Real estate funds and cryptoassets - Luxembourg regulator opens up and offers solutions

Blockchain and related technologies have developed significantly in recent years. But regulators across the EU have been cautious about the potential risks of introducing such technologies in the financial sector. For a long time the regulators’ silence, and the legal uncertainty around the subject, may have stood in the way of maximizing the potential of these technologies.

Market actors, however, have become more interested in distributed ledger technologies, which can be used in numerous fields such as investment, investment fund distribution, collateralization and initial coin offerings. Tokenization, and especially the tokenization of real estate assets, which promises increased flexibility and transferability in a sector characterized by an intrinsic lack of liquidity, has seen an important rise in popularity from market participants. It appeals to both investors, due to the increased flexibility and transferability as opposed to traditional real estate investing, and managers, who understand the potential of tokens to attract new investors. In the Luxembourg fund industry, market actors’ interest in investing in and setting-up cryptoasset investment funds related to real estate assets has become evident in recent years. BlocHome, a Luxembourg real estate fund using the crypto-ecosystem, has received a lot of attention in Luxembourg, but many other projects have been launched recently. And the Luxembourg regulator has responded to the market’s development and needs.

For a long time there was no formal regulatory stance on cryptoassets. The Luxembourg regulator’s position was limited to issuing two warnings on 14 March 2018. One concerned initial coin offerings and tokens and the other addressed virtual currencies. The Luxembourg regulator stressed a number of potential risks associated with Luxembourg investment funds investing in virtual assets. It identified token theft, fraud and money laundering, operational disruption, misleading information, lack of transparency and price manipulation as potential risks. In addition to issuing the warnings, the Luxembourg regulator went a step further. It banned undertakings for investment funds under the prudential supervision of the Luxembourg regulator from addressing non-professional customers and banned pension funds from investing in such types of assets.

Until recently, the solution for initiators in Luxembourg was limited to the use of registered alternative investment fund managers. But the Luxembourg regulator has listened to the market and taken a position on the crypto-ecosystem.

Practical solution: Registered alternative investment fund managers

The Luxembourg market has been somewhat closed to alternative investment funds investing in virtual assets. This is partly because there is no legal framework but also because of the lack of alternative investment fund managers and depositaries willing to onboard this type of fund. Initiators (both from the crypto-ecosystem and the real estate sectors) have become more willing to launch crypto-funds to answer investors’ growing appetite. This has pushed many initiators to consider different solutions. And many of them have chosen to set up their own registered alternative investment funds, a solution that only partly addresses their needs.

While setting up a registered alternative investment fund manager pursuant to the de minimis exemption under article 3(2) of the Luxembourg law of 12 July 2013 on alternative investment fund managers have responded to the need of initiators by giving them a solution to launching alternative investment funds without having the legal obligation to appoint a depositary. This solution is not perfect as registered alternative investment fund managers do not benefit from the AIFMD passport for marketing their funds. As a consequence, subscriptions have to be entirely based on reverse solicitation and national private placement regimes, where available, considerably restricting their fundraising capacity.

Furthermore, the Luxembourg law of 12 July 2013 on alternative investment fund managers provides for strict limitations in terms of assets under management thresholds to qualify for the de minimis exemption. The exemption is limited by the assets under management (ie EUR100 million for those alternative investment fund managers managing leveraged funds and EUR500 million when the portfolios of the alternative investment funds are unleveraged). The thresholds are of the utmost importance as it will trigger the application to request authorization as an alternative investment fund manager pursuant to chapter 2 of the Luxembourg law of 12 July 2013 on alternative investment fund managers. The application for authorization must be made within 30 days following the conditions no longer being met, and the obligation to comply with the requirements set out by the provisions of this law. It’s important to note that the calculation of thresholds includes the assets under management of other alternative investment funds managed by other alternative investment fund managers under common management or under common control.

Until recently, reaching the de minimis thresholds caused a headache for initiators and they would find themselves blocked. But, fortunately, the Luxembourg regulator has clarified its position and finally opened the fund sector.

The Luxembourg regulator is finally opening the investment fund sector to cryptoassets

The Luxembourg regulator has taken steps towards recognizing the benefits that such technologies may bring to the financial sector. It also issued two FAQ documents at the end of 2021 (as updated on 15 March 2022). The FAQ address whether or not alternative investment funds can invest in virtual assets and the question of Luxembourg depositaries acting as depositary of investment funds investing directly in cryptoassets. In this respect, the Luxembourg regulator has given clear answers to all questions.

Regarding alternative investment funds managed by an authorized alternative investment fund manager within the meaning of the Luxembourg law of 12 July 2013 on alternative investment fund managers, the Luxembourg regulator specified that nothing in the legal texts governing this type of investment funds prevents them from investing in virtual assets. But it imposes two main requirements: that alternative investment funds only market their units to professional investors and that the authorized alternative investment manager managing it obtains an extension of its authorization for this type of investment strategy. The authorization should include having appropriate policies (including, AML, valuation and risk management policies). From a practical perspective, we also note that the alternative investment funds managed by registered alternative investment fund managers do not seem to have been dealt with. But the Luxembourg regulator has taken the stance to apply similar requirements to registered alternative investment fund managers (with the exception of obtaining a license extension).

With respect to depositaries, the position of the Luxembourg regulator was of the utmost importance. The Luxembourg regulator answered them through the clarification of the requirements applying to depositaries in relation to the safekeeping of cryptoassets, in particular through the implementation of adequate organizational arrangements and an appropriate operative model.

Furthermore, the Luxembourg regulator has also emphasized (in both publications) the importance of the AML/CFT diligence to be carried out by depositaries and alternative investment fund managers in relation to cryptoassets and the registration as virtual asset service providers, where relevant, given their potential activities.

It’s important to note that the Luxembourg regulator expects alternative investment fund managers or depositaries to inform them before launching such projects.

The next step is coming

The latest legal developments from the Luxembourg regulator have created the framework needed to enable investment funds in cryptoassets to grow in the Grand Duchy of Luxembourg. The final guidance allows market players to take the leap, such as Q Securities in Luxembourg, who applied to serve as depositary of cryptoasset funds. Many other actors are already following and more will come. It remains unknown at this stage if the latest progress will create a revolution in the Luxembourg market (ie attracting new fund sponsors to the Luxembourg investment funds’ sector, established actors joining the flow, scaling of the current players on the market) or if it will remain a niche market. There’s an important (and growing) appetite for cryptoasset investment funds related to real estate assets, from both initiators and investors, and we expect more to come in the next few months following the Luxembourg regulator’s guidance.