As investor interest in crypto funds and assets accelerates, transfer agents face an existential challenge: how to support both the on- and off-chain worlds and remain relevant.
Bitcoin’s launch in 2009 introduced a new paradigm into the financial sector – the idea that assets can be represented on a distributed ledger, potentially disintermediating some of the functions transfer agents perform.
As the OECD observed, distributed ledger technology-based security registries offer “increased transparency and a clear record of beneficial ownership with certainty at any point in time. The role of registrars/transfer agents may thus be rendered redundant and corporate/shareholder registries replaced by the decentralised ledger itself.”
Government or retail money market funds are prime candidates for employing DLTs, noted international law firm Perkins Coie. “The distributed ledger would serve as a virtual transfer book for the shares, recording each trade and the current share balance held by each shareholder.”
Whether DLTs can or should replace traditional market networks and the ledgers used for shareholder registers though is subject to debate. And there is some way to go.
Regulation is one issue. While many alternative funds in the United States maintain the shareholder record in-house, self-administered funds are not permitted in the EU. Investor location will therefore impact on the need for a transfer agent – at least until any rule changes are made.
The blockchain trilemma – a term coined by Ethereum co-founder Vitalik Buterin – poses a further question. The challenge developers face is to create blockchains that are simultaneously decentralised, scalable and secure. At present, achieving all three aspects without compromising any one is proving difficult.
The number of high-profile hacks show cybersecurity remains a concern. And decentralisation comes with a trade-off: speed. That impacts scalability.
In the funds world, security and scalability are must-haves. If they aren’t compatible with decentralisation, then some form of central governance – such as a bank-run private blockchain – may be a necessary trade-off.
Then there’s the role of smart contracts. A distributed ledger with embedded smart contracts could disrupt the role of a transfer agent by automating the transaction processing activities, and decentralising oversight and control of the fund distribution model to the fund managers, distributors and supervisory entities.
Yet the legal status of crypto assets and enforceability of smart contracts under private law in jurisdictions around the world is a thorny topic.
For instance, in the UK the Law Commission published its advice on smart legal contracts in November. It concluded, “the current legal framework in England and Wales is clearly able to facilitate and support the use of smart legal contracts, without the need for statutory law reform.” However, it noted “the problem of digital location – that is, the difficulty of ascribing real-world locations to digital actions and digital objects – is amongst the most significant challenges that private international law will have to overcome in relation to emerging technology.”
The OECD report also pointed to questions around data protection, and the sharing and storage of data, especially in jurisdictions with data privacy regimes such as GDPR in Europe. The report observed that data erasure clauses giving clients the right to be forgotten are antithetical to the immutability of the blockchain.
Supporting parallel worlds
It is clearly too early to write transfer agents’ obituaries. Interest in crypto-assets and blockchain-based security tokens may be growing (a 2021 Arca Asset Management industry survey found 77% of respondents believe most securities will be digitised and settled on a blockchain within the next decade), yet they remain a tiny sliver of the total investment pie.
A distributed ledger would also struggle to perform many of the services transfer agents provide, noted the Perkins Coie paper. These include storing personally identifiable information, responding to shareholder enquiries, transmitting general and shareholder specific communications (e.g. account statements, prospectuses, financial reports), and delivering tax reports or withholding.
The paper added that for blockchain-based funds using electronic fund transfers, the distributed ledger will need to interface with an external system that matches trade orders to cash transfers. “Thus, an essential element of the core function of a mutual fund transfer agent would still need to be handled outside the distributed ledger.”
And here is the rub – the prospect of a dual on- and off-chain environment existing in parallel, which transfer agents will need to support.
Some of our clients are already wrestling with how to handle funds denominated in cryptocurrencies or that invest in crypto assets, and replicate that in their existing non-DLT environment as the third-party fund administrator. To do it, they must accommodate the cryptocurrency (including updating systems to support longer strings of decimal places), handle different settlement processes and reporting currencies, and potentially mirror what happens in a distributed ledger employing smart contracts in a more traditional accounting system.
We’re also seeing situations where fund managers create tokenised funds that run on a distributed ledger. Since it’s a private blockchain, the manager operates the infrastructure, with the fund administrator having to shadow whatever happens in the distributed ledger – the money coming in and out, being invested, the current value of that holding – in a traditional transfer agency system.
Transfer agent flexibility
DLTs may not yet be ready to disrupt all the functions and replace the infrastructure that exist today. But the technology is spreading. Transfer agents will need to understand and interoperate with the blockchain world – as will the software they rely on to carry out their investor servicing tasks.
In an effort to cut costs, boost efficiencies and deliver better service, fund admins have long sought to consolidate their transfer agency systems onto a unified platform. Given the emergence of different blockchain methodologies, we could see a proliferation of complex, non-uniform microenvironments develop to support these new fund types.
With so much of their business still focused on traditional structures, transfer agents need a technology platform with proven capabilities, along with the architectural flexibility to replicate these new methodologies. And that in turn demands a provider with the agility and willingness to make the required system changes to keep up with the times.
For their part, fund administrators will need a strategy to accommodate distributed ledger-based offerings. Their ongoing ability to fulfil their responsibilities, add value and remain an attractive partner to managers depends on it.
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