By Marc Piano
Blockchain, smart contracts and virtual assets (together, DLT) can automate and digitise investment fund operations. Fund operators may want to take a close but careful look at harnessing DLT as regulation of the sector accelerates and central bank digital currencies become a reality.
“Innovation” for investment funds typically means investing in innovative companies, innovative investment strategies, or innovative investment assets. Increasingly onerous legal and administrative burdens placed on investment funds mean innovation rarely extends to the fund vehicle itself.
Despite failed predictions of DLT causing immediate upheaval in the financial services sector, global regulatory bodies and national governments are rapidly developing legal and regulatory frameworks bringing DLT into mainstream oversight.
The direction of travel appears clear: DLT could power significant efficiencies in financial services and will be regulated accordingly. Even as DLT development continues, the focus has shifted from experimentation to practical application.
Meanwhile, central banks around the world look set to introduce central bank digital currencies (CBDCs) in the medium term, which may fundamentally alter society and the economy.
Practical legal and regulatory guidance
Against this backdrop, the UK Law Society published the English law-focused “Blockchain: Legal & Regulatory Guidance” report[i] in September 2020. The report considers general legal and regulatory issues around DLT in-depth and offers practical guidance for stakeholders. The topics range across smart contracts, data protection concerns, DLT dispute resolution mechanics, and regulatory and tax treatment of virtual assets.
Investment funds operators curious about DLT and its potential for investment funds will benefit from reading the report and its analysis of issues, which may be similar in other jurisdictions.
Virtual assets are digital representations of value and their transfers between parties are immutably recorded on a blockchain or distributed ledger. They are sometimes known as cryptocurrencies or virtual currencies, both of which are misleading terms as virtual assets are not nor intended to be representations of fiat currencies issued by national governments or authorities. Virtual assets do not exist outside of their recording ledger.
Tradeable virtual assets (such as Bitcoin, Ethereum and others) as an investable asset class is a topic of already abundant commentary. Investment decisions around virtual assets will always fall to the risk profile and investment strategy of a particular fund and its managers and advisors. Subject to local law and regulation, an investment fund could accept and make distributions in virtual assets. The rapid development and current popularity of decentralised finance – an article in itself – may offer investment managers alternatives beyond ‘buy and hold’ for virtual asset investment strategies.
Virtual assets as representations of equity interests in fund vehicles, and the potential for significant transaction efficiencies when combined with smart contracts fully or partly automating a fund’s operational documents, has received significantly less attention.
Smart contracts and legal contract digitisation
Smart contracts warranted specific attention in the Law Society’s report and will be of most interest to fund operators. These are containers of self-executing code deployed on a blockchain or distributed ledger which can self-escrow and treat virtual assets in accordance with pre-coded instructions; create, distribute and remotely destroy their own virtual assets; and access and act on third party data sources. These features make smart contracts a practical vehicle for carrying out legal transactions, as the agreed terms can be reflected in code and are not subject to misinterpretation.
Paper legal agreements – such as the constitutive or subscription documents of a fund – are capable of being converted into a smart contract. Any or all of its provisions can self-enforce without further human intervention if desired. However, the code is not the law: smart contracts are still subject to the laws and regulations of the relevant jurisdictions, which may be those of the contracting parties or the parties responsible for or otherwise benefitting from the smart contract.
ISDA’s project to partially automate its product suite through smart contracts is one example of this process cited in the report[ii], known as “digitisation”. Digitisation is a project not to be undertaken lightly and a careful balance is needed between automation efficiency and commercial flexibility[iii].
Potential for funds
What follows are hypothetical possibilities.
Virtual assets representing fund equity interests
Some jurisdictions, such as the Cayman Islands, are introducing legislation recognising equity interests in investment fund vehicles represented by virtual assets[iv]. This can open up new ways to operate an investment fund.
For example, a smart contract representing a digitised subscription document could be instructed – or access third party data (such as anti-money laundering documents and checks) that confirms – that an investor has made a capital commitment having passed all commercial and regulatory prerequisites. The smart contract can then immediately issue a tokenised fund equity interest to the investor.
If a fund digitises the terms of its offering or constitutive documents as well as its subscription documents, these smart contracts can interact with each other. The tokenised equity interests can then be subject to rules and restrictions on transfer and redemptions.
Issue, transfer and redemption of tokenised equity interests all generate data which can be used to automatically maintain registers of equity interest holders. Transactions involving the interests, such as distributions, can also benefit from automatically-generated data. Alternatively, the data can be made available in encrypted form to a fund’s operator or service provider.
Valuation policies could be digitised and allow reports to be automatically generated using external data provided to or accessed by the contract at the agreed reporting dates. Where a fund holds virtual assets tradeable 24 hours a day, the smart contract can calculate valuation by reference to external market data to provide live NAV. The smart contract can rapidly distribute these to stakeholders (such as the investment manager, operator, auditors and equity interest holders) when appropriate.
If a fund’s valuation policy offers significant latitude for discretion in valuation, the party responsible for valuation can feed any adjustments into the smart contract. This data cannot be retrospectively altered, which can result in transparency and reduces the risk of disputes.
If there are any valuation disputes, the smart contract could invoke an agreed waterfall of dispute resolution mechanics. These could include both parties negotiating “off-chain” and entering agreed valuation data into the smart contract, or instructing agreed experts to issue a binding decision reflected in amended smart contract valuation data.
If an equity interest holder seeks to exercise excuse rights, a legal opinion could be validated by the fund operator and confirmed to the smart contract. The smart contract can then adjust capital contribution allocations for the investment among the remaining investors and provide this data to the fund operator.
Should an equity interest holder choose or is required to withdraw from the fund for legal or regulatory reasons, the withdrawal process can be activated through the smart contract, which can record all steps in the process including recording the existence of relevant documents outside of the blockchain through a unique and unalterable identifier (known as a hash). If any recalculations of distributions or redemptions are required, these can be provided to the smart contract which can then automatically update relevant registers and records maintained by it.
If an equity interest holder defaults on a capital contribution, an operator usually has a range of remedies. This is one element where full automation may not be desirable so as to retain operator discretion depending on the circumstances of the default. Either way, the “off-chain” actions could be posted to the smart contract, and if any restrictions must be placed on the limited partner’s tokenised equity interest, or the interest is surrendered or transferred, the tokenised equity interest can be frozen, transferred or destroyed and reflected in the relevant register.
Central Bank Digital Currencies
CBDCs are described by the Bank of International Settlements as: “a new form of digital central bank money that can be distinguished from reserves or settlement balances held by commercial banks at central banks. There are various design choices for a CBDC, including: access (widely vs restricted); degree of anonymity (ranging from complete to none); operational availability (ranging from current opening hours to 24 hours a day and seven days a week); and interest bearing characteristics (yes or no)”[v].
Nearly 80% of the world’s central banks are considering issuing some form of digital currency.[vi] It is possible that CBDCs will not use the DLT technology stack. However, if CBDCs do, digitised fund operations could access and use CBDCs to accept subscriptions, make distributions and pay redemptions directly on tokenised fund interests. This raises the possibility of an entirely digitised and automated investment fund operation, including making investments and receiving returns directly using CBDCs.
CBDCs may lead to entirely cashless societies and economies where every transaction is potentially trackable and automatically taxable. Aside from addressing current issues around criminal use of assets, questions arise as to privacy, the role of financial institutions and economic access. For fund operators, however, CBDCs could interact with digitised fund operations, hasten transaction flows and allow new investment strategies.
Legal and regulatory considerations
Numerous legal obstacles must be addressed in any digitisation of fund operations.
Global regulatory acceleration
Jurisdictions and global bodies are rapidly developing recommendations for regulation of DLT. For example, the Financial Stability Board published high-level recommendations for regulation, supervision and oversight of “global stablecoin” arrangements[vii]. Stablecoins are virtual assets seeking price stability through being asset-backed, pegged to an existing fiat currency or using algorithms to adjust supply.
Dencentralised finance activities may also become subject to regulation in the near future.
Financial Action Task Force (FATF) Guidance for virtual assets
As noted in the Law Society report: “Current FATF Guidance on a risk-based approach to virtual asset activities or operations and virtual asset service providers may apply to some stakeholders, parties or counterparties where smart contracts are used to effect legal transactions involving the transfer of virtual assets. In particular, relevant platforms and service providers may be deemed to be virtual asset service providers and fall to be regulated (for AML/CFT purposes at a minimum) by a relevant financial services regulator”[viii].
In practice, many jurisdictions now apply local anti-money laundering and countering the financing of terrorism (AML/CFT) regulatory obligations to any business activities involving virtual assets, including operations of investment funds. At a minimum, these likely require fund operators undertaking customer due diligence on investors subscribing for a tokenised fund equity interest, as this is no different in practice to subscribing for a non-tokenised fund interest.
Fund operators must be alive to any potential additional local requirements, such as higher beneficial ownership verification thresholds. These considerations are particularly important for a fund operator looking to use a third party automated AML/CFT offering.
Whilst smart contracts could access and record AML/CFT documents and data on investors and transactions, the fund remains responsible for compliance. A fund’s operator must be fully satisfied that AML/CFT obligations have been discharged and evidenced before any automated subscription process triggers.
Local regulatory frameworks
Some jurisdictions may have local virtual asset legal and regulatory frameworks.
Popular offshore jurisdictions for investment funds take different approaches. The Cayman Islands passed a law in 2020 creating a full registration and licensing regime for virtual asset service providers[ix]. In contrast, the British Virgin Islands Financial Services Commission issued guidance on the regulation of virtual assets in July 2020[x]. Both jurisdictions approaches are good examples of the proactive approach taken by financial services regulators in offshore jurisdictions, who recognise the legitimacy of and investment interest in DLT and seek to provide regulatory certainty consistent with their global positioning in the investment funds market.
Fund operators should generally consider local laws and regulations around not only virtual asset activities but also securities laws, particularly if they are looking to tokenise their equity fund interests, and take legal advice at an early stage.
As at publication, DLT is enjoying a resurgence following two years of relative stagnation. Whatever the reasons for this, DLT can now offer tangible benefits for fund operators seeking efficiencies in fund operations as well as offering a wide range of new investment assets and strategies. However, fund operators need to carefully consider the implications of automation against a rapidly evolving regulatory landscape.
About the Author
- [i] Law Society – Blockchain: Legal & Regulatory Guidance: https://www.lawsociety.org.uk/topics/research/blockchain-legal-and-regulatory-guidance-report
- [ii] pp 34-36 supra.
- [iii] pp 34-39 supra.
- [iv] Section 2, Mutual Funds (Amendment) (No.2) Law, 2020: https://www.cima.ky/upimages/lawsregulations/MutualFundsAmendmentNo.2Law,2020_1590507642_1599481964.PDF
- [v] Bank of International Settlements – Committee on Payments and Market Infrastructures – Markets Committee – Central bank digital currencies – March 2018: https://www.bis.org/cpmi/publ/d174.pdf
- [vi] International Monetary Foundation – “Cross-Border Payments—A Vision for the Future” – 19 October 2020 – https://meetings.imf.org/en/2020/Annual/Schedule/2020/10/19/imf-cross-border-payments-a-vision-for-the-future
- [vii] Financial Stability Board – “Regulation, Supervision and Oversight of “Global Stablecoin” Arrangements” – October 2020 – https://www.fsb.org/2020/10/regulation-supervision-and-oversight-of-global-stablecoin-arrangements/
- [viii] pp 38-39 supra.
- [ix] Cayman Islands Virtual Assets (Service Providers) Law, 2020: https://gov.ky/portal/pls/portal/docs/1/12964483.PDF
- [x] British Virgin Islands Financial Services Commission – “Guidance on Regulation of Virtual Assets in the Virgin Islands (BVI)” – July 2020 – https://www.bvifsc.vg/sites/default/files/guidance_on_regulation_of_virtual_assets_in_the_virgin_islands_bvi_final.pdf