The times they are a chainin’

Fund distribution is entering the digital age, and so can traditional service providers. Fundsquare’s Paolo Brignardello explains why it’s in their interests.

Anyone operating in the funds industry over the last few years will know that product costs are under pressure, and new ways of doing business in the future will need new operating models.

The advent of several regulations such as the second Markets in Financial Instruments Directive (MiFID II), the Regulation for Packaged Retail and Insurance-based Investment Products, and UCITS V, have or will impose a greater regulatory burden on asset managers, and rising intermediation in distributing funds in the last decade has squeezed margins.

As if things weren’t challenging enough, asset managers must also adapt to changing client behaviour with a growing number of millennials placing greater emphasis on simplicity and convenience of services, as well as security. As we enter the digital era, industry players will need to evolve their distribution models in order to provide services to investors and sustain trust in the future.

The funds industry must also lower overall costs and deliver even more competitive products. A recent report from Deloitte and Fundsquare points out that Luxembourg’s cross-border fund industry alone could save nearly €1 billion a year with improvements to the fund distribution supply chain. However, there’s been little impetus for changes so far. This could soon change with the introduction of new technologies such as blockchain. Blockchain has been something of a buzzword in recent months. Its distributed ledger technology (DLT) is threatening to shake up the business model for financial sector players, including the funds industry. Distributed ledgers and digital tokens are able to use blockchain technology to track ownership of financial assets, in real time and in a less costly method, opening it up to shared economy models.

There has been much speculation that the introduction of blockchain technology could help drive down costs and replace intermediaries that currently operate in the fund space. These include transfer agents, custodians, distributors, and settlement and clearing houses. But these entities provide vital fund administration services and cannot simply be dispensed with. Instead, we see blockchain technology as offering a route towards greater efficiencies among intermediaries, heightened security and improved services for investors around a single ecosystem.

Starting from late 2016, Fundsquare partnered with InTech and KPMG to launch FundsDLT, a new decentralised fund order processing engine based on DLTs, digital tokens and smart contracts to test a fund distribution model using blockchain. The aim was to set a first milestone operating in the existing fund industry ecosystem, in cooperation with existing actors. In this attempt to create a shared economy for funds, the first use case addressed is for asset managers willing to sell funds directly to investors, and to test its effects.

The operating model sees an investor going through an online application to access fund information and perform know-your-customer (KYC) duties and then subscribe to a fund by provisioning cash through a digitalised token. On the other side, transfer agents will perform the validation of KYC requirements and order acceptance, while an asset manager can follow up inflows and outflows in the registrar in real time. Once the net asset value (NAV) has been published, the entire settlement process is executed instantaneously.

FundsDLT is expected to reduce the cost and processing time of transactions by streamlining fund administration and order routing tasks. As a result, investors, asset managers, custodian banks and transfer agents will be able to share information in a far simpler manner. For example, it can currently take up to three days for a transfer agent to execute an order taken from a client. This new fund distribution channel will do it in a couple of hours after NAV publication—and in the not-too-distant future, with multiple NAVs per day. Investors’ experience of lengthy settlement processes for services will be less tolerated when compared to other online transaction services. The proposed ecosystem created by FundsDLT will also ease anti-money laundering, KYC and MiFID II verification by standardising the process. This will reduce costs tremendously and remove the need to repeat KYC tasks for investors or their agents.

FundsDLT intends to expose a complete application programming interface to deliver an open standard covering accounts, transactions, onboarding, KYC, payments and entitlements. This is expected to lead to broader changes in Luxembourg’s pool of expertise. Intermediaries like transfer agents have great stores of knowledge and are well placed to be an active part of the industry’s revolution.

FundsDLT has been developed using a private permissioned Ethereum blockchain and is expected to grow under a consortium blockchain where the consensus process and access permissions are controlled. The experimentation is progressing, in collaboration with fund industry actors, toward a viable product that is driving increases in operational performance.

We strongly believe that the funds industry needs to explore the digital revolution to find alternatives as well as complementary distribution models that will increase efficiency, deliver a new service paradigm to investors and make funds more accessible to new market segments.

Asset Servicing Times, issue 158