Tokenization of financial assets has expanded rapidly since the beginning of 2025, even in the absence of regulatory clarity around issues such as custody, trading and the applicability of transfer agent rules to tokenized assets. The first article in this series examined what tokenization is, how real-world assets are tokenized, and advantages, disadvantages, and risks of tokenization. This article and the previous one examine various issues that a fund board may wish to consider in connection with possible investments in tokenized assets.

Increased Liquidity?

Rule 22e-4 under the Investment Company Act of 1940 requires each open-end investment company registered under the 1940 Act, including funds and exchange-traded funds but not including money market funds, to adopt and implement a written liquidity risk management program reasonably designed to assess and manage the fund’s liquidity risk.[1] Two of the required elements of the liquidity risk management program (except for ETFs that redeem their shares in kind) are:

1. Classifying the liquidity of each of the fund’s portfolio investments, as well as reviewing each classification not less frequently than monthly; and
2. Determining and periodically reviewing the fund’s highly liquid investment minimum, defined as the percentage of the fund’s net assets that it invests in highly liquid investments that are assets.[2]

However, a fund that primarily holds assets that are “highly liquid investments” is not subject to the highly liquid investment minimum.[3]

The liquidity rule imposes a classification framework that requires a fund to assign each of its investments into one of four categories:

• highly liquid investment—based on fund’s reasonable expectation that an investment can be converted to cash within three business days;
• moderately liquid investment—based on fund’s reasonable expectation that an investment can be converted to cash within four to seven calendar days;
• less liquid investment—based on fund’s reasonable expectation that an investment can be sold or disposed of in seven calendar days, but the settlement is reasonably expected to be greater than seven calendar days; or
• illiquid investment—based on fund’s reasonable expectation that an investment cannot be sold or disposed of within seven calendar days.

Recall that one of the expected advantages of tokenized investments is that assets that have traditionally been viewed as illiquid or less liquid should experience increased liquidity in tokenized form by virtue of factors such as fractionalization and near-instantaneous settlement of transactions (so-called “atomic settlement”). However, current market experience with tokenized assets has not demonstrated significant secondary market liquidity for most tokenized assets.[4] 

Board members may wish to ask advisers the following questions:

• Is the adviser finding significant liquidity for any tokenized assets?
• What impediments exist to the creation of liquid secondary markets in tokenized assets?
• Are there particular asset classes in which advisers would be more inclined to invest were liquidity to increase?
• Is the adviser examining liquidity risk management programs to assess what would need to change if tokenization were more widely adopted? If so, what has been identified as needing adjustments?

Custody is Crucial

Custody of client assets is a crucial issue for asset managers. With the advent of blockchain technologies and tokenized assets, questions around the applicability of existing custody rules have accelerated to the forefront of industry participants’ and regulators’ minds alike. Much has been written about how tokenization and blockchain technology can disrupt or altogether rewrite the existing client custody framework.[5] Further, Securities and Exchange Commission Chairman Paul Atkins has indicated that he supports providing registrants flexibility in determining how to custody crypto assets, including the option for self-custody and providing “reasonable exceptions” from qualified custodian requirements “to accommodate certain common practices within crypto asset markets.”[6] A further concern involves custody of the existing financial asset that is being tokenized.

While it is not yet certain where the SEC and other regulators will land on custody issues, fund board members will want to begin to consider, among other things:

• How existing policies and controls around custody of client assets could accommodate tokenized assets on the blockchain, if at all;
• Circumstances under which self-custodied assets (if permitted) would be a better alternative for the fund;
• How to prove who has ultimate “control” of the tokenized asset, given unique technological features of the blockchain and smart contracts;
• Which sorts of features or controls would identify institutions as “qualified custodians” to tokenized assets, beyond those which exist currently;
• How and to what extent tokenized versus non-tokenized assets can co-exist (be interoperable) in a custodial framework; and
• How the firm could secure against security breaches.[7]

How Smart are Smart Contracts?

Smart contracts can include compliance restrictions, such as those related to identity verification, investor credentials, and transfer restrictions.[8] This can simplify investment compliance for investment advisers, as the smart contract should automatically prohibit an ineligible account from acquiring a security that the account is prohibited from acquiring. However, security practices associated with smart contracts continue to evolve, which, in turn, could lead to vulnerabilities that one or more bad actors could seek to exploit.[9] Moreover, smart contracts depend significantly on the accuracy of their code, and coding errors may not be easily remedied once the smart contract is in use.[10]

Board members may wish to consider engaging with advisers regarding which, if any, token protocols they are considering, how they are assessing the coding of the smart contracts associated with a token, whether and to what extent they are contemplating changes to existing compliance practices as a result of smart contracts, and if they have investigated whether insurance coverage is available and economically feasible to protect the fund against risks associated with improperly coded smart contracts. 

Voting and Other Rights

In some instances, voting rights associated with a tokenized asset will be the same as those associated with the real-world asset.[11] However, it is not currently necessary for the creator of the tokenized asset to ensure that voting rights are passed through the special purpose vehicle and to the token holder.

Board members may wish to consider engaging with advisers regarding the due diligence they are performing with respect to tokenized equity assets and whether, and under what circumstances, an adviser would consider investing in a token in which proxy voting is not passed through.

Tokenization can enable automated corporate actions, such as issuer notices, stock splits, coupon payments, mergers and acquisitions, dividend payments and distribution payments. Currently, corporate actions trigger 3.7 million event announcements in the United States alone each year and are estimated to cost custodians, brokers, and investors between $3 million and $5 million per year.[12] However, in practice, one cannot simply assume that a tokenized asset will have the underlying financial asset’s corporate actions encoded in its smart contracts. In at least one jurisdiction, the transfer of a share token transfers only the ownership rights over the share token; it does not transfer rights such as voting rights and receiving dividends.[13] The transferee must separately register the token with the issuing company and request the company include it in the shareholder registry.[14]

Board members may wish to consider engaging with advisers regarding:

• Whether they are considering investments in tokenized assets that do not pass through the corporate actions of the financial asset that has been tokenized;
• The reasoning behind that consideration; and
• If not, the due diligence they are performing to prevent purchases of tokenized assets that do not pass through the corporate actions of the financial asset that has been tokenized.

To Invest or Not to Invest (in Tokenized Assets)

There is no law or regulation in the United States requiring an investment adviser to invest client assets in tokenized assets, and as discussed throughout this series, there are many risks associated with investing in tokenized assets. In today’s marketplace, many advisers specialize in managing certain types of asset classes and investment styles and do not venture beyond those remits. Therefore, if none of the assets in the adviser’s niche areas have been tokenized, the adviser can decide not to invest in tokenized assets.

Of course, many times life is not so simple. For example, if an adviser advertises or otherwise indicates it invests in a particular asset type or class, and then refuses to do so, that would generally be viewed as a violation of the anti-fraud provisions in Section 206 of the Advisers Act. Similarly, if a potential client of the adviser asks the adviser to invest a portion of their portfolio in such assets, it would generally violate Section 206 of the Advisers Act for the adviser to take on that client and not invest some portion of the client’s portfolio in such assets.

Perhaps the area that is most fraught with risk is an instance in which trading becomes bifurcated between a tokenized asset and a non-tokenized asset. For example, the Kraken exchange has begun offering tokenized versions of 55 U.S.-listed stocks and five U.S.-listed ETFs to non-U.S. users.[15] If this is expanded to U.S. users, and a liquid tokenized trading market develops, investment advisers may have to decide whether to trade tokenized or non-tokenized assets of a specific company. Could an investment adviser simply determine that it will never trade tokenized versions of fund assets?

There could be legitimate or non-legitimate reasons for such a decision. An adviser could decide, for example, that as long as traditional trading alone exists for a substantial percentage of fund assets, it does not make sense to invest in the infrastructure to run two side-by-side trading operations. This decision could be based on analysis that any cost savings to the fund from tokenized trading would be outweighed by costs to the fund of establishing a tokenized trading infrastructure. An adviser may also receive soft dollar benefits through traditional trading that would disappear in a tokenized trading environment. At the very least, that conflict of interest would need to be fully and fairly disclosed to the board when it assesses the investment adviser’s decision.

As a general matter, board members may wish to consider engaging with advisers regarding how they are approaching the subject of tokenized trading, including any conflicts of interest related to whether and to what extent the adviser might adopt tokenized investments to supplement or replace traditional investments.

Vigilance Necessary

Tokenization has the potential to revolutionize the asset management industry. However, tokenization also presents risks to funds ranging from relatively minor (e.g., selling a token to a party not permitted to purchase it because the smart contract was improperly coded and failed to block the sale) to catastrophic (e.g., finding that a malicious party has exploited a weakness to steal the vast majority of fund assets).

Board members—particularly independent board members—are not responsible for managing a fund. They are, however, responsible for protecting the interests of the fund and its shareholders. As use cases for tokenization expand, and as fund advisers increasingly explore investing fund assets in tokenized assets, board members would be well advised to engage meaningfully with advisers concerning the benefits and risks of their tokenization strategies, as well as the changes that will need to take place as a result of those strategies.

Click here to read the first article and here to read the second article in this three-part series on tokenization.

Ethan Corey (pictured, left) is a senior counsel at Eversheds Sutherland in Washington, D.C. With more than 20 years of experience in the financial services industry, Corey has deep knowledge in distribution issues (including FINRA rules), as well as those related to the Investment Company Act of 1940 and the Investment Advisers Act of 1940. He also has counseled clients on matters related to Municipal Securities Rulemaking Board rules and regulations set forth by the Commodity Futures Trading Commission, as well as the U.K. Financial Conduct Authority’s Conduct of Business Rules and European legislative frameworks such as MiFID II.

Michael Koffler (pictured, middle) is a partner at Eversheds in New York who works with investment advisers, broker-dealers, and investment funds in their compliance with federal and state securities laws and regulations and SRO rules. Koffler advises clients on the full spectrum of business operations, including advertising, portfolio management, trading, internal controls, compliance programs, mergers and acquisitions, and other management issues. He also counsels banks and insurance companies on securities issues associated with the management and distribution of investment products.

Carolyn Garcia (pictured, right) is an associate in Eversheds Sutherland’s Investment Services and Products Practice Group in Washington, D.C. Her experience includes advising broker-dealers and investment advisers on compliance with federal and state securities laws, including Securities and Exchange Commission and Financial Industry Regulatory Authority rules and regulations. 

[1] Investment Company Liquidity Risk Management Programs, Investment Company Act Release No. 32315 (Oct. 13, 2016), 81 Fed. Reg. 82142, 82154 (Nov. 18, 2016).