In this edition of the Hugely Popular Cummings Pepperdine Crypto Questions, we learn how to tokenise a fund with Danielle Faul of Hash Directors in Cayman, director of a tokenised fund.
Claire and Danielle talk tokenised funds; what they are, why would you tokenise your funds and the different structures and quirks that are out there.
To find out more about Danielle Faul and Hash Directors in Cayman, visit https://hash.direct/
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Well, thank you everybody for joining us on this edition of the hugely popular Cummings in crypto questions. Something we've talked about in the past is tokenization in general, but I wonder how many people have ever thought about how it's possible, or even if it's possible to tokenize a fund. Well, I'm delighted to have with me today, Danielle Fol from Hash Directors in Cayman, who is herself a director of a tokenized fund. So Danielle, how about we just get straight down to it? Tell our listeners what exactly is a tokenized fund and then perhaps we can look at why anybody would tokenize and how to do it, and then the different structures and quirks that are out there. Yeah, no problem. Thanks for having me, um, on the podcast. Very exciting. My pleasure. Yeah, so let's dig right into it. So Tomos Fund is basically the same thing as a normal fund as we know it, but with one small and impactful difference. The shares are on the blockchain, so it uses underlining blockchain technology to issue tokens. That represents the ownership of a fund. So just with normal funds as you can buy and sell and transfer, you know your share in the fund, now you can buy Sal transfer your token that's connected to, to this fund. So how. How would they do it? That's the question. So a fund can meant their own specific token. So clearly if you had your own fund, yeah, you can call it a clearer token, you can really call it anything. And then they choose a blockchain to, you know, launch this on Polygon is very, very, a very, very popular blockchain to do this on. And then, You know, they can start selling these, these tokens and that would represent a share. So one token would be one share in the fund and so forth. So if, so, if I just recap that we think about what we might term the sort of a tra traditional hedge fund. It's a Cayman fund. It has a minimum subscription of a hundred thousand us. And that buys you one, uh, that buys, you say 100 shares. I fill in my form, this subscription form. I send off the money to the administrator, and I've got my shares with a token, though, I get a token, which is a token of those 100 shares. I put my token in my wallet, and I keep it safe, but not just that. If I want to sell my shares to somebody else, presumably I can just take my token out and I can sell it on. Exactly, so, so, so that also means that you can create a secondary market in your fund. Investment liquidity is made well. You don't have to wait for the next quarter or whatever to redeem your fund. Your liquidity is complete. Exactly. So how a tokenized fund works in the backend, and that makes all of this possible, is it's run by a smart, a smart contract, and you can put anything into the smart contract requirements and how subscriptions are made and how redemptions are made. So all of this would be governed by a smart contract. Can you put, if I could just check, nobody can make an investment nowadays in anything without completing full due diligence. And for some people that may be enhanced due diligence. So can that due diligence be also caught, um, built into the smart contract so that say for example, you know, I've got my token of my, my a hundred shares and I want to sell to you. Yeah, so what happens is the smart contract is created where the investor, usually with a, with a tokenized fund, the fund would have either an interface, a ui, or a app where the investor can create a profile, and that profile is then kyc and then used to make the investments to buy and sell, sell tokens. So the KYC process are usually. Automatic where software is used to K Y C E investor and no manual intervention issues at all. What would happen is we would do things like scanning your face and taking a photo. Taking a photo of your id. Doing a likeliness check, for instance, and measuring where your IP is at, so where you're actually creating this, um, profile from or where you're actually subscribing from, ensuring, you know, your proof of address aligns with your IP and in the country where it is. So that is, that can all be done automatically and integrated into your smart contract. So usually as a director, I require my funds to first sign off on the AML before allowing any funds to enter the fund itself before accepting any funds from investors. Yeah, I think that probably if I ask my next question, we probably cut, we've, we've no doubt covered a lot of it, so it might sound a bit silly, but apart from the obvious upside of tokenization tell of of liquidity, tell me why tokenize a fund. Well, I mean, there's a, there's a couple of good, good reasons to do it because of the blockchain basics and the smart contract governance that creates a lot of benefits. So the first one would be fractional ownership. Just like you would buy a Bitcoin. In the beginning, people thought you have to buy an entire Bitcoin, but you really don't have to. In the beginning, you could do, couldn't we? Yes. Well, yes, that would be very, very cheap for you, but now you know, you can probably just buy 0.001 or whatever it is. Um, and that allows for small percentages of investment for, you know, these average day investors into a fund where they wouldn't normally get the option or opportunity to invest in funds like a venture capital fund or other tokenized assets such as fine arts. So the fractional ownership makes that possible then, You know, it's built on a blockchain, so it's very transparent. Um, it allows you Yeah. Transparent and mutable. Yeah. So you've got, so the ownership is there, so there'll be less dispute over ownership. Plus built into the blockchain, as we've already said, is the A M L. Exactly. And also with the transparency comes, you can track all the transactions. You can track the valuation and the performance almost real time. So investors can actually then invest or deves in real time and track the market value of their investment more often than, you know, getting the monthly statement from your fund admin as it would usually work. So it's very, very transparent that way. You can also see. The entire share register on the blockchain, all beholders of the token, all those wallets, that would be the share register of the blockchain. Yes. So you can see entire realtime share register on the blockchain as opposed to manually doing it. So you really get to see inside, but obviously things which need to be confidential, such as who the other shareholders are. Then you, the director, obviously you can see that and you need to, and the administrator. But the other shareholders won't be able to, no, no shareholder can see who the other shareholders are. Can they? Exactly. They can't. So all you can see are the blockchain is the wallet address that holds the token, but you can't see the name of the person that actually holds the token. That would only be known by the fund. Yeah. So it is public, but your identity is still protected. So is also, so what we're talking about really is a great deal of flexibility being built in, which is something which is to me one of one. One of the most important and useful elements of blockchain is that flexibility, you know, you can let the right people see all the way in, but you can also give co confidential protection, which is required by law. Exactly. Exactly. And you the things that's required by law, those requirements that could be governed by the smart contract. So if you build the smart contract clearly, correctly and build that into the smart contract, you don't have to worry about that too much. Another benefit that it can give you is improved liquidity. So typically with. Venture capital funds, their assets are usually illiquid and they have lockup periods. Yes. So in this case, what we're seeing, non lockup periods as well. Yeah. Yeah. Up to, you know, seven or 10 years. And what we're seeing these days is a secondary market, you know, where those LP investors can sell those tokens on a secondary market and liquidated before the lockup. Period has or expired. So that makes it actually now a liquid token as opposed to illiquid token and allows so much, so much more investors to go into those type of funds. Yeah, that's a very, very good benefit to that. Yeah. It raises a very interesting point with is of, is that token, a token? Is that token of share, whatever, but that's that, that's an that, that's an interesting one for me to mull over and maybe we'll, Discussed another day, but tell me how can you tokenize? Because I would imagine that there are gonna be some funds and fund managers who have the ability to, to, to actually code and produce tokens and, and issue them and, and produce smart contracts, and also test the smart contracts internally. But not everybody's gonna have that kind of capacity, are they? So what are the different ways that a manager can tokenize a fund? Well, there's really two ways. So the first one is you can, you know, appoint your own developers and you can develop your own smart contract UI or app, and you can decide the system and how it should work, which is good with in the benefit of doing this is you can build in your jurisdictional requirements into your MOD contract. Um, you have to hire, hire developers though that understand the. Fund nuances and the requirements of your jurisdiction Yes. To build this effectively and you're gonna need to do a spot contract, you know, audit to ensure there's no bugs and, you know, comply with the jurisdictional requirements. Yeah. And the, and I would second. Mm-hmm. And I would, is it, you know, expect me to say this of course, but I would also add that you have to have your lawyers working very, very closely with the developers to make sure that the smart contract is legally correct. Exactly. So you know, that's why you need a developer that could relay the information to legal professionals or you know, accounting professionals, an easy way where you can work together to do it, because they really speak a different language to us, right? Developers, they code in different language to speak a little bit of a different language. So very important when hiring developers. So the second option would be to, you know, employ a service provider or somebody else to do it. You can get a already Build Smart contract, which is basically a package, uh, software that you would usually like, normally buy, and you can customize it according to your needs. A couple of, yeah, things to consider for those is it's not written specifically for the requirements of your jurisdiction. So for instance, fatca, crs or tax requirements. So you have to ensure that your requirements are in, could be implemented in that smart contract, or you have to work with the service provider, um, to update this smart contract to comply with it. So two things to consider there. Internal and external. Yeah, exactly. So, Danielle, let me, let me sort of bring this onto another question, which is what structures are available, and I say this in light as you know, the earlier comment if to me, one of the delights of blockchain is the flexibility in how it can be used. So what structures are available? Are there any that aren't available? Well, that is the interesting part. It really is about the underlying technology, the blockchain and the smart contract. You can have any type of fund or any type of structure tokenized. Yeah, it's all about the technology behind it. So there's not a lot of limitations here. Loin, you've had a bit of a, sort of a, a gallop through these, but one thing which I would find very interesting, possibly slightly gossipy to end on. Would be from your experience as a director of a tokenized fund and having gone through the process of building them, and also now through the process of being an ongoing director. Tell me about some of the quirks that need to be considered. Tell me about some of the things that can go wrong and also the things that went really right and you want people to, to, to, to know more about. So there's quite a bit of things to consider. Yeah, because you know, I. We've been directors on tokenized funds for a while now. We've seen some things go right and wrong and things you would never expect or don't even know about, so, um, a lot of considerations. Yeah, I would say the first one because it's a crypto to crypto transaction because you're subscribing in a crypto and you're getting a token. Of the fund, you know, it's subs. We call it a subscription in kind, and with subscriptions in kind as an independent director, I'm searching for a little bit more than the usual K YC procedures. So we usually require clients to do, you know, scan the wallet and get a risk rating on a wallet. That really is gonna depend on what the inflow into the wallet was and what the outflow of the wallet was. What the risk rating does is it tricks if there's any higher risk inflows for ex, for example, from a mixer, and it gives the wallet a risk rating, which can be used in your K Y C analysis. And then another thing we require or ask our clients to consider is, you know, Ensuring that the person that invest has control over the wallet that they're subscribing from. So there's control tests that you can do as well. Yeah, so those are two additional things that can be written into either the smart contract or those that needs to be done manually. And the smart contract can only be executed once the A M L and K Y C has been signed off. Some things to, you know, consider there in terms of the smart contract. I'm not gonna lie to you. There's some extra hoops to jump through here to develop it and ensure the regulation is also included in the development of the smart contract. Like we men mentioned, the jurisdictional laws need to be incorporated. You need to audit it, and you need somebody to understand the tick there that. Third thing would be a secondary market. It's good and bad because it allows full liquidity for venture capital funds, but it's also bad because if you allow an investor to sell a token of a fund on a secondary market, that's not K Y C or that's not an in eligible investor. Then you're not within your P P M or your regulations, so ensuring that your smart contract regulates that as well, and that you're using only secondary markets that also complies with your requirements is very important. Absolutely key. Mm-hmm. Yeah, absolutely, absolutely key. And then just from a service provider perspective, I mean, in Cayman Islands we have a, a lot of great service providers here for the digital assets industry, from a fund admin perspective. I mean, and I've, I've, I've come from a fundal admin world, specifically digital assets. So just to pull the data from the blockchain and normalize these data and pull the data from the smart contractors. You're either gonna need to do it and normalize it yourself or get a service provider to do it. That could be a challenge sometimes. Then, you know, having the software that can deal with cryptocurrency and crypto transactions, getting the market value for this crypto to crypto transaction. For instance, I'm investing in Bitcoin. I'm buying the fund's, you know, token, I'm gonna need the market value for my Bitcoin and the fund's token at the time of investment. And that needs to be available. So your fund admin needs to have that available to them as well. And then they have to have knowledge about smart contracts, the market and how it works. And then other things like transfer agents for instance. There's also a consideration there. Because usually they would go through the process of accepting, you know, your fiat in the bank account, checking that the fiat has been accepted, checking the subscription document and then paying out redemptions manual. Yeah, exactly. Exactly. But because of the smart contract and how efficient that is. We don't need them to do those things manually anymore. For instance, create a registrar of shareholders because that is already real time available on the blockchain, so it really takes out a lot of that effort. So transfer agents wouldn't be as necessary as they usually were in the traditional fund scenes. You know, you have to also think about private keys if you're gonna have a smart contract, if the, the tokens are gonna be Hal on the app, who's gonna keep the private keys? Is there a custodian that's gonna hold those key, those, um, keys, peaceful, those tokens or those wallets, and maybe you'll even sharp that key as well. That's, you know, Basically shared the key. Yeah. So we usually require, or you know, talk to our clients about NPC Wallet solutions, where you have multiple layers of approval. That you can do for institutional integration, you know, where it's not only one person that can transfer all the funds or assets on the management of a fund, you need two or more people to do it. I mean, I've been in a situation recently where one of my funds actually shared private keys on a post with manager, and the idea was to, you know, send the assets under management and hold the assets under management in that private or in that wallet. So, We had to abandon the wallet and explain to them how the take works behind it. So these things you see, which you need to, you know, focus on as well. Um, there's a couple of other jurisdictional and legal requirements that you need to look at as well, like a VAs Act in Cayman Islands, for instance. We have a virtual asset service provider act, and you need to know if you fall inside or outside of that. If you're inside of it, you need to register with sema. We recommend usually to obtain a legal opinion with that. Yes. Yeah. Important. Well, Danielle, thank you so much for that. I think in particular when we were talking about the quirks and considerations, there was a lot to go through there, and it was even more of a Gallup than usual. I wondered if maybe we could, we could do another podcast soon where we just talk about the quirks and considerations of maybe funds and crypto altogether, so not just tokenized funds. What do you reckon about coming back? And we'll talk about that maybe after the summer. And we can also see how things have progressed over the summer because you know, as you said to me earlier, five years is five lifetimes at the speed that crypto's going. Exactly. We're seeing so much happening these days. So let's cut, uh, catch up again later on. Digital asset funds and also tokenized funds because there's so much to consider as it's a specialized field, you know, with additional tech technical complexities to consider, especially from, you know, a director's PERS perspective as well. So I'll be happy to come back and we can speak about that a little bit more. Perfect. Well, all I need to do, do now is say thank you very much to our listeners, Danielle, thank you very much to you. And I will just give the website addresses for both our websites. So. If anybody would, has any questions, would like to speak to Danielle Fall, f a u l Dan. The website for hash directors is ww.hash.direct, and of course, the website for Cummings Pepperdine is cummings pepperdine.com. Thank you for listening, and Danielle, thank you very much for talking in such detail about such an interesting topic today. Thanks Claire for having me.