Tokenization in the Fund Industry: why it is the future but not yet the present, and a possible solution

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Tokenization of shares has the potential to bring significant innovation to Luxembourg's financial services sector and surely worldwide, offering opportunities to improve processes and operational efficiency in the Investment fund Sector. But today, is tokenization truly beneficial for an investment funds in Luxembourg? The answer is most probably NO - at least not within the current regulatory framework. Despite the theoretical benefits of tokenization - such as democratizing access, enhancing liquidity, and improving processes - these advantages are largely diminished in practice for the Luxembourg fund industry due to regulatory restrictions and structural limitations, and as the present moment it offers more challenges than opportunities. In this article, we will explore the potential and limitations of tokenization within Luxembourg’s current regulatory framework by examining three distinct use cases: Reserved Alternative Investment Funds, UCITS funds, and real estate assets and we will propose a potential solution, which is gradually taking place.

What is Tokenization

Let's start with the definition: What is tokenization? Tokenization is the process of converting ownership rights or other assets into digital tokens recorded on a blockchain. In other words, it is a way of representing assets digitally, where each token signifies a specific share or a portion of the underlying asset. These tokens could be anything from real estate, art, or intellectual property to more traditional financial instruments like shares, bonds, or investment fund units. By leveraging blockchain technology, tokenization makes assets to be divided into smaller, tradable units, offering fractional ownership and increasing accessibility to a broader range of investors.
One of its most attractive features is the fractional ownership, which makes investors to buy smaller portions of an asset. For example, instead of purchasing an entire property, an individual can own a fraction of it, reducing barriers to entry and making investments more accessible to retail investors.

Investor protection is a consideration when discussing tokenization, particularly given the innovative but complex nature of blockchain-based assets. We explored this topic in the previous article on the CSSF’s approach to virtual assets and the regulatory distinction between UCITS and AIFs. There, we highlighted how the CSSF prioritizes safeguarding retail investors while allowing more experienced investors to explore opportunities in virtual assets.

Tokenization and RAIF

Reserved Alternative Investment Funds (RAIFs) have with a minimum subscription threshold of €100,000 per investor, according to the Law of 21 July 2023 and they are designed to be accessible only to well-informed investors who meet specific financial criteria, ensuring that only those with the requisite experience and resources can invest. This threshold creates a high entry barrier, limiting the potential for tokenization to open the fund to smaller or retail investors. Tokenization, by design, allows for fractional ownership, which could theoretically reduce the financial burden of entry and broaden the investor base. However, in the case of RAIFs, the €100,000 minimum subscription requirement applies regardless of the investment’s structure, including tokenized units. In practically, this means that even if the fund’s shares are tokenized, investors still need to commit at least €100,000, which fundamentally reduce one of the core advantages of tokenization. In concrete, the lack of accessibility to smaller investors means tokenized RAIFs fail to fulfill one of tokenization's primary goals. As a result of this, tokenization may add unnecessary complexity to Investment Fund without delivering almost any benefit.

We can also say that tokenization could potentially offers operational efficiencies for fund managers, such as improving subscription and redemption processes, automating record-keeping, and improving transparency through blockchain technology, but still the main problems remains: investor pools remain restricted, as is the case with RAIFs and their €100,000 minimum subscription threshold. Given the current regulatory framework, the potential long-term advantages of tokenization - such as improving subscription and redemption processes, automating record-keeping, and improving transparency through blockchain technology - are offset and mitigated by the significant costs of implementation. For an AIFM in Luxembourg, these costs can become a substantial burden. Integrating blockchain technology into existing systems requires considerable investment in infrastructure, staff training, and ensuring compliance with complex regulatory requirements. While these advancements may provide efficiency gains in the future, the high implementation expenses, combined with the limited investor base due to the €100,000 minimum subscription threshold for RAIFs, make tokenization a challenging proposition. For many AIFMs, the immediate financial and operational burden outweighs the potential benefits, limiting the practicality of tokenization under the current framework.

Tokenization and UCITS

Tokenization is often considered an innovation to enhance liquidity, particularly for traditionally illiquid investment structures, by enabling fractional ownership and facilitating secondary market trading. However, for fund structures like UCITS (Undertakings for Collective Investment in Transferable Securities), which are already designed to provide high liquidity, the benefits of tokenization in this context are less pronounced. UCITS funds are, by definition, liquid due to their regulatory framework, which mandates frequent (often daily) redemption and subscription opportunities, ensuring that investors can easily enter or exit the fund without significant barriers.

The liquidity in UCITS funds is regulated by strict regulatory requirements, including the obligation to invest surely in liquid assets and maintain sufficient cash reserves to meet redemption demands. This existing and strong liquidity means that tokenizing UCITS shares would not dramatically improve their accessibility or tradability. Investors can already redeem or purchase shares in these funds with ease, typically through established financial intermediaries or platforms on a daily basis. As a result, the primary advantage of tokenization- creating liquidity in otherwise illiquid investments - becomes redundant in the context of UCITS.

That said, tokenization could still offer marginal benefits for UCITS funds, such as reducing operational costs, enhancing transparency, and streamlining administrative processes like shareholder record-keeping and compliance monitoring. By utilizing blockchain technology, UCITS funds could potentially lower fees associated with traditional intermediaries and offer investors direct, real-time access to their holdings. Additionally, tokenization could simplify cross-border distribution by allowing seamless transactions across jurisdictions, making UCITS funds more accessible to a global investor base. However all this, comes with an high cost of implementations and efforts, as we were briefly describing above.

Therefore, while tokenization can still play a role in enhancing operational efficiency for UCITS funds, its impact is far more significant in fund structures where liquidity is currently limited or non-existent.

Tokenization and Real Estate/Private Equity

Tokenizing a single real estate asset is a highly compelling use case for blockchain technology, and Luxembourg is well-positioned to play a leading role in this innovative approach
The Blockchain III Law and the implementation of EU Regulation 2022/858 on distributed ledger technology (DLT) significantly impact the potential for real estate tokenization in Luxembourg. By extending the definition of "financial instruments" to include those issued and represented using DLT, the law provides greater legal certainty for tokenized assets. This framework allows tokens representing ownership shares or other rights in real estate to be structured as transferable securities, ensuring they fall within the scope of Luxembourg’s robust regulatory environment. Furthermore, the inclusion of DLT-based financial instruments under the Financial Collateral Law opens opportunities for tokenized real estate to be used as collateral, enhancing its utility and liquidity in financial transactions. By emphasizing technological neutrality, the Blockchain III Law ensures that DLT-based systems are treated equally with traditional methods, fostering innovation without imposing rigid technological mandates. However, while this framework supports tokenization, it requires real estate tokens to comply with securities regulations, which can introduce complexity and cost. Nevertheless, Luxembourg’s progressive legislative initiatives position it as a leading jurisdiction for DLT integration, providing a secure and innovative foundation for real estate tokenization.

A potential solution for Tokenization

A potential solution to overcome the challenges of tokenizing a RAIF within Luxembourg’s current regulatory framework could involve creating a pool of investment outside the RAIF structure. This pool would directly invest in real estate, and its shares could be tokenized to replicate the strategy of a RAIF without being subject to its regulatory constraints, including the €100,000 minimum subscription threshold. I This is a possible solution and direction where the market might go. By tokenizing the shares of the investment pool, fractional ownership could be achieved, allowing smaller investors to participate and broadening the investor base.

This model would make the pool mirroring the investment strategy and objectives of a RAIF, such as focusing on real estate assets and risk diversification, but without the limitations imposed by RAIF-specific regulations. In other words, a RAIF strategy does not strictly qualify as a RAIF in legal terms. Tokenized shares, recorded on a blockchain, would improve liquidity and facilitate transfers, providing a more flexible and accessible investment framework.

While this approach, even if eliminates the regulatory burden of a RAIF, it still requires compliance with other legal obligations, such as securities laws and anti-money laundering requirements, especially if the tokenized shares are classified as securities and surely a adopting a strong AML/KYC due diligence on investors and assets. Investor protection and transparency would also need to be carefully managed to ensure trust and credibility. In conclusion, the challenges remains, but this could be an alternative way to replicate a RAIF strategy without being a RAIF.

Tokenization and Liquidity

A potential significant advantage of tokenization is liquidity. Traditional assets like real estate or private equity are by definition illiquid, often requiring substantial time and effort to buy or sell. Tokenization potentially (and we emphasize potentially) makes illiquid assets more liquid, and this is one of its most significant advantages. However, without a robust and active secondary market, this potential for liquidity remains more theoretical than practical. In the absence of a secondary market, token holders may still face significant challenges when attempting to sell their tokens, as there may be no buyers readily available.

Liquidity is not just about having a secondary market in place. It fundamentally relies on genuine and real demand for the tokenized assets. Even if a trading platform would be in place, if there is limited interest or confidence in the underlying asset, trading volumes will remain low, making the market inactive and tokens difficult to sell. A considerable amount of investors should actively participating to create a dynamic and efficient market. Without sufficient demand, the existence of a secondary market does little to solve the liquidity problem, leaving token holders/investors with assets that remain effectively illiquid.

Tokenization has the potential to revolutionize asset management by enabling fractional ownership and improving liquidity. However, in Luxembourg, its application in the investment fund sector is currently limited by regulatory and structural constraints. While tokenization offers theoretical benefits, such as enhanced accessibility and operational efficiency, its practical advantages are diminished under the existing framework. For tokenization to truly thrive, Luxembourg requires not only regulatory adaptation but also the development of robust secondary markets and infrastructure. Until these elements align, tokenization will remain a promising concept with limited immediate impact on the financial industry.

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The views and opinions expressed in this article are my own and do not reflect the official policy, position, or opinions of any financial institution, or other organization.
The content of this article is based on personal research of the author and understanding of AML (Anti-Money Laundering) and compliance topics.