Tokenized Funds, The Next Investment Trend? Regulatory Developments in the UK, EU, and UAE | Morgan Lewis

There has been a growing trend among traditional funds and asset managers to launch programs to tokenize alternative assets. The main benefits of tokenizing funds include increased liquidity and accessibility, heightened transparency, expanded operational efficiencies, and automation. Morgan Lewis lawyers discuss some key industry terms and look at the regulatory developments in this emerging investment space in the United Kingdom, European Union, and United Arab Emirates (UAE).

Key Terms

• A token is a tradeable piece of code on a distributed ledger digitally representing a traditional asset.
• A tokenized fund is a fund that issues digital tokens on a distributed ledger that represent interests in the fund, meaning the tokenized interests can be traded and recorded on the distributed ledger.
• A distributed ledger is a decentralized database of transactions managed across a shared network, with the distributed nature enabling investors to see holdings in real time, as the ledger updates as transactions occur on the network.

United Kingdom

While regulation relating to funds is technology neutral, the UK has been keen to promote innovation, and in 2022 the UK government announced plans to become a “global hub” for cryptoasset technology and investments, creating a new regulatory framework for cryptoasset businesses.

The UK government has also acknowledged that the tokenization of traditional securities could have substantial implications for how assets are traded or capital is raised following its call for evidence in 2021 on tokenization and distributed ledger technology.

The UK government said it will work closely with the Bank of England, the UK Financial Conduct Authority (FCA), and the industry to consider what changes may be necessary to facilitate tokenization and whether additional guidance or legislation is needed.

The FCA published a discussion paper in February 2023 on improving the UK asset management regime wherein it dedicated a section to fund tokenization. The FCA is seeking to understand the benefits of tokenized units in authorized funds for investors, the regulatory changes needed to enable tokenized units to be issued, and the priority it should put on enabling the tokenization of units.

The FCA will publish a feedback statement later in 2023. Depending on the response, the FCA will consider whether rule changes are needed.

The UK Jurisdiction Taskforce of LawtechUK, a government-backed and industry-led group, helpfully recognizes cryptoassets (such as tokens) as property and smart contracts (that can be embedded in tokens) as enforceable under English law. However, there are still issues in relation to the validity of smart contracts, available legal remedies if they are rendered defective due to error, and how they are to be interpreted by courts.

European Union

There is currently no uniform legal framework for crypto services in the EU; however, some EU countries, such as Germany, Malta, and Estonia, have enacted national crypto laws, while others have no specific crypto laws.

This will soon change with the EU’s Markets in Crypto-Assets Regulation (MiCA) becoming effective, likely toward the end of 2024, which will introduce a uniform European legal framework for cryptoassets and crypto services. It will cover utility tokens, currency tokens, and stable coins but not security tokens (which are subject to Markets in Financial Instruments Directive II (MiFID II)) or non-fungible tokens (NFTs).

• MiCA provides for a technology-neutral regulatory framework for the regulation and supervision of cryptoassets and crypto service providers and is part of the EU Digital Finance Package, supplementing MiFiD II to the extent MiFiD II does not cover certain cryptoassets.
• Similar to the scope of MiFID II with respect to classical financial instruments, MiCA regulates crypto custody services, the operation of crypto trading platforms, the exchange of cryptoassets into money, the brokerage of crypto assets, advisory services, and the offering of cryptoassets.
• Crypto service providers will be required to obtain a license in their home member state, similar to MiFiD II license requirements, with respect to reliability and qualification of managers, organizational requirements, risk management, IT security, and capital, and such license can be passported throughout the entire EU. MiCA does not contain a third-country regime for cross-border services, i.e., non-EU crypto service providers must obtain an EU MiCA license (or acquire an EU licensed entity) to become active in the EU.
• Crypto service providers will have to publish a so-called White Paper, similar to a securities prospectus under the EU Prospectus Regulation, for the cryptoassets they are dealing with.

United Arab Emirates

Broadly, the UAE’s ethos, as evidenced by the Digital National Economy strategy, is to strongly encourage digitalization and the digital economy and create a conducive environment for the launch of crypto and other digital asset products and businesses.

Across the Emirates, there is considerable buy-in at the federal and emirate levels to encourage digital innovation: for example, the Abu Dhabi Global Market’s (ADGM’s) Hub71+ Digital Assets has deployed $2 billion for an ecosystem dedicated to developing Web3 businesses; Dubai’s metaverse strategy aims to attract 1,000 blockchain and metaverse companies; approximately 500 crypto startups have been registered in the Dubai Multi Commodities Centre as of January 2023; and the Ras al Khaimah “Digital Oasis” was announced in February 2023.

On tokenization specifically, while it is of interest, there has been less evidence of implementation, although steps are being taken toward certain tokenized products, including in relation to real estate and renewable energy assets.

Regulation of digital assets in the UAE, while robust and well intentioned, is very complex and fastmoving in nature because it exists at the federal level, the emirate-level, and at the level of the UAE’s two “financial free zones,” with each such jurisdiction having their own approach, regulations, and regulators.

It remains to be seen whether the pace and complexity will create a rich and comprehensive framework or friction for those seeking to establish tokenized funds. That said, the regulatory authorities are open to discussion with market participants, which should improve the likelihood of a successful regime.

The key regulators listed below have released a swathe of new regulations relating to cryptoassets in recent years:

• Securities and Commodities Authority (SCA) – For onshore UAE, which excludes Dubai in respect of digital assets regulation
• Virtual Assets Regulatory Authority (VARA) – For the Emirate of Dubai, which excludes the Dubai International Financial Centre (DIFC)
• Dubai Financial Services Authority (DFSA) – Financial freezone of DIFC
• Financial Services Regulatory Authority (FSRA) – Financial freezone of ADGM

For more information on tokenized funds, their benefits, and regulatory developments across the UK, EU, and UAE, view the presentation Tokenised Funds and Investments in the UK, EU, and UAE, part of the firm’s Technology Marathon Web Series.

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