Jamie Marshall

Scotland has a long, proud history of innovation in investment funds. In the late 19th and early 20th centuries, Scottish fund managers set up a number of the first investment trusts, emerging as a leading centre for collective investment.

That pioneering tradition continues today, through the launch of the UK’s first-ever tokenised UK authorised fund by Scottish-based fund manager Baillie Gifford, advised by CMS’s Edinburgh-based authorised funds team.

Tokenised funds and the benefits they provide present a significant opportunity for the UK’s fund management sector. Their early adoption could be a key driver in helping the sector further distinguish itself as a global market leader and, in Scotland, support the strategic ambition to grow the sector to £1 trillion by 2030.

While “tokenised fund” is a term that can mean different things to different people. That said, it is most commonly understood as referring to a fund in which the investor’s share or unit is created as, represented by or turned into, a digital token that is recorded on a smart contract-enabled distributed ledger (such as blockchain), a highly programmable, automated and cryptographically secure database shared between parties.

The record of who owns those units is itself operated and maintained using distributed ledger technology (DLT), entirely autonomously. This contrasts with conventional funds, the units or shares in which are created, and their ownership recorded, through book entries made by the fund’s operator or its delegate.

The use of DLT and smart contracts in operating tokenised funds has many potential benefits. Chief among these is the potential for automation of many back-office functions in operating funds, and the more efficient sharing of information between fund operators, their service providers, distributors, and investors. These benefits, if realised, could generate substantial efficiency improvements and cost savings, giving tokenised funds a competitive advantage against conventional ones.

In the longer term, there is the potential for tokenisation to deliver lower costs through efficiency savings, with resulting competitive advantages for tokenised funds vs their conventional competitors via enhanced customer outcomes through lower fees.

The benefits do not end there; tokenised funds could open up new distribution channels, such as digital assets platforms; further democratise investment by facilitating the investment of smaller amounts; enable the sector to engage younger investors; and reduce settlement timescales, which has clear appeal for institutional investors.

Inevitably, a tokenised fund model, which remains a work in progress, does involve risks as set-up costs are currently quite high and the hoped-for efficiency savings are yet to be realised. Tokenised funds also require different service providers to conventional ones (such as digital transfer agents), presenting additional due diligence, oversight and governance requirements for fund providers. There are also new operational issues to consider, such as cyber risk, and challenges around interoperability between different blockchains.

Despite these challenges, tokenised funds offer a historic opportunity for the UK fund management sector to stake a claim to the vanguard of financial innovation in mutual funds. By adopting tokenisation at scale, the sector could come to be seen as the natural home of tokenised funds, stealing a march on competitor jurisdictions.

It is important also to acknowledge the risks of inaction. The advent of tokenised funds provides a historic market opportunity. If the UK funds sector does not move decisively to take that opportunity, another jurisdiction will. For historical parallels, consider Luxembourg’s dominance in the money market funds space, or Ireland’s dominance in Exchange Traded Funds.

The UK is well-placed to meet this moment, given its market leading position in both funds (and financial services more generally) and digital assets. A thriving tokenised funds sector could provide reciprocal opportunities and benefits for our entire digital assets and funds ecosystems, including service providers and distributors.

It is encouraging to see that the FCA is attempting to meet the moment, having recently published its finalised guidance on the operation of tokenised UK authorised funds. We are aware from first-hand experience that the FCA is committed to the advancement of the UK tokenised authorised funds sector, and will enthusiastically and constructively support firms wishing to get a tokenised fund off the ground.

This is a welcome stance: tokenised funds are genuinely new, and their operating model can diverge from a conventional fund model in important ways, creating some friction against the current rules (notwithstanding the new guidance). Early regulatory engagement in this space would be recommended.

However, while the regulator can provide favourable conditions they need to flourish, tokenised funds will only be a success if they are adopted at scale, to achieve the critical mass required to refine the operating model and realise the potential benefits tokenisation presents.

It is up to the UK funds sector to take responsibility for delivering on the promise that tokenisation presents. Moving decisively could secure first-mover advantages, unlock new sources of international capital and define global standards for the next generation of tokenised funds.

The opportunity is real, but it will not remain open indefinitely.

Jamie Marshall is an Of Counsel and financial services specialist at law firm CMS in Edinburgh