Tokenised Fund Units As Collateral Goes Digital

The MFSA has issued a Position Paper exploring the use of tokenised fund units as collateral on public DLT networks. This development represents a shift in bridging traditional fund structures with emerging digital solutions. Tokenisation of financial instruments enables regulated entities such as brokers, credit institutions, and investment firms to leverage these fund units as collateral more efficiently on DLT networks, while simultaneously ensuring investor protection, compliance, transparency, and increased efficiency in collateral transfers.

The MFSA delves into the benefits of incorporating tokenised fund units as collateral. Operational efficiencies are among the primary benefits, as the settlement and transfer of tokenised assets can be completed near-instantaneously, with enhanced traceability for identifying suspicious transactions. Smart contracts can be set up to restrict the transferability of the pledged token and to detect liquidation triggers, among other things, thereby reducing manual processes and operational risk. Additionally, this model benefits fund administrators by reducing paperwork and enabling an automated, accelerated KYC/AML process. Incorporating a hybrid architecture offers a practical approach to maintaining regulatory oversight while benefiting from DLT functionalities: administrators continue to hold the share register (off-chain) and combine it with on-chain token registers.

From a regulatory perspective, tokenised fund units remain financial instruments and hence are subject to MiFID II, ensuring that investor rights and protections remain applicable. The recognised fund administrator continues to maintain the official share register, while tokenised records operate as a supplementary, on-chain ledger, enhancing transparency and auditability. Valuation, NAV calculations, and dividend distributions are conducted under established CIS rules, with independent valuation applied to illiquid assets. Tokenised units can also be efficiently used as collateral, either through regulated lending arrangements or, where applicable, through decentralised finance (DeFi) protocols, provided that liquidators are formally approved, whitelisted, and operate under robust governance and AML/CFT standards.

Tokenisation introduces new operational and technological risks. While permissioned DLT networks mitigate certain risks, they remain susceptible to cyberattacks, smart contract errors, and interoperability issues. The MFSA recommends strict risk mitigation strategies, involving independent audits, secure management of private keys, cyber resilience measures, and clear contractual agreements that outline ownership, collateral enforcement, and governance.

The MFSA recognises the potential of tokenised fund units as a collateral mechanism to modernise fund operations, improve liquidity, and generate additional returns through the lending of tokenised units as collateral. Undoubtedly, success depends on robust governance, secure permissioned DLT architectures, comprehensive KYC/AML procedures, and clear regulatory compliance.

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