© Benedict Heidbüchel
Benedict Heidbüchel, Director for Digital Assets & Fundraising, Licus Capital Markets
The tokenization of investment funds, financial instruments and illiquid alternative assets is accelerating worldwide. The tokenization of assets on a distributed ledger technology based (DLT) network (e.g. blockchain) using security tokens has the potential to digitize funds, investment shares and securities to enhance fundraising as well as access to illiquid alternative assets.
In addition to that the disruptive potential of blockchain-based applications can redesign the mechanics of transaction processes. Current market studies put the market potential of tokenized (illiquid) assets at up to 16 trillion US dollars by 2030.
The German Electronic Securities Act ("eWpG") in combination with the regulation on Crypto Fund Units (KryptoFAV) has partially opened the German fund industry to tokenized investment products. This guest column discusses the fundamentals of distributed ledger technology (DLT)-based tokenization of investment assets and analyses the legal framework.
Especially, the target image of tokenized funds in the context of an updated fund regulation, the ELTIF 2.0 will be outlined as it was established as a pan-European fund vehicle, which can be sold to both professional and retail investors throughout Europe.
The legal framework for the issuance of blockchain-based securities in Germany
The fact that securities can be digitally securitized via tokens means that they can be traded via crypto exchanges or DLT-based trading venues. Therefore, the tokenization of funds and securities enables a liquid (secondary) market and easier access to new trading, distribution and sales channels while simultaneously reducing costs and accelerating transaction processing.
The legally secure issuance of electronic securities has primarily been enabled through the German Electronic Securities Act ("eWpG"). The electronic securities are entered in crypto securities register pursuant to paragraph 16 eWpG, which is maintained by a register-keeping entity controlled by the Federal Financial Supervisory in Germany (BaFin).
Crypto securities are issued in dematerialized form using distributed ledger technology and enable fast and barrier-free issuing processes. The main difference between traditional and electronic securities, apart from the new type of issuance, lies in their safekeeping.
While traditional certificated securities are physically held in custody with a central securities depository as a global/collective certificate, electronic securities can be held in a crypto securities register. The maintenance of a crypto securities register is a financial service requiring a license pursuant to paragraph 1 (1a) sentence 2 no. 8 KWG). The advantages associated with the eWpG enable more efficient and cost-saving securities transactions.
In addition to eWpG the German legislator has established a regulation on crypto fund units (KryptoFAV). The new regulation enables providers of investment funds to issue electronic unit certificates in investment funds in the legal form of a contractual-type fund (Sondervermögen) and issue them as so-called crypto fund units by entering them in a crypto securities register.
It is ensured that the registrar of a crypto securities register in which crypto fund units are entered is always the depositary of the investment fund itself.
ELTIF Regulation 2.0 - European long-term investment funds as a fundraising booster in challenging market environments?
ELTIFs (European Long Term Investment Funds) were introduced in Europe in 2015 as a fund vehicle. ELTIFs are distributed via a single EU passport and offer a regulatory protected structure for the distribution of private market funds.
However, its commercial success has so far been limited. Within the "Impact Assessment Report", the European Commission found that only a total of 57 of ELTIFs in just four jurisdictions had been launched by the end of 2021. These funds only managed assets of approximately EUR 2.4 billion.
To unfold the full potential of the fund vehicle the European Parliament adopted Regulation (EU) 2023/606 amending Regulation (EU) 2015/760 on ELTIFs on February 15, 2023. ELTIFs have not been able to contribute to commercial success in fundraising activities.
Therefore, the reform is intended to make ELTIFs more attractive and accessible to a wider range of investors, especially private investors. The new regulations mean that since January 10, 2024, private investors have been enabled to invest in infrastructure projects or tangible assets on an unrestricted long-term basis.
The legal forms permitted for an ELTIF are not regulated by the ELTIF Regulation. They are therefore determined by the German Capital Investment Code (KAGB) which is the implementation of Directive 2011/61/EU on Alternative Investment Fund Managers. Consequently, all legal forms permitted under the KAGB are possible for ELTIFs and the corresponding provisions of the KAGB apply.
Therefore, the management of an ELTIF covers both an open-ended and a closed-ended fund structure. It also includes the acquisition of real estate as well as securities. Finally, the units of the ELTIF can be distributed to private investors or (semi-)professional investors; the ELTIF could therefore be set up as a mutual fund or special fund.
What does that mean in terms of fund structures and tokenized funds mentioned earlier? One does appreciate the newly won flexibility. Nevertheless it leads to the paradoxical result that, a German asset management company (Kapitalverwaltungsgesellschaft, KVG) could set up funds in the legal form of an open-ended mutual real estate contractual-type fund (offenes Publikums-Immobilien-Sondervermögen) if it qualifies as an ELTIF, but not, according to current administrative practice, if it were merely a "simple" contractual-type fund („einfaches“ Sondervermögen).
However, this makes it possible to issue ELTIF crypto fund units using blockchain technology and enter them in a crypto securities register. Therefore, private investors can buy tokenized ELTIFs and trade them via crypto exchanges or DLT-based trading venues.
Advanced fund managers can enhance private market access and embrace closing of funds via private investors. On the other side private investors outlook is likely to be positive in terms of having the opportunity to invest in high-profile illiquid assets.
For private investors, the ELTIF offers a Europe-wide harmonized set of rules for investing in illiquid assets, which also allows for more flexible structures. In addition, ELTIFs can be tokenized when set up in a certain legal structure which allows fund administrators a promising combination of lowered investment limits in the amount of 10k EUR for private investors as well as new digitized distribution and sales channels.
About the Author
Benedict Heidbüchel is a Director for Digital Assets & Fundraising at Licus Capital Markets, leading the commercialization of blockchain solutions within the Group's private debt portfolio. In addition, he is a second-year doctoral candidate at the Chair for Corporate Governance and Capital Markets Law at the Technical University Munich (TUM) doing research on the regulatory harmonization of Blockchain-based tokenization of illiquid alternative asset classes.
