional ownership of an asset, real estate property or other.

The Tokenization process involves the engagement of the services of qualified consultants with the relevant expertise in relation to this sector. This expertise should cover legal, business, technology, and digital marketing aspects of the tokenization process.

The legal governance of Security Tokens, which represent fractional ownership in real world assets, falls under Securities Law, making them a much more reliable and secure investment option than cryptocurrencies.

Tokenization usually involves higher upfront costs than the setting up of a fund, but much lower annual management fees, administration costs and reporting requirements, making it an attractive alternative to funds from both a cost but also administration perspective.

Tokenizing Funds

Fund owners and fund managers have as of recent started exploring the potential of tokenizing the fund, thus utilizing the benefits of blockchain technology. But what do we mean by a tokenized fund? And since funds comprise of many different moving parts, a question may arise as to what part of a fund will be tokenized and how will that be done. Furthermore, what will be achieved by tokenizing the fund? All are serious considerations that need to be addressed when it comes to fund tokenization.

There are potentially several ways to tokenize a fund.

One approach that currently seems to prevail is focused on tokenizing the units of the fund. Tokens in this case are issued and exist on blockchains comprising the register of tokens resembling the units of the fund that are registered in the register of units maintained by the transfer agent. The fund may now be described as Blockchain-enabled Fund (BEF); the units have been tokenized but not the underlying fund infrastructure.

Therefore, the fund continues to operate in the traditional way, under the relevant laws and regulations each time, i.e. with custodian, transfer agent, fund accountant, asset manager and distributor.

And a question may logically arise here, since the fund continuous its operations in the traditional way, what would the benefit of tokenizing the units be? The main benefits of tokenizing the units of a fund, as aforementioned, include increased liquidity, wider access to alternative assets, data integrity, heightened transparency, transferability, expanded operational efficiencies such as speed of settlement and greater automation. Another important benefit is that a token can be used to provide information to the token holders such as financial and ESG reporting as well as voting.

Another approach is to tokenize the asset(s) rather than the units of the fund. This approach seems to go much deeper as it focuses on the tokenization of the underlying asset. The asset is fractionalized and digitalized via tokenization. This essentially means fractionalization of ownership. As a result, there’s greater access to capital at a global scale on the one hand, increased liquidity, and access to assets with traditionally high barriers to entry on the other hand by both, crypto and fiat investors.

In this case the fund infrastructure changes, fund administration is enhanced by automation and analytics are made simpler. i.e. the traditional value chain encompassing custodian, transfer agent, fund accountant, asset manager and distributor is brought onto a blockchain system running as a platform.

Blockchain removes much of the friction that currently exists in asset management. In essence, an entire fund is set up and/or created and administered on blockchains, allowing increased efficiency, reduction of operating costs, and improved compliance.

Transparency is considerably increased, allowing for better relationships between the parties involved. Data (including pricing) being available to all at real time, i.e., running digitally end-to-end. The data are gathered and securely kept in one place, no longer need to be moved manually, and are being available to all at real time, i.e., running digitally end-to-end significantly boosting collaboration between providers, simplified investor communication and management and very importantly the speed of product development.