This is the third paper in the Investment Association (IA) series on tokenized funds, in collaboration with CMS.
Previous works have provided an overview of the concept and the regulatory environment. In this paper, we explore the considerations that firms should have in relation to the publication of prospectuses for regulated collective investment schemes. This is an evolving topic, and the regulatory position and requirements for launching such funds are still early days.
What are tokenized funds?
As explained in earlier documents, the Financial Conduct Authority (FCA) takes a technology-neutral view of regulation. A tokenized regulated collective investment scheme can take the form of:
- unit trust (AUT);
- open investment company (OEIC); or
- authorized contract scheme (ACS).
It has units, shares or interests (as applicable) that are digitally represented in token form and can be traded and recorded using distributed ledger technology (DLT).
Assets in corporate form include:
- investment funds;
- non-UK investment companies; and
- Real Estate Investment Trusts (REITs).
The investment will usually be an investment in shares or possibly debentures issued by the relevant company.
The share itself will not be a digitized security for UK company law reasons, but will usually be registered in the name of a nominee and a security token representing the right to it.
In the context of the UK regulatory perimeter, the fund will issue regulated tokens in the form of security tokens: these are tokens that grant all the rights granted to shareholders or unit holders.
Prospectus Requirements – Regulated Funds
The FCA’s Collective Investment Schemes Handbook (COLL) requires the publication of a prospectus in relation to a regulated collective investment scheme so that investors and potential investors can access detailed information about the fund. It also prescribes certain content for such a prospectus (see COLL 4.2.5R and 8.3.4R). Other sources of prospectus requirements, such as the FCA’s pool of sources in relation to alternative investment funds, are not considered in this paper.
Given the FCA’s technology-neutral approach, the regulator would be expected to require a tokenized fund to produce a prospectus for COLL purposes. However, it is too early to say with certainty what differences there may be in the required disclosures contained in a prospectus for a tokenized fund.
From the application of the current COLL requirements to a tokenized fund, the differences in disclosure are likely to be around the following:
- a description of the mechanics behind tokenization, such as the specific DLT solution adopted by the authorized fund manager and the tokens themselves, or any network entry restrictions or specific technical/IT investor requirements;
- details of the entities involved in the tokenized fund – together with summaries of the relevant contractual arrangements – that would not currently be found in the prospectus, such as the DLT network provider and the cash exchange provider;
- details of any differences in AML/KYC requirements for investors, such as the method for AML verification, whether any AML syndication will be used among network participants or any differences in documentation checks;
- details of the arrangements for dealing within the structure of the tokenized fund, such as any changes in trading terms or mechanics, or any changes in settlement timing or mechanics;
- details of the specific risks arising from the shares/shares in the fund being tokenised, such as reliance on the relevant DLT, the relative novelty of the concept in UK practice or a summary of any legal uncertainty; and
- any other differences in the performance of the fund due to it being tokenized.
At the time of writing, IA is aware of a number of initiatives using or seeking to enable tokenized assets within the UK, Luxembourg, Ireland and France. It seems likely that the first UK-domiciled tokenized fund – or at least a class of fund – will be available in the near future. Future adoption of the model will depend on the ability to realize the claimed benefits. |
Corporate funds
If the token is a transferable equity or debt security and the tokens will either be offered to the public in the UK or admitted to trading on a regulated market, the issuer will need to publish a prospectus unless an exemption applies, such as a recognition of the trading exemption.
A public offer of securities will have to have the prospectus reviewed and approved by the FCA, where the UK is the relevant home country regulator. If the securities are to be listed on an official list maintained by the FCA (listed securities) and admitted to trading on a recognized investment exchange – such as the main market of the London Stock Exchange – similar requirements apply. The UK is still waiting for a listed fund or security token company, but the FCA and London Stock Exchange are understood to be looking at it.
A corporate fund’s prospectus must provide potential investors with information for making an investment decision. Specific disclosure requirements will depend on the type of security – such as stocks or bonds – as for existing securities. It will contain information about, among other things:
- security tokens and underlying securities;
- Issuers of tokens/issuer of related securities;
- business or relevant assets,
- management and investment strategy;
- requests for historical financial information;
- statement of working capital for current needs (at least 12 months from the date of the prospectus);
- statement of capitalization and indebtedness within 90 days from the date of the document;
- risk warnings (these will need to be extended for all security token risks such as DLT custody and use); and
- a statement on the responsibility of the director or the company depending on the nature of the problem.
If the securities are to be listed on an official list maintained by the FCA (listed securities) and admitted to trading on a recognized investment exchange – such as the main market of the London Stock Exchange – similar requirements apply. The UK is still waiting for a listed fund or security token company, but the FCA and London Stock Exchange are understood to be looking at it.
Listed token issuers or those admitted to trading on a recognized exchange will also have similar requirements, as well as ongoing obligations such as the Disclosure Guidelines and Transparency Rules and the Market Abuse Regulation
Do marketing and financial promotion rules apply?
In general, the marketing and financial promotion regimes governing tokenized funds are similar to traditional funds. As security tokens are considered designated investments under the RAO, they already fall within the scope of the current financial promotion regime.
The requirements and exemptions for financial promotions will also be relevant to security tokens sold on a limited basis without the need for a prospectus.
What are the challenges?
The main regulatory challenges facing tokenized funds stem from uncertainty around:
- the status of tokenized assets within the established framework;
- regulators’ appetite for tokenized assets;
- adoption and initiation of funds;
- knowledge of the product and by the advisor;
- whether DLT records of cryptoassets can represent a “register” for proving, consulting or transferring rights to certain types of securities under private law;
- operational resilience and business continuity as a result of greater reliance on technology;
- perception of high risk of fraud and fraudulent transactions. This is often based on limited traceability of cryptoasset transactions and deficiencies in compliance with AML and KYC procedures (can be improved by DLT); and
- different national regulatory frameworks in operation.
What is the current outlook for tokenized assets?
This is a rapidly developing field. The recent consultation paper published by HM Treasury on cryptoassets and stablecoins will hopefully shape the FCA’s perspective on this new technology. The outcome of this could be the addition of new laws and regulations to govern DLT and cryptoassets. There is increasing interest and activity in product creation.
This paper provides an overview of prospect disclosures as they apply to tokenized assets in June 2021, and future papers will address more technical details in other areas. We want to hear from members what is important to them – contact us with requests and suggestions at john.allan@theia.org. |
The original version of this article was first published by CMS and in collaboration with IA in June 2021.
Please find links to parts one and two in this series of practice notes.
Reproduced on Connect with kind permission of IA and CMS.
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