Can disruptive tech change the face of the fund industry?

Disruptive technologies have been a talking point across the fund industry for a number of years with various parties involved in the fund supply chain looking into Artificial Intelligence (AI), Robotic Process Automation (RPA), Internet of Things (IOT) and Blockchain or Distributed Ledger Technology (DLT) as a means to enhance their internal processes. With the threat of new entrants to this market, existing key players are exploring these technologies to see how they can stay ahead of the game. Their aim is to reduce internal costs as well as providing a more competitive product/service to the clients they serve. Before we delve into this subject matter, one has to understand what the landscape of the fund industry is like today.

Taking a simple example of a Professional Investment Fund (PIF), a unique fund structure regulated in Malta, we can identify the key parties involved and observe how they all interact with one another in the conventional way in which the industry currently operates.

disruptive technologies Malta

Diagram 1- Conventional model

Diagram 1 illustrates that, even in its simplest of forms, given the complexity of the current environment, clear communication between the various parties and accurate execution of their responsibilities is imperative. Diagram 2 provides an overview of the various medians used in order to achieve this.

disruptive technologies Malta

Diagram 2- Communication medians currently used by the various parties

Diagram 2 highlights that mail usage is still required to attain original or certified true copies related to agreements and legal documentation. This can be timely and costly for organisations both at the initial setup stage of the fund and the on-boarding of new investors at the Anti Money Laundering (AML) and Know Your Client (KYC) stage.

Equally, the number of parties involved can incur high expenses to the client promoting the fund. This often results in endless negotiations prior to achieving favourable terms of agreement that ensure the fund is viable and competitive to its counterparts. These financial pressures have led the industry to seek current technologies in order to address such challenges.

Malta as a location, given its size and close working relationship with all parties involved in the above chain, has been at the forefront in promoting the need for this technology and more importantly the regulation of it. Several bills have already been passed in 2018 allowing for funds to invest in Cryptocurrencies utilizing the PIF scheme and most recently the regulation of DLT and ICOs under the Virtual Financial Assets Act (VFA), The Malta Digital Innovation Authority Act (MDIA) and The Innovative Technology Arrangements and Services Act, which are due to come into effect at the end of 2018.

Under the PIF scheme and the recent VFA act, the MFSA outlines that ‘the governing body of the scheme and the in-house investment committee, at all times, should have at least one member who has sufficient knowledge and experience in the field of information technology, Virtual Currencies and their underlying technologies, including but not limited to the Distributed Ledger Technology’ in order to be able to hold virtual currencies and utilise DLTs.

We, as a country, are already seeing the benefits of being at the forefront of this awareness and the introduction of this legislation has opened doors to various virtual currency, blockchain and technology companies which have already established a presence in Malta.  One can only hope that this surge in influx is only the beginning of a steady flow of such companies opting for Malta as their base.

With the evolution and regulation of such technology, various individuals are questioning the current operating model, some believing that we can do without all of the intermediaries leading to the existing argument for an alternative decentralised process based on the model below:

disruptive technologies Malta

Diagram 3 - Potential future model eliminating multiple stakeholders from the industry

If the model in diagram 3 is achieved, this could revolutionise how the industry operates today and greatly reduce the process time that is currently required to set up a fund and generate a Net Asset Value (NAV), potentially allowing investors to invest in a real time NAV. Having multiple blockchains communicating through a centralised platform, removes the requirement for most notably the transfer agent, the fund administrator as well as the custodian and broker. The roles of the MLRO and Compliance Officer could be digitalised by allowing direct access to the centralised platform with predefined rules embedded in the code to ensure that the fund is operating per the requirements outlined in the Offering Memorandum and Supplement. Under the VFA act, ‘the scope of an auditor’s work would increase to include an annual reporting to the competent authority on the licence holder’s systems and security access protocols in the manner and format required by the competent authority’.

The reality is that although the model illustrated in diagram 3 is attainable, the technology to support it hasn’t yet been fully developed and tested. It may take years to fully digitalise physically-held assets onto a blockchain environment in the form of security tokens and to build an accounting platform capable of handling all the intricate complexities which require human input today. Additionally, further work is needed to build an environment which allows various blockchains or DLTs to communicate with one another, which is imperative to the success of this futuristic model.

As a result, we are seeing the formation of new companies working with existing parties in offering more tailored products, which provides more of a hybrid model and aligns better to the regulation and the systems that companies currently have in place.

disruptive technologies Malta

Diagram 4 – Proposed Hybrid model

Under this model, the industry would continue to operate at an optimal pace whilst exploring ways on how to implement these disruptive technologies and cryptocurrencies into key areas of the process flow. The role of fund administrator, transfer agent and custodian rendered obsolete in diagram 3 could evolve and potentially continue to add value. In addition, it can be argued that no one single technology can provide the ideal operational model, leading to the expenditure of billions by the industry which, in the short term, is not cost-effective but could theoretically provide massive gains in the long run. Trust also continues to be a fundamental aspect of the financial sector especially after the banking crisis in 2008. Investors continue to show cynicism since it is still unknown as to whether investors would trust a fully decentralised environment.

Whatever the outcome, the face of the fund industry continues to evolve, and all parties involved must endeavour to keep up with this evolution, with Malta being at the lead in providing the niche market for this to occur. One must however not get entirely invested in a future model without nourishing its existing regulatory and operating model. As noted, a compromise can be reached in which the existing model can be gradually enriched by implementing applicable technologies.

Edward McArdle
Funds Senior Manager