New Era in the Alternative Investment Fund Industry through Tokenisation

In light of the current global health threat, the importance of reaching a new level of technological readiness to facilitate smooth remote working and to reshape the way business is carried out worldwide cannot be ignored. This unprecedented situation is expected to split the world and the available technology into “before and after” the COVID-19 lockdown.

Across the world, from the US to Europe and Singapore, digital currencies and tokens are ushering in a new era for investment financing. While there are some conservative countries that are yet to develop their legislative strategies to accommodate cryptocurrencies and the tokenisation of assets, there are also some advanced ones such as Singapore and Malta that have made important steps in shaping their regulatory landscape around these virtual assets.

Tokenisation of Alternative Investment Funds

Most investment funds are set up as limited partnerships (“LPs”), allowing investors to participate as limited partners without taking an active role in the management of the fund, which is the responsibility of the general partner (“GP”). The investors and the managers of the fund are typically entitled to receive a share in the profits of the fund.

The new generation of tokenised investment funds follows those principles, splitting units with a view to conferring specific economic rights to each investor. Technically, a token could allow any unit to be converted into a virtual asset by way of a piece of code with a predefined value. Tokenised funds can also help ensure investor protection and transparency. To this end, tokens can be listed in secured digital ledgers that allow all of their trades to be monitored, while also storing information about the holders of the tokens and all executed transactions.

Liquidity

Throughout their development, investment funds continuously face the challenge of managing their liquidities. It is a well-known fact that the return on investment period is approximately 7 to 10 years on average, thus raising challenges for fund managers when it comes to planning their liquidities. The tokenisation of assets could be a solution to this problem: by transforming fund units into virtual tokens, investors are able to conduct “traditional” investments, as well as having the opportunity to trade their tokens for immediate returns and liquidity. This same opportunity exists for fund managers, who can deal with potential illiquidity issues by trading new/existing tokens, and thus broaden their investment portfolios. 

Needless to say that, in past crises, the alternative investment fund industry has been criticised for its lack of liquidity during a downturn. Today, the digitisation of funds could be one way to solve this issue by creating even greater opportunities – from business to day-to-day activities – through technology.

These new opportunities raise questions such as the type of contracts to be used to record the transactions, the cost of trading, and the degree of security that technology can offer.

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Accessibility to (new) investors

Traditionally, investments in funds were intended for institutional investors with substantial capital and a sufficiently long-term investment horizon. Issuing tokens may broaden the investor base, as the invested amounts and holding periods can be reduced and thus become more accessible.

It is worth noting that the accessibility that tokens could create is still unclear. In order to ensure the security of all transactions, it is also likely tokens would be increasingly regulated, thus restricting their availability to accredited investors only. This would result in only a slight increase in the portfolio of investors.

Transparency

Tokens are a virtual representation of tangible assets. They can also store information on the identity of investors, their percentage holding, and other related transactions, which can then be made public in virtual ledgers, allowing for full transparency and security.

Virtual ledgers cannot be modified by a single party. Tokens provide a solution that ensures that all information is correctly and securely recorded.

AML & KYC procedures

In the current regulatory landscape, virtual currencies and the tokenisation of assets are rarely considered due to the numerous concerns associated: high risk of fraud and fraudulent transactions, limited traceability of transactions, and inconsistency of anti-money laundering (“AML”) and know-your-client (“KYC”) procedures.

The identity of investors, the time of purchase and the type of assets represented by tokens could be embedded in virtual ledgers. But there could also be a risk of illegal transactions or cross-border exchanges that may not be traceable to a specific jurisdiction.

That being said, tokenisation opens the way for unified digitised AML and KYC procedures. In recent years, there has been a general interest in achieving an international standardisation of AML/KYC procedures for funds, and technology can be the answer once again by achieving a standardisation of data collection and processing and ensuring that transactions performed via tokens can be easily tracked.

Tax framework for the tokenised assets

The existing European legal framework is currently not fully equipped to handle cross-border transfers of tokenised assets. The same also applies from a taxation perspective. As mentioned in the 2018 European Parliamentary Study on cryptocurrencies and blockchain, digitised assets are not covered by regulations, and as such are prone to misuse and fraudulent transactions. Tax authorities should be aware of the respective taxable basis, which, in the case of cryptocurrencies and tokenised assets, can be difficult to achieve.

A new era of funds should bring with it a new era of taxation. Tax legislation, which traditionally focus on shareholding percentages or voting rights, must follow technical developments and be adjusted to these new assets. Interestingly, it is still yet to be proven the extent to which the recent tax regulations aiming at reshaping the international tax standards (e.g. the anti-hybrid measures) will apply to tokenised funds.

With respect to Luxembourg, the tax authorities have begun to take steps to recognise the potential of blockchain technologies and cryptocurrencies , but have not yet started to tackle tokenised assets. In order to keep pace with technology and to retain its status as the preferred location for alternative investment funds, Luxembourg must be swift to address and embrace this technology.

¹ https://impotsdirects.public.lu/dam-assets/fr/legislation/legi18/circulaireLIR14-5-99-3-99bis-3du26072018.pdf

References:

1. Ashford’s LLP UK (Legal advisors): https://www.ashfords.co.uk/news-and-media/general/tokenization-of-venture-capital-and-private-equity-will-tokenization-disrupt-the-venture-capital-and-private-equity-industries
2. Forbes – “Taxation of Token Swap”: https://www.forbes.com/sites/shehanchandrasekera/2019/12/19/how-cryptocurrency-swaps-are-taxed/
3. Alliot Group – “Taxing cryptocurrency in Malta”: https://www.alliottgroup.net/practice-management-resources-for-owner-managed-firms/taxing-cryptocurrencies-in-malta/
4. The National Law Review – “A Taxonomy of the Proposed Token Taxonomy Act”: https://www.natlawreview.com/article/taxonomy-proposed-token-taxonomy-act
5. LinkedIn – “The Tokenization Of Venture Capital”: https://www.linkedin.com/pulse/tokenization-venture-capital-rob-frasca
6. The South China Morning Post, Will there be adults in the room when tokens disrupt the financial order of venture capitalists and angel investors?”: https://www.scmp.com/business/money/wealth/article/2179295/will-there-be-adults-room-when-tokens-disrupt-financial-order
7. Banque de Luxembourg: “Private Equity: an asset class worth considering” (https://www.banquedeluxembourg.com/en/bank/bl/blog/-/blogpost/le-private-equity-une-classe-d-actifs-a-considerer#page-01)
8. Advancing Financial Crime Professionals Worldwide; authored by Scott, Sherri: “Cryptocurrency Compliance: An AML Perspective” (link)
9. European Parliament study, “Cryptocurrencies and blockchain” (link)
10. Clarke, Osborne – “Taxation of cryptocurrencies in Europe: an overview” (link)