Interest from market participants in tokenized funds continues to grow. To date, much of the growth has been in tokenized money market funds. As of mid-year, estimates of assets in these funds range between $8.6 billion and $13 billion. A number of money market funds have been available in tokenized form for some time now, including Franklin Templeton’s FOBXX; Circle/Hashnote’s USYC; WisdomTree’s WTGXX; and BlackRock’s BUIDL. Franklin Templeton’s OnChain US Government Money Fund (FOBXX or the OnChain Fund), was the first SEC-registered fund to use a public blockchain as its share register. A tokenized fund, just as any fund, must comply with applicable regulatory requirements, which include, among others, custody requirements. Section 17(f) of the Investment Company Act of 1940 requires that a registered fund maintain its securities and other investments in the custody of a “bank” that meets certain conditions or with a member of a national securities exchange. The 1940 Act also allows funds to “self custody” securities but only in compliance with specific requirements, which still include depositing securities in a bank for safekeeping. Rule 17f-2, or the self-custody rule, requires securities to be held in the safekeeping of a bank or similar federally supervised or state-supervised depository and physically segregated, a signed notation for every deposit and withdrawal, and regular verification by the fund’s independent public accountant. Registered investment advisers are subject to similar restrictions under the Investment Advisers Act of 1940; an adviser must maintain client funds or securities with a “qualified custodian,” which may include a “bank” or a registered broker-dealer. It’s difficult to comply with these requirements for fund shares held in tokenized form.
Franklin Templeton’s OnChain US Government Money Fund (the OnChain Fund) uses a blockchain system to maintain its share ownership records. The recordkeeping function is performed by Franklin Templeton Investor Services, or FTIS. FTIS keeps the official share ownership record on a system that combines an internal book-entry ledger with one or more public blockchains. Because FTIS is an affiliated person of the Funds, the Funds’ proposed custody of shares of the OnChain Fund with FTIS is also a self-custody arrangement subject to Rule 17f-2.
The SEC’s Division of Investment Management granted Franklin Templeton’s request for no-action relief to permit its family of Franklin Templeton funds to establish custody arrangements for their investments in shares of the OnChain Fund without complying with paragraphs (b), (e) and (f) of Rule 17f-2 under the Investment Company Act. The relief relies in part on a prior letter issued to Franklin Investors Securities Trust in 1992 addressing custody issues in an affiliated master-feeder fund arrangement. The 1992 relief addressed circumstances in which the feeder fund’s investments in the master fund were maintained by the master fund’s affiliated transfer agent in book-entry form subject to specified safeguards set out in that letter. Of course, in this case, FTIS will maintain the official record of share ownership in part in reliance on distributed ledger technology rather than solely through a book-entry system. The SEC’s Division of Investment Management said that it would not recommend enforcement action against Franklin Templeton funds that hold shares of an affiliated, blockchain-integrated money market fund without fully complying with the Investment Company Act’s self-custody rule. The relief covers the funds’ investments in the OnChain Fund. The relief is subject to 12 conditions that represent additional safeguards. These include, for example, board approval and at least annual review, segregated records and a separate blockchain wallet for each investing fund, limits on who may transmit instructions, passwords or other authentication and cryptographic tools, confirmations sent to people other than those who placed the instructions, daily reconciliation of confirmations against transaction authorizations, and three annual independent accountant verifications each fiscal year, two unannounced. While the conditions are quite specific and prescriptive, these do provide a roadmap for compliance and might allow for broader adoption of recordkeeping using distributed ledger technology. In addition, the letter is yet another step in terms of guidance provided by the Staff of the Securities and Exchange Commission relating to “custody” in tokenized contexts. See the incoming request from Franklin Templeton Funds, and the relief issued.