Distributed Ledger Technology

The advent of blockchain technology and digital currencies brought about a wide-spread paradigm-shift in the financial environment. The firm provides a superior level of legal support in this area, particularly through its relationship with Blockchain Advisory Limited, a VFA Agent duly authorised by the MFSA.  

Malta is positioning itself to be a leader when it comes to Distributed Ledger Technology (‘DLT’) regulation by recognising and embracing these technologies as well as creating the right regulatory environment in Malta, which can serve to attract innovation and investment in this sector. Both central government as well as specific sectoral regulators (including the Malta Financial Services Authority and the Malta Gaming Authority) have, during 2018, issued a number of consultations as to how these Malta laws need to be fine-tuned in order to best embrace the DLT revolution as well as setting up specific sandboxing projects. The three pieces of legislation properly regulate the DLT field and the operators within the same, which pave the way for Malta to establish itself as the blockchain Island and a key player in the crypto arena. The three pieces of legislation which were published on the 20th July 2018 and which came into effect on the 1st November 2018 are the following:

  1. Virtual Financial Assets Act, 2018 – provides a regulatory framework pursuant to the issuance of Initial Virtual Financial Assets Offerings and Virtual Financial Assets, which are more commonly known as Initial Coin Offerings, and other ancillary services related to cryptocurrencies.
  2. Innovative Technology Arrangements and Services Act, 2018 – provides for the regulation of innovative technology arrangements and innovative technology services as referred to in the First and Second Schedule to the Act.
  3. Malta Digital Innovation Technology Act, 2018 – provides for the establishment of the Maltese authority – the Malta Digital Innovation Authority – the main purpose of which, amongst others, is to support the development and implementation of technology innovation, including distributed and decentralised technology.

The three Acts work together by providing a broad legal framework. Indeed, Malta has in fact seen an influx of interest and several key players have already setup or are in the process of setting up base in Malta.

The three laws are in force as from the 1st November 2018, however one may start operating prior to said date, since the Acts provide for a transitionary period.

The rapid spread of internet-based commerce and the idea of having a decentralised banking system, amongst other reasons, have led to the emergence of cryptocurrencies, or more precisely, DLT assets. The term ‘cryptocurrencies’ is often interpreted as including all forms of DLT assets that use cryptography through the Distributed Ledger Technology (DLT) for their security. Although probably being the most popular forms of cryptocurrencies, Bitcoin, Ether, Litecoin, and other Altcoins are only examples of one form of DLT assets. DLT assets may either be utility tokens, security tokens, or Virtual Financial Assets (VFAs), which is a new category of cryptocurrencies provided under Maltese law.

Cryptocurrencies, together with their underlying technology are still unregulated in most countries around the world.  We are glad to see that Malta has kept its promise to be one of the pioneers in regulating the area of cryptocurrencies and Initial Coin Offerings (ICOs), and to strive to become the ‘blockchain island’. In fact, Malta has recently enacted three new legislations which regulate ICOs, service providers relating to cryptocurrencies, and technology arrangements such as DLT platforms and smart contracts.

​The aim behind the enactment of such laws is to support innovation and new technologies in the area of financial services in Malta whilst ensuring effective investor protection, financial market integrity, and financial stability. The Parliament of Malta has enacted the following legislations:

  1. The Virtual Financial Assets Act – which regulates issuers and providers of services, such as operators of exchanges, in relation to DLT assets which are classified as VFAs;
  2. The Innovative Technology Arrangements and Services Act – which regulates the recognition and certification of DLT platforms and smart contracts, and service providers to such technology arrangements such as auditors and administrators;
  3. The Malta Digital Innovation Authority Act – which establishes a new central authority responsible for supervising, monitoring, and reviewing the services provided in Malta in relation to innovative technology arrangements.

At novolegal we offer our experience from previous involvements to provide high-level legal advice in the process of an issue of cryptocurrencies through an ICO and legal assistance to service providers relating to cryptocurrencies. We promise to provide the following services in the most time-efficient manner and to the best of our ability:

  • Advising on the internal and token structure;
  • Carrying out the Financial Instrument Test to determine the classification of the DLT asset;
  • Reviewing of the whitepaper;
  • Drafting of the Terms & Conditions;
  • Liaising with local banks for the setting up of bank accounts; and
  • Liaising with the authorities for the registration of the whitepaper or for the licensing to provide services in relation to VFAs; and
  • Advising to ensure compliance with all the Anti-Money Laundering (AML) requirements and establishing effective KYC procedures.

Distributed Ledger Technology

Distributed Ledger Technology is the technology which makes cryptocurrency possible. DLT is the recording of transactions being made on a common ‘ledger’ which cannot be altered. Besides the transfer of cryptocurrencies, DLT may be applied to other alternative scenarios such as in the voting process. DLT, and consequently blockchain, are based on the following four main pillars:

  • Shared Information – A shared digital ledger that keeps a record of all transactions taking place on a peer-to-peer network;
  • Decentralisation – The digital ledger is decentralised which eliminates the need for a central certifying authority;
  • Encryption – All information transferred is encrypted and every occurrence recorded to ensure no unauthorised alterations occur; and
  • Security – Private keys ensure that encrypted information is shared without the risk of privacy breach.

​Malta is one of the first EU countries to holistically regulate blockchain and DLT. In fact, it has enacted ‘The Innovative Technology Arrangements and Services Act’ (TAS Act) which regulates the recognition and certification of DLT platforms and smart contracts, providing a tangible proof of quality and standards maintained by the relevant DLT platforms. The TAS Act also regulates service providers in relation to these technology arrangements, such as auditors and administrators.

​The Parliament of Malta has also enacted the Malta Digital Innovation Authority Act (MDIA Act) which establishes a new central authority, the Malta Digital Innovation Authority (MDIA), which will be focusing on innovative technology arrangements, the certification of such technology arrangements, and the registration of their service providers. Service providers to technology arrangements may seek registration from the authority on a voluntary basis if they:

  • Provide services in relation to any DLT platform which is certified by the MDIA;
  • Provide services in or from Malta;
  • Provide services through Maltese legal persons; and
  • Provide services in such other cases as the Minister may prescribe.

Since there may be technology arrangements which are not owned by a corporate structure and would not have a proper legal personality, the act is proposing that such technology arrangements may register with the ‘Registrar for Legal Persons in Malta’ and acquire legal personality upon satisfaction of a number of requirements.

Smart Contracts

A smart contract is a computer protocol intended to act as the underlying contract behind transactions occurring on a DLT. Smart contracts, depending on how they are programmed, define the rules behind the transactions made on that DLT, similar to a traditional contract. Smart contracts, and their contents and obligations, are automatically enforceable and cannot be altered.

Malta now recognises and validates smart contracts. In fact, the ITAS Act states that smart contracts and related applications, including decentralised autonomous organisations, as well as other similar arrangements, are considered as innovative technology arrangements and are therefore regulated under the ITAS Act, and may be certified in terms of such act.

Cryptocurrencies & DLT Assets

In the Virtual Financial Assets Act (VFA Act), all forms of cryptocurrencies are referred to as DLT assets. A DLT asset is defined in the VFA Act as an asset which is “intrinsically dependant on, or utilises DLT”. DLT assets can be either:

  • Virtual Tokens – commonly known as utility tokens;
  • Security Tokens or any other financial instrument;
  • Electronic Money; or
  • Virtual Financial Assets – tokens which are none of the above.​

Before issuing or commencing the provision of any service in relation to DLT Assets in or from within Malta, such issuer or service provider must determine the classification of the DLT Assets in question, whether they are Virtual Tokens, Financial Instruments, Electronic Money, or Virtual Financial Assets. Such determination is reached after carrying out the Financial Instrument Test.

The Financial Instrument Test

The VFA Act requires issuers and any person who provides any service in relation to DLT assets to make a determination as to whether the DLT assets in relation to which the services are to be provided fall within the definition of VFAs, unless such determination has already been made when the DLT assets were issued through an Initial VFA Offering.

Recently, the MFSA has published a ‘Guidance Note to the Financial Instrument Test’ where the authority explained how such test shall be carried out.

The Financial Instrument Test asks questions on the DLT asset in question to see whether it falls under the definition of a Virtual Token. If it is determined that the DLT asset is not a Virtual Token, additional questions are asked to the person carrying out the test to determine whether the DLT asset is a financial instrument in terms of MiFID II or electronic money in terms of the Electronic Money Directive. If the Financial Instrument Test result shows that the DLT asset is not a virtual token, electronic money, or a financial instrument; then DLT asset is a Virtual Financial Asset and is regulated under the VFA Act.

Virtual Tokens

The VFA Act defines Virtual Tokens as “a form of digital medium recordation whose utility, value or application is restricted solely 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”. The VFA Act clarifies that where a Virtual Token may be converted into another DLT Asset type, it shall be treated as the DLT Asset type into which it may be converted.

Virtual tokens are exempt from the scope of the VFA Act. This means that the whitepaper relating to an issue of Virtual Tokens is not required to be registered with the authorities, and providers of services relating to Virtual Tokens are not required to hold any licence.

Financial Instruments

The ‘Guidance Note to the Financial Instrument Test’ provides detailed guidelines on the questions asked and on the mandatory requirements which determine whether a DLT asset is considered as a financial instrument. If the DLT Asset is considered as a financial instrument, then it shall be regulated and subjected to conventional EU and Maltese laws and regulations such as MiFID II, the Prospectus Directive, and the Investment Services Act; and falls outside the scope of the VFA Act.

The most common form of DLT assets which fall under the classification of financial instruments are security tokens. Besides security tokens, any DLT asset which falls under any of the following categories is considered as a financial instrument:

  1. Transferable securities;
  2. Money market instruments;
  3. Units in collective investment schemes;
  4. Derivative contracts relating to securities, currencies, interest rates, or emission allowances; which may be settled physically or in cash;
  5. Derivative contracts relating to commodities, that can be settled in cash;
  6. Derivative contracts relating to commodities, that can be physically settled provided that they are traded on a regulated market, an MTF, or an OTF;
  7. Derivative contracts relating to commodities, that can be physically settled and not being for commercial purposes, which have the characteristics of other derivative financial instruments;
  8. Derivative instruments for transfer of credit risk;
  9. Financial contracts for differences (CFDs);
  10. Other derivative contracts relating to climatic variables, freight rates or inflation rates or other official economic statistics that must be settled in cash; or
  11. Other derivative contracts relating to assets, rights, obligations, indices and measures which have the characteristics of other derivative financial instruments, having regard to whether, they are traded on a regulated market, OTF, or an MTF.

Electronic Money

In terms of applicable law, “electronic money”  is defined as “electronically, including magnetically, stored monetary value as represented by a claim on the issuer which is issued on receipt of funds for the purpose of making payment transactions…. and which is accepted by a natural or legal person other than the financial institutions that issued the electronic money.”

When considering whether a DLT asset qualifies as E-Money, the following evaluations are to be considered:

  1. Whether the DLT asset is or was issued at par value on the receipt of funds by an Issuer; and
  2. Whether it is or can be redeemable by the said issuer.
  3. Whether the respective DLT asset represents a claim on the Issuer arising from the funds originally placed against such issuer.
  4. Whether the asset may be used for  the purpose of making payment transactions. 

Virtual Financial Assets

Once it is determined that the DLT Asset cannot be considered as a Virtual Token,  electronic money in terms of the Electronic Money Directive, or a financial instrument in terms of MiFID II, then the DLT Asset will be considered as a Virtual Financial Asset and shall be regulated by the new enacted law, the ‘Virtual Financial Asset Act’. Therefore, the VFA Act shall only regulate DLT assets which according to the Financial Instrument Test are considered to be VFAs.

VFAs are defined in the VFA Act as “any form of digital medium recordation that is used as a digital medium of exchange, unit of account, or store of value and that is not an electronic money, a financial instrument, or a Virtual Token.