The Financial Instrument Test

A. INTRODUCTION

By
enacting the Virtual Financial Assets Act (VFAA), the Maltese Government has
regulated the Blockchain / ICO / DLT industry. The law appoints the Malta
Financial Services Authority (MFSA) as the designated authority to oversee this
business.

Since
this industry has elements of the Financial Service Regulations (namely MiFID),
it is important to clearly distinguish one from the other.

In
order to ensure a clear difference, the MFSA has sought to further clarify the
instances under which the new legislation applies. It has done this by
introducing the Financial Instrument Test, which will be analysed below.

B.   
PURPOSE OF THE TEST

The
objective of the Financial Instrument Test (hereinafter ‘the Test') is to
determine whether a Distributed Ledger Technology (‘DLT')
asset falls under:

• the
  existing Financial Services legislation (e.g. MiFID)
• the
  proposed Virtual Financial Assets Act (‘VFAA') or
• is
  otherwise exempt.

By
undergoing the Test, the DLT asset will be classified accordingly.

C.    WHEN TO APPLY THE TEST

The
Test will be applied in the following scenarios:

• In
  an Initial Coin Offering (ICO); and
• During
  the intermediation of DLT Assets by persons undertaking certain activities in
  relation to such DLT Assets (VFA Services).

Being
the designated authority specifically appointed to oversee this business, the
Malta Financial Services Authority (MFSA) is proposing that the Test is
mandatory in the above scenarios.

In
addition, the MFSA has also proposed that the Test is confirmed by an
external reviewer.

D.   
DEFINITIONS

It
is important to take into account the below definitions:

• Distributed Ledger Technology (DLT) – means a
  digital or electronic database or ledger which ordinarily is –

a)  
distributed, shared and replicated;

b)  
public or private or hybrids;

c)   
permissioned or permissionless or hybrids;

d)  
protected with cryptography or equivalent
forms of encryption; and

e)  
auditable:

Provided that this term shall also include any other
technology that achieves the same ends.

• DLT Asset – means –

a)  
A
Virtual Token; or

b)  
A
Virtual Financial Asset; or

c)   
A
Financial Instrument

That
is intrinsically dependent on, or utilises, DLT.

• Virtual Financial Asset – a
  VFA is 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 one of the
  following as defined below:

a)  
Electronic
Money;

b)  
Financial
Instrument; and

c)   
Virtual
Token.

Legal definitions of the above are analysed in our
brochures:

➢   
Malta
– ICOs – The New Legislation

➢   
Malta
– Virtual Financial Asset Services – The New Legislation

E.   
METHODOLOGY OF THE TEST

In
a nutshell, the Test shall consist of a number of checklists. The aim of the
Test is that the DLT Asset
is analysed against a set of instruments in a prescribed order.

If
the asset falls to be classified under any of these instruments, then by
default it does not qualify as a Virtual Financial Asset under the new laws,
and hence the latter shall not apply. It is important to keep in mind that this
Test is to be used during both ICOs as well as when offering any of the VFA
Services as regulated by law.

In
brief, the following instruments will need to be analysed in the following
order mentioned below. First there is a focus on Virtual Tokens and then the
Test progresses to analyse various financial instruments under MiFID.

F.   
ANALYSIS OF THE VARIOUS
INSTRUMENTS

It
is now important to analyse the details of the Test by analysing the proposals
of the MFSA:

1.  
Does
the DLT Asset qualify as a Virtual Token under the VFAA?

The proposed definition of a Virtual Token is a DLT
asset that:

a.   
Has
no utility, value or application outside of the DLT platform on which it was
issued; and

b.   
That
cannot be exchanged for funds or legal tender on such platform or with the
issuer of such DLT asset.

If
the DLT Asset qualifies as such under the proposed regulations,
then it should be exempt under the new laws, and hence the VFAA
is not applicable.

If
it does not qualify under the definition of a Virtual Token, one has to proceed
to the next point below.

2.  
Does
the DLT Asset qualify as a Transferable Security under MiFID?

The
definition of "transferable security" refers to those classes of securities
which are negotiable on the capital market, (except instruments of payment),
such as:

a.   
shares
in companies or other entities, and depositary receipts in respect of shares;

b.   
bonds
or other forms of securitised debt, including depositary receipts;

c.   
any
other securities giving the right to acquire or sell any such transferable
securities or giving rise to a cash settlement.

The
main characteristics in order for a DLT Asset to be
classified as a Transferable Security hence are the following:

• The
  DLT Asset is negotiable on the capital market; And
• The
  DLT Asset confers rights analogous to those of shares in company or other
  entities such as:

▪    
Participation
in the capital of the issuer;

▪    
Right
to receive proceeds from liquidation of issuer;

▪    
Entry
in the register of shareholders;

▪    
Right
to acquire or sell transferable securities –

▪    
Right
to voting;

▪    
Right
to dividends or other proceeds from company assets.

▪    
Rights
to periodical inco/ proceeds derived from

Or confers rights analogous to bonds such as:

▪    
Principal
amount due of fixed sum with fixed / variable maturity; or

▪    
Entry
in the register of debenture holder

▪    
Right
to sell or acquire

• Is
  not an instrument of payment.

If
the DLT Asset
falls under any of the above definitions, the applicable regulatory regime is
the MiFID, and not the VFAA. Hence, the new legislation will not
apply in this case.

If
it does not qualify under the definition of Transferable Security, one has to
proceed to the next point below.

3.  
Does
the DLT Asset qualify as a Money Market Instrument under MiFID?

These
are defined as instruments which are normally dealt in on the money market,
such as treasury bills, certificates of deposits and commercial papers and
exclude instrument of payment.

The
main features of a Money Market Instruments are the following:

• Have
  a valued that can be determined at any point in time;
• Are
  not derivatives; and
• Have
  a maturity at issuance of 397 days or less; and
• Have
  features substantively equivalent to treasury bills, certificates of deposits
  or commercial papers.

If
the DLT Asset
falls under any of the above definitions, the applicable regulatory regime is
the MiFID, and not the VFAA. Hence, the new legislation will not
apply in this case.

If
it does not qualify under the definition of Money Market Instrument, one has to
proceed to the next point below.

4.  
Does
the DLT Asset qualify as a Unit in a Collective Investment Scheme?

A
Collective Investment Scheme is defined as a scheme that has the following
legally-defined characteristics:

• Objective
  of the issue is the collective investment of capital
• The
  scheme operates according to the principle of risk spreading; and either
• The
  contributions of the participants and the profits or income out of which
  payments are to be made to them are pooled; or
• At
  the request of the holders, units are or are to be repurchased or redeemed out
  of the assets of the scheme or arrangement, continuously or in blocks at short
  intervals; or
• Units
  are, or have been, or will be issued continuously or in blocks at short
  intervals.

If
the DLT Asset
falls under any of the above definitions, the applicable regulatory regime is
the MiFID, and not the VFAA. Hence, the new legislation will not
apply in this case.

If
it does not qualify under the definition of a Unit in a Collective Investment
Scheme, one has to proceed to the next point below.

5.  
Does
the DLT Asset qualify as a Financial Derivative under MiFID?

The MiFID gives a detailed definition of ‘derivatives'
as follows:

• Options,
  futures, swaps, forward rate agreements and any other derivative contracts
  relating to securities, currencies, interest rates or yields, emission
  allowances or other derivatives instruments, financial indices or financial
  measures which may be settled physically or in cash;

• Options,
  futures, swaps, forwards and any other derivative contracts relating to
  commodities that must be settled in cash or may be settled in cash at the
  option of one of the parties other than by reason of default or other
  termination event;
• Options,
  futures, swaps, and any other derivative contract relating to commodities that
  can be physically settled provided that they are traded on a regulated market,
  a MTF, or an OTF, except for wholesale energy products traded on an OTF that
  must be physically settled;
• Options,
  futures, swaps, forwards and any other derivative contracts relating to
  commodities, that can be physically settled not otherwise mentioned in point 6
  of this Section and not being for commercial purposes, which have the
  characteristics of other derivative financial instruments;
• Derivative
  instruments for transfer of credit risk;
• Financial
  contracts for differences;
• Options,
  futures, swaps, forward rate agreements and any other derivative contracts
  relating to climatic variables, freight rates or inflation rates or other
  official economic statistics that must be settled in cash or may be settled in
  cash at the option of one of the parties other than by reason of default or
  other termination event, as well as any other derivative contracts relating to
  assets, rights, obligations, indices and measures not otherwise mentioned in
  this Section, which have the characteristics of other derivative financial
  instruments, having regard to whether, inter alia, they are traded on a
  regulated market, OTF, or an MTF.

If
the DLT Asset
falls under any of the above definitions, the applicable regulatory regime is
the MiFID, and not the VFAA. Hence, the new legislation will not
apply in this case.

If
it does not qualify under the definition of a Financial Derivative Instrument,
one has to proceed to the next point below.

6.  
Does
the DLT Asset qualify as an Emissions Allowance?

Emission
Allowance Financial Instruments relate to units recognized for compliance with
the Emissions Trading Scheme Directive. Emission Allowance is an allowance to
emit one tonne of Carbon Dioxide or other greenhouse gases (as defined) during
a specified period, which unit shall be transferable in accordance to the
Directive.

In
order for the DLT asset to qualify as an emissions allowance, it should be
issued within the national competent authority in accordance to the directive.

If
the DLT Asset
falls under any of the above definitions, the applicable regulatory regime is
the MiFID, and not the VFAA. Hence, the new legislation will not
apply in this case.

If
it does not qualify under the definition of an Emissions Allowance, then the
new laws will apply.

H.   
CONCLUSIONS

By introducing the Financial Instrument Test, the MFSA has ensured a clear
distinction between the current Financial Services Laws (MiFID) and the new
Virtual Financial Asset Act.

The
Test will be rendered mandatory and will have to be confirmed by an independent
verifier. This confirms the importance of the test, as it will have a material
bearing on which regulatory regime to apply.

Hence,
one has to proceed with great caution before embarking on any ICO / DLT
project, as there might be various laws that might need to be taken into
consideration. A detailed analysis of the intended project is thus necessary in
order to ensure legal compliance and avoid severe legal consequences.

To
this effect, it is highly advisable that all ICO / Blockchain intended issuers
seek proper legal advice and guidance at all stages of their project.