The fund industry is permanently evolving, but incremental changes are hardly noticed. Sometimes however, industries undergo radical changes, where the process of evolution is significantly disrupted by outside technological, demographic, regulatory, and economic forces.
This article discusses two important potential/probable developments of the Luxembourg investment fund industry in the coming decade. First, it explains why it is expected that Luxembourg investment funds will continue to rise in importance comparatively to many other jurisdictions. Second, it sheds some light on how blockchain and decentralised autonomous organisations (‘DAOs’) are due to reshape the investment fund industry with a flourish of new actors attracting significant attention from markets, customers, and investors alike.
1. The continuous rise of the importance of Luxembourg investment funds
ALFI announced in October 2017 that assets under management of Luxembourg domiciled funds reached EUR 4.037 trillion - an all-time high. Apart from the recent positive economic and financial developments, we see two big underlying trends on the short and the long term that indicate that the importance of investment funds in Europe will continue to rise in the next decade.
Currently, the tighter regulation and increased capital requirements imposed on traditional lending banks have reduced the capacity for banks to issue loans. Recently, this has created a gap in the financing market. This, combined with the search for yield in a low-interest rate environment, has led institutional investors to look to diversify their assets. The rapid rise of debt funds not only in Luxembourg, but in Europe in general exemplifies this development.
Apart from this, the continuous growth of investment funds might be fuelled by inadequacies in the legal frameworks of retirement provisions. Currently, there is a dynamic and ongoing improvement in life expectancies that is not accounted for in pension systems designed to provide financial security in retirement. All over Europe, there are employment-based (2nd pillar) pension funds and first pillar pay-as-you-go ('PAYG') state pension systems that are facing incremental funding deficits as a result thereof. Investment funds could potentially be a workable solution to mitigate the growing challenge of this so-called ‘pension gap’, i.e. the gap in savings most people have in order to ensure they achieve a decent standard of living following retirement age.
The recently proposed Pan-European Pension Product Regulation (‘PEPPR’) aims to introduce a ‘European 401(k) account’ that may be provided by, amongst others, banks, fund managers, and insurance companies. This so-called ‘PEPP’ is a ‘wrapper-product’ embedding all types of (European) individual retirement products that have certain common features and comply with the product regulation as set out in the proposal. A key characteristic of the ‘PEPP’ is that it always embeds ‘PEPP schemes’ that will be in practice investment funds in the form of ‘target date funds’, ‘balanced funds’, or ‘life-cycle funds’ that are established for the purpose of ‘capital preservation’ and will have to abide by the ‘prudent-man principle’.
The proposed PEPPR may unleash a true revolution in Europe. Currently, many Member States do have regulations in place that warrant compulsory memberships to a specific pension scheme. Member States, such as the Netherlands, however, restrict members to specific company- or industry-wide schemes. Compulsory membership restrictions in Europe leave the pension assets of migrant workers with pension money being scattered all over Europe and many self-employed persons with very little or no pension at all. The proposed PEPPR could help to overcome this problem by allowing for pension solutions on a crossborder basis, thus, helping to alleviate this problem better than any current scheme.
Although the proposed PEPPR focuses on the so-called third pillar of retirement provision, it will allow Member States to unilaterally extend the PEPPR to their second-pillar. Apart from this, the PEPPR may, on the European level, foster debate as the current compulsory membership restrictions are not in line with the free movement of persons, establishment, and capital. The proposed PEPPR might, thus, lead to a ‘European Pension Union’ in which Member States set out the percentage of income that its residents have to mandatorily invest in a PEPP. Contrary to traditional (2nd pillar) pension funds, PEPPs, embedding investment funds, are not restricted to any specific Member State. The liberalisation of services in the pension domain is expected to lead to lower costs and higher pension benefits in the European pension market.
The importance of investment funds is, thus, likely to grow for the next decades and it is expected that Luxembourg will have much to offer in this respect. Such growth will be paired with important technological developments. This will be discussed in the next section.
2. The future of investment funds: blockchain-based investment funds & DAOs
Currently, more and more investment fund-based solutions are being offered through ‘blockchain’ and ‘DAOs’ in Europe and the United States. We expect that the role played by fund managers and depositaries as ‘core’ intermediaries in fund governance will not disappear in blockchain-based investment funds. Blockchain technology will, however, transform their role and make the process much faster and cheaper than with ‘traditional’ investment funds. A parallel development currently taking place that is expected to evolve to a further extent in the coming decade is the emergence of investment funds that are established as DAOs. Both the expected development of blockchain-based and ‘DAO’ investment funds will be discussed in this section.
2.1. Blockchain-based investment funds
The rapid growth of the number and value of cryptocurrency and a surge of general interest in blockchain technology opens up new possibilities in the field of investment funds. More and more promotors realize this and are switching to distributed, blockchain-based investment funds that brings significant cost savings to them and their clients. The questions that remain are, (1) what is blockchain and (2) what sweeping changes can we expect it to bring to the role that intermediaries, such as fund managers and depositaries, play in the fund industry?
Blockchain is a type of database that takes a number of records and puts them in a block (rather like collating them on to a single sheet of paper). The underlying ‘distributed ledged technology’ is basically an accounting book where all transactions are tracked. When a transaction is completed, a new block is then ‘chained’ to the next block in a linear, chronological order. All the information on it is securely and accurately stored using cryptography and can be accessed using keys and cryptographic signatures. Once the information is stored, it becomes an immutable database and is governed by the rules of the network. The data recorded in the blockchain is incorruptible due to a built-in ‘consensus mechanism’ in which transactions are validated by the participants (‘nodes’) in the network on a P2P basis. This allows blockchains to be used as ledgers for any transactions or contracts maintained in decentralised form across different locations and people, eliminating the need of a central authority to keep a check against manipulation. Instead, each participant would ultimately access the same ledger and all copies of the ledger would be simultaneously updated, thus ensuring identical copies of the ledger, with no ledgers or versions of data out of synchronisation.
The trading of entitlements may be complemented by smart contracts, i.e. self-executing contracts with the terms of the contract between buyer and seller directly written into lines of code that may be partially or fully enforced without human interaction.
Blockchain, in combination with artificial intelligence and big data, has great potential to transform the role that fund managers, depositaries, and other intermediaries play in the fund industry.
Hedge fund managers, for instance, due to market pressure on their fee structures, increasingly are appointing Robo-advisors to perform portfolio management. Some funds already use trading systems that are determined by an algorithm based upon the investors’ risk preferences. The Robo-advisor selects and executes trades that are recorded in the blockchain ledgers on a weekly basis.
Other benefits for fund managers associated with the introduction of blockchain are the optimisation of compliance functions as part of a fund’s risk management organisation and administration functions. By automatically recording all transactions in a given investment fund along with any documentation or information that is associated with a given transaction, blockchain technology reduces the otherwise significant costs associated with human oversight in recording, organising, and maintaining investment fund data and records. The technology reduces the need for information exchange among parties because all transactions are fully recorded and transparent. Furthermore, smart contracts may be used that are fully self-executing based upon algorithms that are triggered upon an expected input and outcome that is known when the contract is being designed. These contracts may not only be used for administration, but also for distribution purposes.
Recently, for the first time in the Luxembourg fund industry, an investor was able to use a blockchain-based platform to purchase real fund shares with real cash. The investor used the fund platform’s mobile App to submit the standard subscription order for the shares. The order was transmitted to the blockchain platform and the information was immediately and simultaneously transmitted using blockchain technology to all parties involved in the transaction, each one being a participant on the blockchain platform. The transfer agent was responsible for confirming the transaction and logging it as ‘approved’ or ‘declined.’ Approval triggered the clearing and settlement processes, all of which took place on the blockchain platform. This change in the distribution chain promises a real revolution for distribution activities.
Similar developments are to be expected for depositaries. In the blockchain-based fund platforms referred to above, no depositary is necessary to ensure the integrity of the fund’s assets. Assets are digitally represented on the platform by a digital code referred to as a ‘token’ and sent across the network with the ‘public key’ identifying the transacting blocks in which the assets/ownership are recorded. Private keys give the ‘block owners’ access to their digital (tokenised) assets. Nevertheless, depositaries may transform their role to ‘data-intermediaries.’ They may, for instance, specialise in preserving the integrity of the private keys that give the ‘block owners’ access to their digital (tokenised) assets, the provision of the application layer over the blockchain, and performing oversight duties related to the assets recorded in the blockchain with ‘Regtech-solutions’. However, because the ‘intermediated securities holding chain’ for the assets held in blockchain can cease to exist, the differences between ‘financial instruments that can be held in custody’ and ‘other assets’ will be blurred. Consequently, blockchain-based investment funds will also lead to an evolution of the depositaries’ responsibilities and liability under the relevant legal Directive(s).
Many flavours of blockchain have evolved over the years and the terminology is often misconstrued. Broadly, a distinction is to be made between ‘public’ and ‘private’ blockchain networks. The distinction is related to who is allowed to participate in the network, execute the consensus protocol, and maintain the shared ledger. Public blockchain networks are open and anyone can join. Bitcoin is one of the largest blockchain networks today. One drawback of the openness of the networks is that there is little to no privacy for transactions and only a weak notion of security. For this reason, blockchain-based fund platforms are structured as ‘private’ blockchain networks. Private networks require permission and must be validated by the platform operator or by a set of rules put in place by the platform operator. This places restrictions on who is allowed to participate in the network. Private blockchain platforms depart from the original blockchain ‘consensus mechanism’ and requires trust among the participants involved. The consensus mechanism is centralised in the hands of a single entity, i.e. the platform operator, whose mission is to verify and add all transactions to the blockchain. A network based on a private blockchain, thus, offers a number of advantages in terms of flexibility.
Private blockchain networks may be operated by fund promotors and will slowly pave the way for ‘vertical consolidation’ in which fund services will be consolidated. In the private blockchain network, regulators might require that the financial intermediaries participating have an authorisation as depositary, a fund management company, and that their respective delegates are also authorised under the relevant laws. Complementary intermediary regulation applying to the entities mentioned above may solve this issue. Transactions related to a specific sector on the platform could be ‘controlled’ as they relate to specific sectoral legislation, and for which an authorisation would need to be obtained. Competent Authorities could become active ‘full nodes’ in order for them to obtain a copy of the records made and better supervise the platform and its operator. Slowly, the process would then transition towards the ‘Fintech era’ in which the focus is not on (intermediary) regulation targeting platform operators and nodes, but on regulation which targets platforms that are largely self-governing. The focus of regulation in this era is likely to be on platforms that are under European regulation setting out legislation applicable to fund platforms.
2.2. Investment funds as DAOs
The final stage of development in the fund industry of the coming decade may be marked by investment funds as DAOs that are set up as ‘fund blockchain platform’ and consist of a ‘bundle of smart contracts’. These are decentralised structures in which multiple ‘bundles of smart contracts’ are operating autonomously on the basis of rules and mechanisms programmed into them.
DAOs have the potential to implement the organisational theory of the corporation as ‘bundle of contracts’ as they do not require traditional business (legal) entities to be incorporated. It is even expected that these organisations may enter into contractual relationships through (smart) contracts with third parties on an autonomous and self-executing basis.
A ‘democratic humanless venture capital structure’ established in 2016 that was named ‘The DAO’ showed that these organisations are technically possible. Although the organisation raised 150 million USD, 50 million USD was diverted by a malicious node that led to the abandonment of the project. Further development of smart contracts and DAOs as a ‘substitute’ for financial intermediaries may, however, lead to autonomous self-governing organisations that may provide fund services. Although this shows potential for (retail) investment funds, such as ETFs, this example shows that many IT and cyber-related risks will need to be overcome in order to make DAOs commercially viable.
3. Conclusion
In view of the permanently evolving fund industry, two conclusions can be drawn related to the expected development of the Luxembourg investment fund industry in the coming decade. First, investment funds are a possible solution for the tighter capital requirements imposed on banks and may, with the possible introduction of the PEPPR, help to alleviate the European ‘pension gap’. This paves the way for investment funds to continue to rise in importance in Luxembourg. Second, blockchain-based investment funds and DAOs will lead to a transformation of the role played by fund managers, depositaries, and other intermediaries in fund governance and make the process much faster and cheaper than with ‘traditional’ investment funds.
The article first appeared in NautaDutilh.
The views expressed in this article reflect some of the author’s experience to date on the subject matter. As the Luxembourg fund market continues to develop – namely in relation to blockchain and DAOs – these views may and will most likely continue to evolve in one way or another. This articles should in no wise be construed as legal advice rendered by the author or by NautaDutilh Avocats Luxembourg S.à r.l., nor should it be interpreted as reflecting the views of NautaDutilh Avocats Luxembourg S.à r.l.
Sebastiaan Hooghiemstra is an associate in the investment funds practice of NautaDutilh Luxembourg. He assists asset managers, funds promoters, depositary banks and institutional investors in the structuring and setting up of Luxembourg investment fund structures. Prior to joining NautaDutilh Avocats Luxembourg, he was a Doctoral Candidate at the University of Utrecht and worked as a Research Associate at the University of Liechtenstein. He recently obtained a Ph.d. in Financial Law from Utrecht University.
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