The Financial Conduct Authority (FCA) has unveiled proposals for fund tokenisation that are potentially transformative for how authorised funds are bought and sold in the UK, experts have said.
The proposals, which were outlined by the FCA in a recent consultation paper, herald a potentially seismic shift in the fund management industry by introducing guidance to implement a blueprint for fund tokenisation, an optional new model for direct dealing in conventional and tokenised authorised funds, and a roadmap for future fund tokenisation.
Fund tokenisation – the process of using distributed ledger technology (DLT) to convert an asset or cashflows, and their ownership rights, to digital form – could make trading of authorised funds quicker and reduce settlement times, with the potential to transform the asset management sector, product offering, and market in the UK.
Blockchain technology first began to be used for financial services in the cryptocurrency and banking and payments sectors, but it has captured the attention of asset managers keen to see similar trading efficiencies elsewhere in the financial services industry, with the tokenisation of unit holder records in the blueprint as the first step.
The blueprint model comes from the November 2023 interim report of the industry-led Technology Working Group (TWG) under the previous government’s Asset Management Taskforce. The report contained a staged approach to fund tokenisation, starting with a baseline (‘stage one’) model compatible with the UK’s existing legal and regulatory framework centred around using DLT for the fund unitholder register.
In March 2024, the TWG explored further market thinking and use cases in a second interim report, considering fully on-chain investment markets in which tokenised funds also invest in tokenised securities, and envisaging use-cases for units in Tokenised Money Market Funds (TMMFs). The TWG’s second interim report also set out three critical steps that would be needed: on-chain fund settlement with digital money; funds holding tokenised assets in their portfolio; and including the use of public permissioned networks. This further thinking comprises the basis of the roadmap in the FCA’s latest consultation paper.
Josie Day, financial services regulation expert at Pinsent Masons, said: “The first interim report focuses on the register infrastructure for funds, with a long-term vision of replacing traditional record-keeping and functions with a distributed ledger across client, unit and asset registers.”
Day said that using DLT across registers could have “wide-ranging benefits”, both at fund and market level. “This could include faster settlement and reconciliation with real-time data visibility, ease of transfer, and improvements to reporting. Further transformative changes to the way funds and the market operate could then flow from layering-in smart contracts, but the first stage is focused on the unit register,” she added.
The FCA’s current consultation does not look at the ability of investment funds to hold cryptoassets for investment purposes, although it is one of the next steps envisaged for fund tokenisation in the TWG’s second interim report. Day said that the consultation paper does, however, contain the FCA’s response to market feedback to its earlier consultation on TMMFs, and discusses use of stablecoins for settling deals in units. “With its proposals, including guidance for funds using the industry’s blueprint model, the FCA is supporting firms to drive transformation in the market, by providing the regulatory underpinning that gives them greater confidence to do so,” she said.
The FCA’s paper also takes forward proposals for an alternative direct to fund (D2F) dealing model as an optional alternative to the authorised fund manager (AFM) dealing as principal, enabling investors to transact directly with the fund as principal, rather than with the AFM.
Commenting on this change, Elizabeth Budd, financial services regulation expert at Pinsent Masons, said: “This would mark a significant change in approach to the current UK market practice of the manager’s ‘box’ model run by AFMs in which the AFM acts as principal, selling units to subscribers and redeeming from selling investors, and co-ordinating the resulting transactions with the fund or depositary, to issue or cancel units and manage the float in the box.”
Budd said this proposal could reduce compliance for AFMs, streamline transaction mechanics and reduce costs in the long-term for AFMs. She added that the fund industry has been supportive of the D2F model to-date, but cautioned that “care does need to be taken to ensure that its adoption is robust – not least ensuring adequate back-up systems which can cope with network outages”.
The FCA considers that the proposed, broader use of direct dealing with the fund would bring the UK in line with practices in other fund centres, such as Ireland and Luxembourg, as the D2F model includes a specific bank account for payments to and receiving payment from investors – an issues and cancellations account (IAC).
The FCA is also focused on consumer protection and firms meeting their regulatory obligations, including operational resilience. In keeping with its focus on financial crime set out in its recent strategy and work programme, the FCA also outlined several points for firms exploring tokenisation to consider with respect to anti-money laundering (AML), sanctions, and compliance with the Money Laundering Regulations (MLRs).
Firms proposing to launch new funds using direct dealing, or to convert existing funds to direct dealing, need to ensure scheme documents are clear about who has responsibility for AML and sanctions controls and will apply them in practice: AFMs and depositaries may both be subject to the MLRs. Firms that would be providing tokenised units in exchange for cash, where this is recorded on a register that is operated through DLT, may need to register with the FCA as a cryptoasset business under the MLRs.
Where a firm is registered under, or otherwise subject to, the MLRs, it will need to assess its money laundering and terrorist or proliferation financing risks in relation to fund tokenisation, and maintain proportionate policies, controls and procedures to mitigate the risks. Controls will be needed to cover customer identification and verification, ongoing monitoring, and suspicious activity reporting.
Nicholas Kamlish, financial crime expert at Pinsent Masons, said: “Given that the FCA is likely to regard tokenised fund business as a potentially higher risk activity from an AML perspective, firms will need to evidence robust, embedded controls, supported by appropriate records and staff training. Firms which do not do this may be at risk of regulatory action, like voluntary requirements (VREQs) and skilled person reviews, if the tokenised fund regime is implemented.”
Opportunities from tokenisation may open the door to funds offering innovative products and client solutions, some of which are explored in the FCA’s consultation, as well as wider structural changes to the asset management sector. The FCA is urging consumer groups and individuals to read chapter five of the consultation paper, which explores how tokenisation might change investment management in the future, and is asking for feedback on this area by 12 December.
The regulator is accepting feedback until 21 November on its proposals in the other chapters in the consultation paper.
The FCA’s proposals come ahead of the UK introducing a new regime to regulate cryptoassets, which is expected to be implemented by the end of 2026.
Earlier this year, the FCA’s chief executive Nikhil Rathi highlighted the UK’s potential to lead in areas such as tokenisation during a speech on competitiveness and growth in the UK financial services sector.
“The FCA’s current proposals support innovation in investment funds moving forward,” said Day. “The potential for both structural and operational changes lie ahead for the fund management industry and for investors.”
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