Courtesy of Damiano Di Maio, LL.M. and Andrea Vianelli, LL.M
Cryptocurrencies and blockchain technology are two of the hottest topics in finance. While most discussions surrounding the crypto industry revolve around the underlying technology and its potential applications in the financial industry, the regulatory treatment of crypto-assets is less discussed and remains opaque to most market participants. This note aims to shed light on the regulatory framework applicable to collective investment schemes in the EU (in particular, hedge funds) which, as part of their investment strategy, invest in cryptocurrency (also called virtual currency). In particular, given the forward looking approach adopted by the local regulator, this note focuses on the regulatory framework currently in force in Malta, the first EU country which created a crypto-friendly environment for asset managers and service providers.
Cryptocurrencies and their regulatory treatment in the EU
In order to identify which regulatory regime should be applied to cryptocurrencies, one must first assess whether any of the existing categories of financial instruments already regulated under the MiFID II Directive (“MiFID II”) may encompass cryptocurrency.
According to article 1 par. 1 number 15 of MiFID II, ‘financial instrument’ means those instruments specified in Section C of Annex I and includes: (1) transferable securities; (2) money market instruments; (3) units in collective investment schemes; (4) financial derivative instruments, which include a number of financial instruments, and (5) emission allowances consisting of units recognized for compliance with the requirements of Directive 2003/87/EC.
Because of the open-ended definition of ‘financial instrument’ under MiFID II, Member States retain significant discretion in determing the regulatory treatment of crypto-assets. Unsurprisingly, this has resulted in the varied treatment of crypto-assets across jurisdictions. For instance, the German Federal Financial Supervisory Authority (BaFin) in accordance with its legally binding decision on units of account within the meaning of section 1 (11) sentence 1 of the German Banking Act, has stated that “Bitcoins are financial instruments.[1]” BaFin’s interpeetation appears to be based purely on German law rather than in accordance with MiFID II. Indeed, MiFID II does not refer to units of account as being financial instruments in their own right. Thus, the German regulator appears to have widened “the scope of regulated instruments in Germany and so only has relevance in that jurisdiction[2]”.
Contrast BaFin’s treatment of cryptocurrency with that of the UK’s Financial Conduct Authority (“FCA”) who has stated that cryptocurrencies are not part of other regulated products or services and that it doesn’t consider cryptocurrencies to be currencies or commodities for regulatory purposes under MiFID II. However, the FCA has specified that cryptocurrency derivatives are capable of being financial instruments under MiFID II[3]. Similarly, the French Supervisory Authority (Authoritè des Merchiès Financiere – “AMF”) has specified that “the Bitcoins are not considered as financial instruments as the law stands, so “crypto” assets do not fall within the scope of direct supervision of the AMF[4]”.
With regards to the pan European regulator, the European Securities and Market Authority (“ESMA”) in a recent statement aimed at identifying the relevant regulation that applys to firms involved in Initial Coin Offerings[5], has adopted a third approach which leaves open the possibility that coins or tokens qualify as financial instruments under MiFID II on a case-by-case basis (the “case-by-case assessment”). In this view, firms involved in ICOs and/or in the provision of certain investment services in relation to crypto-assets are likely conducting regulated investment activities – such as placing, dealing in or advising on financial instruments – that would fall under the MiFID II regime which would trigger authorization requirements in terms of the aforesaid directive.
Malta’s approach
Given the absence of a harmonized European framework that defines the meaning of cryptocurrency and the lack of a general answer to the question of whether cryptocurrency constitutes a financial instrument within the meaning of MiFID II, we believe that ESMA’s case-by-case assessment based on facts and circumstances should be the essential rubric when it comes to classifying crypto-assets as financial instruments subject to MiFID II regulation.
The question arising from this approach is which methodology should to be used to assess whether in concrete:
- a virtual currency (“VC”) should be classified as a financial instrument under Section C of Annex 1 of Markets in Financial Instruments ), and the activities of the firm involved in such VC constitute a regulated activity as listed in Section A of Annex 1 of MiFID II, or
- a virtual currency does not fall under the aforementioned definition of a financial instrument, and, consequently, the provision of the investment services listed in MiFID II, Annex 1, Section A and B, would therefore fall outside the scope of MiFID II.
To answer this question, the Malta Financial Services Authority (“MFSA”) has proposed the Financial Instrument Test (the “Test”) as an innovative, efficient, and forward looking approach aimed at determining whether the features of a virtual currency, “either on a stand-alone basis or within the context of an ICO, constitutes a financial instrument (‘Financial Instrument Test’) under MiFID II and other relevant EU legislation, specifically in the forms of: (i) transferable securities; (ii) units in collective investment schemes; (iii) commodities and (iv) their respective financial derivatives contracts and financial contracts for difference[6]”. This test forms part of the Virtual Financial Assets Act (“VFAA”) in order to determine the scope of activity and instruments that “would fall under this Act that would regulate the carrying on of business associated with VCs falling outside the scope of the existing EU and national financial services legislation and make provision for matters ancillary thereto or connected therewith[7]”.
According to the proposed Financial Instrument Test, the modalities of which are detailed in the MFSA’s Guidance Notes on the Financial Instrument Test issued on July 24th, 2018, the user of the Test would be required to sequentially and systematically assess the features of a distributed ledger technology (“DLT”) based asset[8] (i.e. including a Virtual Currency) compared to a set of predetermined checklists. On the basis of the user’s input, the Test would determine whether that DLT asset falls within scope of the existing EU legislative and regulatory frameworks. The Test shall consist of twelve , the first of which focuses on Virtual Tokens[9] under the VFAA, while the remaining focus on the various financial instruments under MiFIDII[10].
Overall, we believe that the pioneering Maltese approach will guide European regulators towards a flexible and business-oriented framework that is able to tackle the challenges and opportunities offered by cryptocurrencies. Malta is a clear example of an innovative regulatory strategy that is able to efficiently anticipate market trends rather than breathlessly chasing them.
Setting up a virtual currency fund
The Investment Services Act (Cap. 370 of the Laws of Malta) (the “ISA”) and the Investment Service Rules (“ISR”) issued by the Malta Financial Services Authority (the “MFSA”), set out the statutory basis for regulating collective investment schemes (“CISs”) constituted in or operating in, or from, Malta.
Looking at common practice, it is customary to set-up CISs as multi-fund investment company with variable share capital (“”) with segregated sub-funds (also known as “umbrella structure”). Indeed, this structure offers several advantages to promoters interested in achieving the objectives of asset segregation and investment diversification. As to the latter feature, each sub-fund falling under the umbrella structure constitutes a separate share class within the SICAV and each sub-fund may pursue different investment strategies and objectives. In terms of asset segregation, it should be noted that the assets and liabilities of each sub-fund are treated as a patrimony separate from the assets and liabilities of each other sub-fund of the SICAV. CISs may be structured as self-managed funds or externally managed funds.
From a regulatory standpoint, in the aftermath of the Alternative Investment Fund Management Directive (the “AIFMD”), all CISs may now be qualified as Undertaking for Collective Investment in Transferable Securities (“UCITS”) funds or Alternative Investment Funds (“AIFs”). Falling within the AIFs remit, Professional Investor Funds (“PIFs”) and Notified Alternative Investment Funds (“NAIFs”) constitute a distinct sub-class of AIFs and offer certain flexibilities vis-à-vis the AIF structure.
The MFSA is currently consulting on the potential to issue specific rules which would enable promoters to set up virtual currency (VC) funds as AIFs, thus availing them to (i) an unlimited threshold of assets under management AUM and (ii) the marketing passport granted in terms of the AIFMD. However, for the time being, a VC fund may be constituted only as PIFs, a “Maltese product” which escapes most of the regulatory constraints set out under the AIFMD.
In this respect, the PIF structure may be availed of by fund managers or self-managed funds whose assets under management fall below the thresholds set out in Article 3(2) of the AIFMD; that is in the case of unleveraged funds with lock-in periods of five years or longer, €500m.
Currently, PIFs may be constituted as PIFs targeting ‘Qualifying Investors.’ In this respect, PIFs may be marketed to investors having net assets/worth in excess of €750,000 or the currency equivalent thereof, and who will be subject to a minimum investment threshold of €100,000 or its currency equivalent. While additional investments during the life of the PIF are not subject to any statutory minimum, the aforesaid investment threshold shall not be reduced below this minimum amount at any time during the operation of the fund unless the shortfall is the result of a fall in the sub-fund net asset value.
In early 2018, the MFSA issued supplementary license conditions applicable to PIFs (the “Rules”) laying out the conditions applicable to PIFs which, as part of their investment strategy, invest in virtual currency (“VC”). In terms of the Rules, VC Funds are required to undertake certain arrangements aimed at ensuring investors that the VC Fund’s functionaries have the industry-specific expertise suitable to adequately manage the Fund and, at the same time, to ensure an adequate degree of investors’ protection. Moreover, PIFs investing into units of other CISs which are, or have been, created through initial coin offerings shall be subject to the same Rules, given that such investment shall be qualified as ‘direct’ investments in VC for the purpose of the Rules. Looking at the different corporate forms available to set up VC Funds, promoter may choose to structure a VC Fund as (i)
The key role of service providers
In terms of the Rules, service providers cover a primary importance in the regulatory process and as part of the ongoing life of the fund.
Investment Manager
As an ordinary CIS, VC Funds can either be externally managed or self-managed. When externally managed, a duly licensed management company shall be entrusted with the management of the fund’s assets. If the management company is incorporated and operating in Malta, it will be required to hold a Category 2 investment services license from the MFSA and shall provide the bulk of investment management activities, i.e. collective portfolio management and risk management services.
In terms of the Rules, the VC Fund shall ensure that the appointed manager has the sufficient business organization, systems, experience and expertise that is necessary to manage a VC PIF. Notably, considering the nascent state of the crypto industry, the ordinary qualifications proving the knowledge and expertise of portfolio managers may not suffice and additional qualifications may be introduced in the coming months. However, as previously mentioned, VC PIFs may also adopt a lighter (and, to a certain extent, more cost efficient) internally managed structure. To this end, the Board of directors of the scheme is required to establish an in-house Investment Committee (“IC”) which will be, inter alia, responsible for: (i) setting out the investment guidelines and asset allocation strategies which the VC PIF intends to adopt (by means of their terms of reference) and (ii) designing the portfolio architecture and composition of the VC PIF. In this structure, at least one IC member shall have sufficient knowledge and experience in the field of information technology and VCs and their underlying technologies, including, but not limited to, distributed ledger technology. The Investment Manager (or, in the case of self-managed VC PIFs, the IC) shall carry out appropriate research to assess the quality of the VC being invested into and shall keep a record of the quality assessment and make it available to the governing body of the Fund and to the MFSA upon request.
Custodian
In terms of the Rules and PIF regulatory framework, PIFs are not subject to the requirement to appoint a custodian (as opposed to the AIF regime), provided that adequate safekeeping arrangements are in place. With respect to a VC PIF, the MFSA may consider that “adequate safekeeping arrangements” are in place where certificates and other relevant documentation evidencing title to the virtual currencies comprising the VC Fund’s portfolio are kept under a cold wallet/hot wallet arrangement and/or proper lock and key arrangements are in place.
Administrator
In terms of the Rules, the Administrator shall have the business organization, systems, experience and expertise deemed necessary by the MFSA for it to act as an Administrator to a PIF investing in virtual currencies. In this respect, the assessment (and, in turn, the existence of the aforesaid qualifications) on the Administrator shall be carried out by the VC Fund, which shall be also responsible for demonstrating that the Administrator meets the above requirements on an ongoing basis.
Compliance Officer and MLRO
Pursuant to the Rules, the resolution of the governing body of the PIF that must be submitted by an applicant for a PIF license (i), shall identify the person(s) responsible on behalf of the governing body for the compliance obligations of the PIF, and (ii) shall identify the person(s) responsible on behalf of the governing body for the anti-money laundering (AML) obligations of the PIF (the “MLRO”) who may be either an individual within the VC Fund or within the Administrator. In addition, the individuals proposed to carry out the functions of compliance officer and money laundering reporting officer should fill out personal questionnaires and a dedicated competency form that will be part of the documentation that the PIF is required to submit and are expected to have the experience and expertise deemed necessary by the MFSA for it to act as MLRO and, respectively, as Compliance Officer of a VC Fund. In our view, such expertise may be assessed on the basis of the professional track record of the individual involved (e.g. considering whether the proposed individual has served as Compliance Officer and/or legal advisor for other companies that utilize blockchain technology) and/or the academic credential of the same.
Valuation
The VC Fund is required to establish a valuation function which will be responsible for valuing the assets (i.e. VC) comprising the fund’s portfolio. Such valuation function can be performed by an external valuer or may also be performed internally by the fund, provided that certain arrangements are taken. In the latter case, the appointment of an auditor, accountant and/or other qualified professional who, as part of his previous engagements and/or academic credentials, has experience and/or proper instruments suitable to value crypto-assets, ought to suffice in satisfying the MFSA. Given the “listed” nature of VC, asset value may be retrieved from the data published by the exchanges previously disclosed in the offering documentation of the VC Fund. With respect to VCs traded outside exchanges, other arrangements might be pursued, such as benchmarking against similar traded VCs.
Audit
The VC Fund shall appoint an independent auditor approved by and with the prior consent of the MFSA. The Auditor shall have access to the information and explanations he or she needs to discharge their responsibilities as an auditor and meet the MFSA’s requirements and shall be required to prepare a management letter in accordance with International Standards on Auditing in respect of each annual accounting period. In addition to the aforesaid duties and obligations, auditors of VC Funds shall have the business organization, systems, experience and expertise deemed necessary by the MFSA for it to act as an Auditor to a VC Fund investing in Virtual Currencies.
Taxation
In terms of taxation, it is worth highlighting that when more than fifteen per cent of the VC fund’s investable assets are located outside of Malta (this is likely to be the case with respect to crypto-assets) then the VC Fund is exempt from income tax and capital gains on the revenue generated from the aforesaid investment. CISs are also not subject to value added tax (VAT) for the supply of services outside Malta.
From an investor’s perspective, in terms of Maltese law, non-resident investors are generally exempt from income tax and capital gains tax on dividends and income received from the transfer of their participation or shares in the CIS.
Non-resident ultimate beneficial owners (“”) of the investment manager, where appointed, may benefit from a reduction in the effective rate of tax payable – equal to five per cent – as result of a partial non-taxable refund of the full corporate tax paid by the investment manager.
Risk Management
VC Funds shall have in place a risk management function (internal or external) which will be responsible for: (i) assessing whether the risk profile of the VCs selected for investment by the PIF are aligned with the risk profile of the fund; and (ii) monitoring the liquidity profile of the fund and the ability of the fund to meet redemptions under normal and exceptional market conditions. Where a risk manager is appointed, he shall also assess whether, following the aforesaid quality assessment, the Virtual Currency being invested in on behalf of the Scheme falls within scope of the risk management policy of the VC PIFs.
Blockchain based technologies are reshaping the traditional way of doing business in finance and forcing financial regulators in all jurisdictions to rethink the regulatory framework. In this respect, the increasing pace at which hedge funds are looking at the virtual currency market is pushing the main financial centers around the globe to embrace fintech innovation by means of creating a regulatory system capable of balancing investor protection and financial innovation.
National regulators in Europe are not unified in their determination of whether or not virtual currency falls within MiFID II’s scope. This notwithstanding, we argue that virtual currencies most likely fall outside MiFID II’s scope. We also believe that the incoming Maltese regulatory landscape offers a new and useful tool that facilitates a better understanding of the relations between virtual currency (VC) and MiFID II. In this respect, Malta become the first EU Member State to regulate hedge funds investing in VC and focused, in particular, on the role of service providers and on the required industry knowledge of VC fund managers.
The Maltese framework incentivizes fund managers and other key players in the industry to gain the required industry specific knowledge to assist fund promoters during launch and the on-going life of the fund. In addition, a key role is covered by the risk management function, which mitigates operational risks and monitors the market risk taken by the VC Fund, thereby assisting investor protection. Furthermore, given the nascent regulatory framework and the expected amendments and innovation in the financial legislation, the importance of experienced and creative legal advisors during the structuring phase should constitute a core element of the VC Fund operational set-up plan.
While other EU regulators are currently discussing proposals to regulate fintech, Malta is full steam ahead in their embrace of the Blockchain revolution.
[1] https://www.bafin.de/EN/Aufsicht/FinTech/VirtualCurrency/virtual_currency_node_en.html (accessed 23 May
2018).
[2] https://www.diacle.com/new-blog/2017/4/28/bitcoin-as-a-financial-instrument (accessed 23 May 2018).
[3] FCA statement on the requirement for firms offering cryptocurrency derivatives to be authorised, available at https://www.fca.org.uk/news/statements/cryptocurrency-derivatives (accessed 23 May 2018).
[4] Buying Bitcoin: the AMF and the ACPR issue a warning to savers available at http://www.amf- france.org/en_US/Actualites/Communiques-de-presse/AMF/annee 2017?docId=workspace%3A%2F%2FSpacesStore%2Fc2dfeaab-35c0-4fdf-9a1b-d4601eff2097 (accessed 23 May 2018).
[5] ESMA alerts firms involved in Initial Coin Offerings (ICOs) to the need to meet relevant regulatory requirements, 13 November 2017 ESMA50-157-828.
[6] MFSA, “Discussion Paper on Initial Coin offerings, virtual currencies and related service providers”, 30 November 2017.
[7] See note 6.
[8] Pursuant to section 2.3. of the MFSA’s Consultation Paper on the financial instrument test issued on 13 of April
2018, a DLT asset means – (a) a virtual token; (b) a virtual financial asset; or (c) a financial instrument that is
intrinsically dependent on, or utilises, Distributed Ledger Technology.
[9] Pursuant to section 2.3. of the MFSA’s Consultation Paper on the financial instrument test issued on 13 of
April 2018, Virtual Token “means a form of digital medium recordation that has no utility, value or application
outside of the DLT platform on which it was issued and that cannot be exchanged for funds on such platform or
with the issuer of such DLT asset
[10] Please refer to the MFSA Guidances on the Financial Instrument Test issued on the 24th of July 2018.
