Tokenisation of investment funds: some legal challenges

This piece was originally published by Butterworths Journal of International Banking and Financial Law.

Much like the industrial and information revolutions before it, the Digital Assets revolution will fundamentally reshape the landscape of financial services. Everything we now know in financial services will be impacted. With the tokenised assets market projected to reach $18.9trn by 2033 (Ribble and Boston Consulting Group¹), this article explores some key legal issues arising from the tokenisation of investment funds.

Key Points

• The Digital Assets revolution will fundamentally reshape the landscape of financial services.
• Fund tokenisation has a multitude of benefits including near instantaneous settlement and administrative efficiencies.
• Digital assets are at a tipping point. There will be increased institutional adoption, broader use cases together with a mindset shift as people start to view blockchain as a fundamental part of the financial ecosystem.
• The law and regulation of digital assets will continue to develop and mature, building confidence and encouraging wider adoption.

Some concepts

Digital assets

We live in the digital age, and digital assets are an increasingly important part of digital life. The term digital asset is extremely broad and captures a huge variety of use cases. In this article digital asset means an asset that is represented digitally or electronically.

DLT and blockchain

There is no formal definition of distributed ledger technology (DLT). In simple terms, a distributed ledger is a digital store of structured data (hence ledger). This structured data may include transactions, records and other operations. The enabling technology system is the distributed ledger technology (hence technology). The distributed ledger might be replicated across a network of computers (hence distributed). Every DLT can have different attributes and functions, but each will have a pre-established consensus method for approving and validating ledger changes. The ledger, in the case of a blockchain iteration of DLT, consists of blocks of information. Any change to the ledger is made by adding a new information block to the existing blocks (hence blockchain).

Tokenisation

Tokenisation is the process of creating a digital representation of a pre-existing real asset. It has many uses cases, particularly in financial services. Tokenised Securities are issued and custodied traditionally but also converted onto a distributed ledger token that represents the underlying traditional security. In contrast, Security Tokens are issued and custodied at their inception natively on a distributed ledger only and therefore do not have an underlying traditional security.

Fund tokenisation

Investment funds are a prime tokenisation use case. An investor’s share (say fund units) is represented by a digital token recorded on a blockchain. Fund tokenisation has many benefits:

• All fund transactions take place on the blockchain, which holds the definitive record. Blockchain removes the need for separate reconciliations and record updates are almost instantaneous.
• Blockchain can facilitate near instantaneous settlement (atomic settlement).
• Simplified and stream-lined record keeping, removing the need for reconciliation, reducing the need for intermediation, and atomic settlement all reduce administration costs.
• Enhancements through blockchain mean that real-time reporting and data disclosure can be made to investors, brokers, counterparties and regulators.
• A blockchain can incorporate automation via smart contracts (ie self-executing actions programmed into the blockchain). Smart contracts also drive cost and timing efficiencies.
• Tokenised assets can be sub-divided (fractionalised) to a much greater extent than real world assets. For example, whilst there is a practical limit as to the number of co-owners of a gold bar, tokenised real world gold is already a commercial product.
• Tokenised investment funds offer investors greater personalisation potential. For example, a wider set of tokenised investments to mix and match into their personal portfolio. Greater administration efficiencies can also reduce investment minimums.
• Reduced costs, atomic settlement, smart contracts and greater personalisation all benefit liquidity which entails advantages for capital markets more generally.

Legal issues

Prior to DLT the structure of financial institutions, markets and instruments had – arguably – not materially changed since the advent of modern banking during the early Renaissance. This article explores some novel DLT legal issues.

Are there personal property rights in DLT?

Property rights in law are a fundamental tenet of jurisprudence. Property rights can (in principle) be enforced against the whole world. The owner of investment fund units, whether in the real world or digitally, needs to be confident that their assets are legally sound and protected.

Each major common law jurisdiction recognises that there are personal property rights in a digital asset on a public blockchain network. For example Australia,² Hong Kong,³ Singapore,⁴ and USA.⁵

This is also the law in England and Wales. In a recent (and newsworthy⁶) case⁷ the claimant sought to retrieve a computer hard drive from a Welsh landfill. The hard drive allegedly contained the private key to 8,000 Bitcoin (worth approximately US$800m at the time of the judgment). The claim failed. The judge found that the case concerned the ownership of the hard drive itself (not the Bitcoin) and the application of the relevant waste legislation. However, there are many interesting points of digital assets law. The case concerned cryptocurrency, but in our view applies more broadly to digital assets on a blockchain. The judgment found that digital assets are property, specifically a third category of personal property (in line with the Law Commission’s recommendation (see below)). And that a private key to access digital assets is information, confidential information.

There is less agreement between common law jurisdictions on the type of personal property right. The common law in England and Wales traditionally recognised two types of personal property:

(i) things (or choses) in possession; and

(ii) things (or choses) in action.

Things in possession are generally tangible things, whereas things in action are legal rights or claims enforceable by action. Colonial Bank v Whinney (1885) 30 (Ch) D. 261 held that there were only two, not three, categories.

The Property (Digital Assets etc) Bill⁸ is (at the time of writing) in the legislative process. If enacted, it would permit a third category thing (“including a thing that is digital or electronic in nature”) to have personal property rights in England and Wales.

The Law Commission⁹ recommended the existence of the third category, and drafted the Bill. The Law Commission’s reasoning included the fact that digital assets do not easily sit within the two existing categories and that the courts have already started to recognise a new category which better fits digital asset attributes. The Bill is permissive, and the courts would develop the third category.

As far as we know, the Bill is the first common law legislation to deal with a third category of personal property rights. There are strong and learned views on both sides of the debate as to whether there is a need for a third category and the consequences of permitting one.

A critique of the Bill is that it does not itself resolve any uncertainty. Development of third category law is left to the courts, which will necessitate the litigation of disputes with ensuant time, cost and delay. Whilst a fair challenge, this is how the common law has functioned since the early Middle Ages.

Justice Jackson’s (of the Australian High Court) unequivocal view¹⁰ is that there is no need to create a third category of personal property because Australian law already adequately provides for digital assets.

If digital assets have personal property rights, why does the type of right matter? This goes to how the law treats the different types of rights. For example:

• the taking of security;
• tracing, following or other attempted retrieval of digital assets;
• the operation of trusts;
• bankruptcy and insolvency; and
• succession on death.

In our view, digital assets will be fundamentally transformative in ways that we cannot currently conceive. The law will need commensurate novel concepts. The Bill, if enacted, will permit this to happen with very limited downsides.

Permissioned and permissionless blockchains

Each blockchain network can have different attributes and functions, including the consensus method for approving and validating distributed ledger changes; for example, the entry recording the ownership transfer (and thus owner) of a token on the blockchain (unit in the investment fund).

A permissionless public blockchain is an open and decentralised network. There is no central authority controlling the blockchain. The blockchain’s consensus methodology will be hard-wired into the computer code. Separate participants in different locations (nodes) each maintain a copy of a common ledger, proposing new transactions and verifying proposed transactions to be appended onto the ledger. Verification of transactions requires the consensus of participating nodes. Verified transactions form a record that is protected by cryptography so historical transactions cannot be altered. The blockchain is therefore said to be immutable. Block transactions will be visible to all participants although counterparty identity, as pseudonyms, is effectively anonymous. Ethereum is an example of a permissionless public blockchain with these attributes. Conventionally a blockchain “whitepaper” summarises its attributes including its consensus methodology (eg Ethereum’s whitepaper¹¹).

In contrast, a permissioned private blockchain’s key feature is its central authority. That authority determines the consensus of transactions, updates the blockchain and the blocks might not be visible to all participants.

For an investment fund, a permissioned private blockchain would mean that (say) the transfer agent is the consensus authority and determines when units have transferred. For a permissionless public blockchain investment fund, a consensus of nodes determine when units have transferred.

There has been a view that permissioned blockchains are “good” and that permissionless are “bad”, and that the decentralised nature of permissionless public blockchains can entail legal and regulatory lacunas. For example, which laws and jurisdiction apply to operations on the blockchain? Is an enforceable contract formed? If so, where and when? Is there settlement finality? Can a pseudonymous counterparty be identified? Can any rights be enforced against digital assets? Whereas permissioned private blockchains offer a panacea, for example with the fund’s offer document stipulating law and jurisdiction, identifiable counterparties (enabling compliance checks) and conventional enforcement rights.

The binary distinction is not apposite. Each blockchain (and applicable layers and/ or applications on it), permissioned or not, should be risk-assessed on its own merits.

Permissionless public blockchain risks can be managed by built-in controls, eg using certain Ethereum token standards, network-level credentialing, verifiable decentralised infrastructure, gas-free (zero transaction fees) blockchains and/ or by adding secure blockchain layers. As an example, the smart contracts underlying tokens on a permissionless blockchain may allow the token issuer (say the fund manager) to unilaterally cancel, correct, and amend transactions involving its governed tokens, thereby mitigating the risks associated with irrevocable transactions. Additionally, the smart contract has an ability to restrict the movement of its governed tokens (units in the investment fund) to permitted wallets (eg only pre-vetted potential fund unit-holders).

The use of public blockchains enhances interoperability (see below) and collaboration between financial institutions, to the benefit of customers.

Permissionless public blockchains can be compared to the public protocols of the internet and emails. In other words, permissionless public blockchain can be secured and risk controlled in the same way.

Permissionless versus permissioned is not a binary choice; a view increasingly shared by governmental bodies (eg the European Commission¹²) and industry (eg S&P¹³).

On-ramping and off-ramping

An on-ramp enables a person to convert fiat (ie real world) currency to digital assets for use on an investment fund blockchain. For example, person A wants to invest in a fund which runs on the Ethereum blockchain. Person A needs Ether (Ethereum’s digital currency). They convert US Dollars to Ether using an online cryptocurrency exchange. They use the Ether to purchase the fund units.

An off-ramp is the opposite. Person A sells their fund units and exchanges the Ether for US Dollars using an online cryptocurrency exchange.

On- and off-ramping plays a crucial role in bridging the gap – the transfer of value – between traditional financial systems (TradFi) and DLT-based systems.

There are different types of ramps. For example, centralised exchanges such as Coinbase or Binance, and decentralised peer-to-peer exchanges.

Fiat currency to digital asset conversion is currently a limiting factor in wider spread DLT investment fund adoption.

• Frictional TradFi systems: on- and off-ramping currently often relies on traditional financial market infrastructure (FMI) which entails time delays and cost. Person A transfers US Dollar fiat currency from their real world bank account to the crypto exchange’s real world bank account using (so called) traditional plumbing.
• Lack of interoperability: blockchains often use different value-exchange protocols. For example, to move from an Ethereum-based investment fund to a Solana blockchain-based investment fund, person A would need to exchange Ether for SOL (Solana’s digital currency).
• Settlement risk: any FMI entails some settlement risk. TradFi has sought to reduce the risks (eg the EU’s Settlement Finality Directive). Blockchain lacks this protection. An unbacked cryptocurrency relies for value on its supply and demand. Whereas a fiat currency is supported by a Central Bank’s full faith and credit.
• Legal and regulatory: although the blockchain eco-system is increasingly regulated, users of on- and off-ramps can face issues. For example, person A having sold their Ethereum-based units, and exchanged Ether for US Dollars, seeks to transfer fiat currency to their bank account. Their bank refuses to accept the transfer for anti-financial crime concerns.

Central bank digital currency (CBDC) is money that a country’s Central Bank issues in digital (rather than physical) form. Crucially, CBDC is backed by the full faith and credit of the Central Bank. CBDCs will greatly streamline the digital assets lifecycle. In our example, person A would use CBDC currency to buy Ether-denominated fund units.

The aspiration is complete interoperability; a system where digital value can be exchanged instantly, without friction and with minimal cost. There are many initiatives in progress to promote and develop interoperability. For example, fostering tokenisation interoperability is an objective of the Monetary Authority of Singapore’s Project Guardian.¹⁴ The European Commission¹⁵ notes the ability of public permissionless blockchains to foster interoperability.

A blockchain bridge is a technical commercial solution to facilitate a level of interoperability between different blockchains. Each bridge uses a different process. Person A wants to exchange Ether for SOL to invest in a Solana-based investment fund. Person A uses a wrapped token bridge. This means person A’s Ether is locked on the Ethereum blockchain and in exchange SOL is minted (created), which person A uses to buy the Solana fund units. If person A wants to return to Ethereum, the SOL would be burnt (destroyed) and person A’s Ether unlocked. Each bridge methodology has its own advantages, risks and fees. Bridges are a stop-gap, not a risk-free panacea.

A stablecoin is a cryptocurrency which aims to maintain a stable value relative to a specified asset. For example, a US Dollar stablecoin would seek to maintain parity with fiat US Dollars. Although lacking a CBDC’s Central Bank guarantee, each stablecoin will have a parity stabilising mechanism (with consequent degrees of risk). For example, off-chain stablecoin collateralisation is supported by real world assets on traditional finance rails. The devil is in the detail: is there full parity collateral, how is it held and by whom, who has rights of enforcement etc? On-chain collateralisation provides stablecoin stabilisation with digital assets. Whilst off-chain collateralisation is not risk-free, TerraUSD’s May 2022 failure demonstrates some on-chain collateralisation pitfalls.

Following President Trump’s January 2025 ban¹⁶ on a US Dollar CBDC, stablecoins will play an important role in the short to medium-term digital asset ecosystem filling the USD CBDC gap.

Digital identity

Anti-financial crime (AFC) processes are a cornerstone of financial services sector compliance. The digital assets ecosystem can be particularly exposed to the potential of financial crime.

AFC is vitally important; however, it can be a manual and time-consuming process. Digital identities can facilitate a faster, secure and less cumbersome process.

DLT offers a technological solution. For example, using zero-knowledge proofs (ZKP). ZKPs are cryptographic tools that allow one party (say the fund’s potential unit-holder) to prove to (say) the fund manager that something (the client’s identity) is true without revealing any information beyond the truth of that statement.

The European Union has adopted the European Digital Identity.¹⁷ It will use advanced cryptographical and interoperability standards, but is not fundamentally based on blockchain technology as a core architectural component.

The United Kingdom is adopting a non-DLT or cryptographically based digital identity and attributes trust framework. Users and businesses trust a certified service provider to be private, secure and reliable.

Where to from here?

Digital assets are at a tipping point, moving from niche or marginal use to widespread adoption and mainstream acceptance. There will be increased institutional adoption, broader use cases together with a mindset shift as people start to view blockchain as a fundamental part of the financial ecosystem. Law and regulation will continue to develop and mature, building confidence and encouraging wider adoption.