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The brave new world of Bitcoin
Given the convenience of established currency and payment systems, what is driving the ever-growing interest in Bitcoin and other virtual currencies?
In 2009, bitcoin emerged as a catalyst following the 2007-2008 global financial crisis and the subsequent loss of trust in the banking system, offering a peer-to-peer version of electronic cash which would allow payments to be sent directly from one party to another without going through a central financial institution.
While fiat currencies are given legitimacy as legal tender by national regulators, and established payment systems such as banks, electronic money institutions and payment institutions are thoroughly regulated since they form an integral part of the global economy, there are a number of pitfalls which become easily apparent to industry insiders.
First, banks and financial institutions are centralised and thus create a central repository that, if compromised – whether through malicious intent or system error – would render vulnerable all data or funds/assets within that system. While virtual currencies can be offered through a centralised system, the majority of these cryptocurrencies, including bitcoin, are decentralised since they are based on a distributed ledger technology platform. In practice, the bulk of cryptocurrency issuers are choosing to base their virtual currencies on the decentralised Ethereum blockchain owing to the ease of using the ERC-20 and ERC-223 protocols as the technical framework for their new cryptocurrency. Nonetheless, new dapp platforms such as Tron and EOS are gaining popularity as the distributed ledger of choice for a growing number of virtual currencies issuers.
The use of blockchain technology as the basis for these new cryptocurrencies also brings with it the added benefits of immutability and transparency since transactions are easily auditable, and changes cannot be made unless there is the consent of a majority of the network. The immutable audit trail of distributed ledgers would give auditors or future regulators the option of full visibility and supervision of such transactions.
Decentralisation of virtual currencies via blockchain and peer-to-peer transactions also means that the role of banks as intermediaries will be set aside, thus cutting out costs and delays for users.
The benefits underpinning virtual currencies as opposed to traditional fiat currencies are promising, and their potential has been recognised by several jurisdictions, including Malta, which have sought to enable virtual currencies to develop unencumbered within a sound regulatory framework which safeguards investors without stifling innovation.
While several crypto proponents maintain that traditional national currencies will eventually be phased out in favour of cryptocurrencies, a number of issues need to be addressed before this is possible. From an EU law perspective, member states which are part of the Economic Monetary Union may not freely take action in this respect since their economic and monetary policy falls within the jurisdiction of the European Central Bank (ECB).
In Annex 1: Legal qualification of crypto-assets – survey to NCAs the European Securities and Markets Authority (ESMA) noted that bitcoin, which was referred to as a “pure-payment type crypto-asset”, accounts for half of the total market value of crypto assets. However, the fact that distributed ledger technology and tokenisation work well for various functions has led to the emergence of virtual currencies which do not serve as a means of payment, but which fulfil the function of investment or security, or a mere utility function by giving access to application or services. It must also be considered whether cryptocurrencies will ever be an efficient form of payment given their volatile nature. While it is conceivable that a fiat currency may be available as a stable cryptocurrency, its value would need to remain centrally regulated.
At present, virtual currencies mostly serve as speculative instruments for investment with the ultimate aim of receiving profits in fiat currency by trading them through exchanges, as evidenced by the bull market throughout 2017 and early 2018, when an estimated $21 billion worth of initial coin offerings (ICOs) was launched worldwide. Even bitcoin, which was intended to serve as a means of payment or exchange by its issuer, was ultimately being used for speculation.
Has your jurisdiction taken steps to regulate virtual currencies? What is their current status?
Malta has been a trailblazer with respect to the regulation of virtual currencies and technology firms offering blockchain/distributed ledger technology (DLT)-based solutions. The Malta Financial Services Authority (MFSA) started issuing consultation papers with respect to the regulation of virtual currencies in the second half of 2017 and throughout 2018 to gather opinions of the financial services sector and interested stakeholders on the matter. These efforts culminated in the promulgation of three acts:
- The Innovative Technology Arrangements and Services Act, which is a technology-neutral act which sets out the regime applicable for the registration of technology service providers and the certification of technology arrangements such as software and architectures which are used in designing and delivering DLT, smart contracts and related applications.
- The Malta Digital Innovation Authority Act, which set up the Malta Digital Innovation Authority specifically to promote the development of the innovative technology sector in Malta.
- The Virtual Financial Assets Act (the VFAA) and subsidiary regulations, which create a framework within which ICOs may be legally issued and service providers, including crypto-advisers, crypto portfolio managers and crypto-exchanges, may be set up. It collectively refers to assets which intrinsically depend on or which utilise DLT as DLT assets. The VFAA comes as a breath of fresh air in an industry where there is little clarity as to how assets are to be treated. Most countries agree that cryptocurrencies are not to be considered as currencies or legal tender, but are a digital form of investment or asset. In jurisdictions without specific legislation for cryptocurrencies, there is great uncertainty as to how DLT assets should be classified, particularly when there is the potential that digital assets may be qualified as financial instruments under the EU Markets in Financial Instruments Directive (MiFID) II. To mitigate this problem, by virtue of the VFAA, the Maltese legislature created the financial instruments test, which helps issuers and their legal advisers to classify DLT assets. Companies seeking to set up an ICO in or from within Malta, companies which issued DLT assets overseas but wish to carry out a related activity in or from Malta and all other entities which will be dealing with DLT assets must take this test in relation to any DLT asset issued. A DLT asset may be classified under four categories:
- Virtual tokens, which are a form of digital medium recordation whose utility, value or application is restricted exclusively to the acquisition of goods or services, either solely within the DLT platform on or in relation to which it was issued or within a limited network of DLT platforms. Under the VFAA, virtual tokens (which often include fungible or utility tokens) cannot be traded on exchanges. In defining virtual tokens, the VFAA provides that a virtual token which is or which may be converted into another DLT asset type will be treated as the DLT asset type into which it can be converted. If the token standard used for a virtual token allows for such conversion, technical restrictions must be put in place to prevent conversion into other DLT asset types. Once a financial instruments test has duly classified a DLT asset as a virtual token, the asset and any activity carried out in relation to such asset requires no further regulation.
- ‘Electronic money’, as defined in the EU Electronic Money Directive (2009/110/EC), refers to issues of tokens which electronically (including magnetically) store monetary value as represented by a claim on the issuer which is issued on receipt of funds for the purposes of making a payment transaction. If a DLT asset qualifies as electronic money, such an asset and any activity undertaken in relation to such an asset will be regulated under the Maltese Financial Institutions Act, which transposes the EU Electronic Money Directive.
- Financial instruments, which are instruments regulated under Section C of MiFID II, generally include transferable securities, money market instruments, units in collective investment schemes and derivative instruments. The test assists issuers and their legal advisers in determining the kind of financial instrument being issued since this will also have a bearing on the applicability of other EU legislation such as the EU Prospectus Directive (2003/71/EC) and the EU Transparency Directive (2004/109/EC), as noted by the ESMA in its Advice on ICOs and Crypto-Assets issued on 9 January 2019. The aforementioned two directives will have significant application with respect to financial instruments which are set to be issued to the public, have been dematerialised onto the blockchain and which qualify as transferable securities.
- ‘Virtual financial assets’ (VFAs) are, by elimination, defined as DLT assets that do not qualify as virtual tokens, electronic money or financial instruments. Generally, traditional virtual currencies such as bitcoin would fit this criterion. Issuers seeking to qualify their VFAs in terms of the VFAA must set up a company in Malta, draft a white paper which complies with the requisites set out within the VFAA and register that white paper with the MFSA. If a VFA has been admitted to trading on an VFA or DLT exchange without the consent of the issuer, there is no obligation on the issuer to register the white paper in terms of Article 3 of the VFAA. This provision exempts established cryptocurrencies such as bitcoin and Ethereum which qualify as VFAs from requiring a white paper to gain legitimacy under Maltese law. Nonetheless, it is still incumbent on VFA service providers (including VFA exchanges) to conduct the test to ascertain the classification of any DLT asset admitted to trading on their platform.
In order to ensure that issuers arrive at a proper classification, the VFAA creates the role of the VFA agent. All issuers must have a VFA agent in place at all times. The VFA agent is a person registered with the MFSA who can offer legal counsel and submit documents and information to the MFSA as requested. The VFA agent must confirm to the MFSA that the DLT asset qualifies as a VFA as set out in the test, and must note any reservations or assumptions which it has made when submitting the test. Moreover, the VFA agent acts on behalf of the MFSA in order to ensure that the issuer complies with the milestones set out in the white paper in a timely manner. An annual compliance report must be drawn up by the issuer, and will be reviewed by the VFA agent to ensure compliance with the VFAA, regulations and rules issued by the MFSA.
In addition to the VFA agent, issuers must have in place at all times a money laundering reporting officer, an auditor, a systems auditor and a custodian. The role of custodian may also be fulfilled through the implementation of a smart contract which has been certified by a systems auditor. The systems auditor shall be responsible for reviewing and auditing the issuer’s innovative technology arrangements and cyber security arrangements. Systems auditors must obtain a certification from the MDIA to fulfil this role.