Connect with us

Thought Leaders

Three Types of Security Tokens To Know – Thought Leaders

mm

Published

 on

Three types of security tokens you should know about

Similar to traditional security, a security token performs the same function except that it confirms ownership through blockchain transactions and also make fractional ownership possible. Federal laws that govern securities also apply to Security tokens with the intention of protecting investors on some levels. Security tokens are programmable. Tokenizing securities, in theory, remove the need of a third party by using smart contracts. For example, a loan “tokenized” on a blockchain could automatically make payments without the use of a traditional middleman like a bank. A detailed article on STO was written by Moonwhale Ventures that discussed deeper on the various regulatory requirements around security tokens.

Let’s take a look at three commonly known types of security tokens:

  1. Equity Token
  2. Debt Token
  3. Real Assets Token

Equity Token

Equity tokens represent the value of shares issued by a company on the blockchain. The difference between an equity token and a traditional stock lies in its method of recording ownership. A traditional stock is logged into a database and the records are then represented by a paper certificate. For an equity token, however, it is recorded on an immutable blockchain essentially digitizing the traditional means of recording. Owning an equity token entitles the investor a portion of the company’s profits and a right to vote. It is important to note that these tokens are not limited to only the early stages of funding though it is more common to find companies offering its tokens during seed round. There are three benefits to this system:

  • Enables investors to invest in blockchain companies while staying in compliance with securities law
  • New fundraising model for early startups
  • Framework for regulators to evaluate the project’s fundraising

ICOs provided an opportunity for early startups to seek funding through utility tokens. However, it came under major scrutiny by authorities as utility tokens do not represent ownership to the company.  An STO ensures their fundraising efforts are compliant with securities law. One example of an equity token offering is Documo. They will be launching one of the world’s first equity token offerings to fund its business initiative to drive the mass adoption of paperless document technologies. Their tokens DCMO represents actual equity ownership in Documo.

Debt Token

Debt securities that includes bonds, notes, debt instruments

Debt-based security tokens represent debt instruments such as real estate mortgages and corporate bonds. The prices of these tokens are dictated by two factors: Risk and Dividend. A medium risk of default in a real estate mortgage cannot be priced the same way as a bond of a pre-IPO company. Therefore, modeling the price of a security token after risk and dividend is key. In blockchain terms, the smart contract representing a debt security token should include operations such as repayment terms that dictate the dividend model but also incorporate the different risk factors of the underlying debt.

The benefits of tokenizing debt include:

  • Fractionalization

Fractionalizing debt vehicles brings new opportunities to a larger scope of investors

  • Futures

Tokenizing futures contracts and derivatives could open up a whole world of new opportunities. As a result, they can bring massive liquidity into the tokenized market, thanks to its highly leveraged nature. It also provides a great way of hedging portfolios.

  • Market Size

The current public market that includes bond and debt security is worth $100 trillion dollars. Should tokenization be the next evolutionary step for financial instruments, the potential for debt-based tokens can be massive.

  • Dividends

The difference between dividends from equity and from debt is its regularity. Dividends from bonds are typically more frequent than equity because dividends from equity heavily depend on the underlying companies’ performance.

Real Asset Tokens

tokenizing commodities in agriculture, metals, livestock and energy

This type of token represents ownership to a certain asset such as real estate or commodities. Commodity-backed tokens address issues of trust, their inefficiencies and the complexity of transactions, which typically involve multiple parties. Blockchain technology allows a transparent record of complicated transactions, track goods, and reduce fraud, which seems to make it a natural fit for the commodity business.

Tokens can be used as virtual currencies, which have the same characteristics as any commodity (like gold) that can be traded with profit-making intentions. Commodity-backed cryptocurrencies included tokens linked to gold, silver, and oil . And each of those commodity has its own advantage and disadvantage.

Commodity-backed stable coins are one of the most exciting developments in the crypto world. Commodities such as gold or diamonds giving the tokens stability and value.

Some examples:

  1. Bananas — a cryptocurrency backed by bananas.
  2. Cannabium — backed by liquid cannabis extracts from legal sources
  3. PowerLedger —backed by renewable energy of the sun.
  4. “El Petro” — Oil-backed. Venezuela’s economy has been plummeting.
  5. Diamonds are an easy-to-redeem commodity with a good potential of a soon-to-be unlocked market. Among commodities, diamonds are one of the most stable in value. While gold, silver, and other commodities are exposed to financial markets and speculators’ whims, diamonds have remained steady for over three decades (enjoying a positive appreciation).

The STO Market Today

With regards to these three types of security tokens, the majority of projects that offer the token is lacking in quality. There are several great examples of real asset tokens such as the project led by Inveniam Capital Partners to tokenize $260 million worth in real estate and debt transactions. However, buyers have to hold at least $10 million in Crypto to participate and purchase a minimum of $500,000 worth. It is clear that the world of security tokens are fundamentally geared more towards institutions.

It will take a considerable amount of time to incorporate the true beauty of initial coin offerings into security tokens. Initial coin offerings democratize the fundraising process which was only open to larger institutions and accredited investor. Imagine a world where a student living in Argentina being able to own equities to a company based in Russia simply from their phones. But for now, the Argentinian student has to wait and proceed with the current ways to invest in security tokens. The STO market is definitely one to watch for in the next coming years as we attempt to revolutionize the financial markets.

Spread the love

Iliya Zaki is the Head of Marketing & Business Development for Moonwhale Ventures. Moonwhale Ventures is an STO Financial Advisory offering companies strategic advice on STO process & structure, as well as token issuance incl. lifecycle management and secondary market on-boarding for their projects.

Thought Leaders

Regulated Digital Assets Take Over in 2020 – Thought Leaders

mm

Published

on

Regulated Digital Assets Take Over in 2020 - Thought Leaders

2018 was the highwater mark for initial coin offerings (ICOs), when 1,253 new coins raised $7.8 billion. In 2019, this “Wild West” market went from boom to bust. Dollars raised in ICOs plummeted 95% compared to 2018, and the Securities and Exchange Commission (SEC) continues to announce new actions against various ICO players for fraud and unregistered issuances. The sheriff has come to town.

Regulation, my old friend

It’s no consolation to investors who lost millions in ICO scams, but they were part of a natural market evolution. The laws governing traditional securities were also originally inspired by bad actors like “bucket shops” that emerged as another new technology, the telegraph, was changing financial markets. The SEC’s decision to crack down on digital assets and apply those same laws to blockchain securities is good news for market participants.

Blockchain securities have the potential to increase efficiency, lower costs, provide greater transparency and mitigate risk. However, the financial industry can’t fully realize the potential of blockchain securities without a public market and regulated ecosystem to support their full lifecycle. That means fully compliant issuing, investing, trading, settlement and custody.

Governments around the globe are working to establish the necessary frameworks in their own jurisdictions. This is lowering the risk of investing in blockchain securities by introducing investor protections associated with traditional markets. Although different jurisdictions have different requirements for regulated entities, investors, traders and users, there are four common areas being addressed:

  • Distribution – how are security tokens created and why, and how are they delivered to their owners?
  • Custody – where is the ultimate record of ownership kept and by whom?
  • Reporting and Record Keeping – what additional regulatory requirements are placed on participants such as transfer agent services?
  • Specific Processes – what additional processes are required, for example, in order to move security tokens between personal and master wallets?

The SEC and the Financial Industry Regulatory Authority (FINRA) have established guidance in all four areas through a series of communications including the report on The DAO and a joint statement on broker-dealer custody of digital assets. The necessary U.S. framework is finally in place to allow regulated, public trading of blockchain securities to blossom.

If the juice don’t look like this

In parallel with these regulatory developments, companies have rushed to create the necessary market infrastructure. Critical components are in place and more are coming this year. The question for those considering whether to participate: is the juice from this 2.0 version of digital assets worth the squeeze? The answer will be yes if the blockchain securities market looks like an upgrade of traditional markets, which would require that it offers two key benefits to investors and companies looking to raise money.

The first is efficiency. Blockchain securities need to eliminate the cumbersome data systems and manual paper-based processes of traditional securities trading. The potential is there but execution is everything as the saying goes. Implemented correctly, blockchain can efficiently support the entire lifecycle of digital assets from issuance and investing through trading, settlement and custody.

The second benefit is smart oversight. To be viable over the long term, the blockchain securities market needs to be fully compliant not only to satisfy regulators, but to create liquidity. It needs to supply investors with convenient access to transparency, account safeguards, and regulated trading. This will require integration with traditional brokerage accounts as well as intuitive user interfaces.

I’ve become so numb

I was hoping to get through this article without using “disruption” because I know we are all numb to the concept. Unfortunately, I keep hearing that blockchain securities will disrupt financial markets. I’ve said it myself! But the reality is that blockchain securities are an evolution not a revolution. The same year that ICOs peaked at $7.8 billion, the traditional US securities industry raised $2.4 trillion. For blockchain securities to become a mainstream asset class, they can’t remain on the island of personal wallets. They need to be bought, held and sold by retail investors, institutions, and advisors through traditional trading systems and brokerage accounts. That could happen as early as this year.

Spread the love
Continue Reading

STO Launch Strategies

Under Scrutiny: How to Pass Due Diligence as a Blockchain Project – Thought Leaders

mm

Published

on

Under Scrutiny: How to Pass Due Diligence as a Blockchain Project - Thought Leaders

Every business is destined to undergo multiple assessments. Regulators granting licenses and permissions, potential partners, investment advisors and investors – each of them has a set of filters that a tech project should pass to be considered viable. The task gets more tricky for deep tech startups utilizing blockchain, AI and other cutting-edge technologies.

This article is structured as a list of questions for a startup to check its investment readiness and prepare for a due diligence process, grouped in three broad categories: 1) technical, 2) legal, and 3) business. Starting with generic ones, we are diving deeper into industry-specific questions with particular examples in the tech part to illustrate nuances and pitfalls a project might face, especially fueled by high competition in the space.

Technical considerations:

Is the proposed solution technically possible?

This might sound obvious – but many founders neglect this question while chasing the visionary technological dream, especially in deeptech areas like AI/ML, brain-computer interfaces, biotech, or blockchain. If your project exists only as a concept yet (especially if you’re not the tech guy and will do external hiring), make sure that it is possible to develop before you pitch.

If the solution is not technically possible at the moment, how much time and effort is needed for research and development (R&D)? Are these estimates aligned with time and funding limitations, if there are any? 

In some cases, a tech team is strong and the idea is very promising, but it might take full five or ten years to develop and be adopted – like quantum computing for solving enterprise-grade problems in the pharmaceutical industry.

You have to be honest – and realistic – about the timing and expenses. You will certainly get this question. Here you need to distinguish between research and common software development costs: the research stage is inventing algorithms to build something that previously hasn’t been possible due to technological limitations, with uncertain results and timelines. The software development stage is building a well-understood solution, which only requires a certain period of time.

Clearly enough, investments at the research stage are much less predictable. However, development can also take much longer than team plans originally, trying to impress investors and overestimating capacity. Make sure you don’t.

In the case of a software product, does the project really need proprietary software and not a white-label solution or SaaS?

Reinventing the wheel might be seductive. However, in some cases, spending resources for the development of a new in-house technical solution can be a waste of time. If you as a startup do not suggest a software innovation, it might be easier and cheaper to purchase a ready technical part and customize it to the particular business needs.

What are the external dependencies (e.g. libraries)? How is external software maintained?

No software is written totally by the company in-house team. Every project in the world uses multiple external databases and code libraries, often open-source, maintained by global communities of developers or by corporations. The resilience of the project depends on the timely update of external software for security and efficiency.

If you’re doing an AI project, what is the source of data? Is it sufficient? Is it available?

The viability of AI projects is extremely dependent on data quality. Algorithms may be inefficient when there is not enough data. Also, inherent biases in the data (e.g. racial) will impact the final algorithm. Furthermore, there may be a chicken-and-egg problem if the customers are a source of data and, at the same time, the main value is delivered using the AI/ML. If the data is not free, its cost should be considered vs potential value compared to using less advanced methods.

If you’re doing an AI project, how is the context-dependence addressed? 

Even if there is plenty of data available, it may be gathered in a specific context, often being non-applicable in another. For example, if the network was able to distinguish cats and dogs indoors, it may be unable to do so outdoors.

If you’re doing a blockchain project, why the database should be distributed, in other words, why do you need blockchain? 

Many problems that are claimed to be solved with the blockchain can be solved with a simpler cryptographically protected database with a robust permission management system that can also utilize public-key cryptography if needed.

In the case of the original concept of blockchain, the database is distributed among multiple participants with all of them being able to make an input. This is not always needed. For example, an enterprise may need a database to store and process its internal data, in which case it shouldn’t be distributed. Or it may be a database of a governmental body, to which everyone should have access but only the government should be able to validate input data.

If it makes sense for a database to be distributed, does blockchain have to be public?

Blockchains can be generally divided into public and private. Public (permissionless) blockchains are the ones in which anyone can host a node, thus having access to all data recorded and validate database updates. In private (permissioned) blockchains only certain participants can have access to data and validate input.

Public chains significantly reduce the control over the business as the state of the database is now controlled by multiple people scattered across multiple countries. This also means an increased regulatory uncertainty, especially in the case of heavily regulated industries or the ones that are of systemic importance. For these reasons, the case for public chains must be really strong. In many cases, a private blockchain is enough to satisfy business requirements. For example, transaction processing requires only financial institutions participating in the blockchain, sharing medical history data requires only hospitals participation.

If you’re doing a blockchain project, what are the incentives of participants to act for the benefit of the system? What are the ways to break these incentives and how are they addressed?

As blockchain, especially the public one, is maintained by common efforts, and the quality of data, the transaction costs depend on the participants, incentives should be designed in a due way to ensure that the system is sustainable.

An example of where it is problematic is the Tezos blockchain that utilizes the so-called Liquid Proof of Stake (LPoS) consensus algorithm. A consensus algorithm is a way in which validators agree on the new state of the ledger. In LPoS consensus participants can stake a certain amount of a blockchain native token to get a right to either validate transactions themselves or select another trusted person that would do that instead, who would validate a transaction and distribute the reward. Although such algorithms have multiple benefits, the common point of criticism is that incentives for participants to become validators are questionable as they can select someone else, and still receive a significant chunk of reward because of the competition among potential validators, while not spending time and computational resources on network maintenance and governance. This creates a risk of blockchain centralization and various types of attacks.

How is the cybersecurity ensured?

Cybersecurity is a primary feature of any IT infrastructure. Especially for a regulator, who’s main concern is protecting customers.

If you’re doing a hardware business, how is the quality of supplies ensured?

While software businesses are dependent on external libraries, hardware businesses depend on supplies providers for the quality of their solutions.

Legal сonsiderations

Assessing legal implications of a project, compliance costs and limitations arising from legal requirements.

Does the company need licenses to operate legitimately, and which ones? 

This point is especially important for heavily regulated industries, such as fintech. Almost any financial services require some kind of licensing, and some of them – such as MiFID II in Europe – can take up to two years or more to acquire.

Also note that in most cases you need a separate license in every country where you intend to operate and provide services, although there may be various arrangements between competent authorities, especially between the EU Member States, that allow facilitated transfer of license.

How does the company handle KYC/AML issues?

All clients need to be identified, especially in the financial services industry, as well as the origin of their funds so that the business is not used as a means for money-laundering. However, making customers confirm their identity may not be a great and engaging UX, negatively impacting conversion rates. The proportionality principle should be applied – the higher the risk, the stricter measures.

Who holds the custody of the funds?

This question will be asked to any business that allows clients to deposit their funds, such as investment management. Holding clients’ money and assets also requires licensing, and the project should consider a partnership with an applicable license holder institution.

Who is liable for failures?

This happens to be one of the most neglected matters. Even if you will suffer eventual reputation damage, you can still protect itself from legal liability by building corresponding arrangements with service providers. For example, if client data is stored on third-party servers, they should be responsible for the data safekeeping. Note, though, that such arrangements will increase service costs. Sometimes providing a service for which a liability may be taken is a core business of a company. Although it is impossible to avoid liability completely in such case, it can still be reduced, for example, if employees are liable, and not a company, or if limits are imposed on the amount of liability.

Founders of blockchain projects, especially of decentralized ones, tend to consider that they hold no liability, as they don’t control the network. However, regulatory authorities may have another view as the legislation is built on the premise of a liable service provider who has the responsibility to ensure that the system operates in a due manner. Thus, the project team may become subject to claims in case of failures.

Taxes

Being poorly managed, taxes can significantly reduce company profits, especially in the case of unfavourable double taxation regime between countries the company operates in. Furthermore, taxation issues can make the company much less attractive as an investment opportunity. A proper optimization should be undertaken in order to mitigate these problems.

What is the intellectual property of the company? Is it protected? Does the company violate any IP?   

There are three main points to it.

Firstly, a company may at some point become a target for patent trolls, so it should get patents and copyrights for all its relevant assets.

Secondly, in order to make an MVP startups may violate someone’s intellectual property in some cases, for example, use protected images, design, UX, etc. It is unlikely to be problematic at the initial stage but may be when the company grows bigger. Especially if the IP violated belongs to direct competitors.

Thirdly, IP is an asset that increases valuation, that may be used for tax optimization.

Data Protection

In recent years GDPR became an increasingly pressing issue. Basic privacy setup goes far beyond cookies disclaimers and should include proper storage of personal data, hijacking of which may result in significant lawsuits, proper data management, such as not giving to third parties without consent, the possibility of erasure, etc.

The blockchain may often store sensitive personal and financial data, which are strictly protected on the regulatory level. They can sometimes be contradictory to the nature of the technology, such as the right to be forgotten or the obligation to store data on the server of the country where the person resides. It is advisable to consider not storing personal data on the public blockchains at all, which enables more control over them.

Business considerations

What problem does the project solve?

Emerging technologies are sometimes called “a solution looking for a problem” – not unjustly. Behind the engaging narrative and brilliant technological thought, it can be easy to lose the most important question: who is your target audience, and why it will use the proposed solution?

Check if the stated problem does exist, confirmed by the potential clients. Customer surveys and test can help a project make sure that you are moving in the right direction. If a project operates in a vacuum with no direct contact with its target audience – it is a red flag for investors, as it risks meeting no demand once it goes live.

Sometimes a problem is not pressing enough for it to require a separate solution.

How is the problem currently solved? How is the proposed solution better?

In order to be adopted, a project has to offer a very clear benefit to its customers – saving someone’s time or money, fulfilling a particular need or simply providing positive emotions.

If the benefit is marginal, clients are unlikely to pay more or bother switching to a new service at all – so make sure a project has to lead a competitive analysis and found its clearly defined niche in the market.

We once had a discussion with a project building a network of supercomputers in different countries that would solve the AI problems with built-in algorithms so that customers would only input data and choose algorithms. The problem was that in cloud computing they were competing with Amazon and Microsoft, and in AI software – with IBM. No chance they would win.

What are the core assumptions on which the business model is based? How are they validated or are going to be validated?

How actually the company is going to make money? What metrics in such cases determine the profits? Are the revenue predictions realistic?

For example, if transaction fees are the main source of revenue, certain transaction volumes are expected and should be justified by market analysis.

What is the place of a company in the industry value chain? Who are other participants the company is working with? How supply chain sustainability is managed?

No company delivers its value to end customers independently, it is always working together with multiple other actors. It is critical to identify the exact added value the company provides. All other companies in the value chain are external dependencies that may pose risk and should be managed, for example, by diversification.

How does the unit economics of the company work? Can it be profitable at all?

That is, does a single customer bring more money than it costs, including processing and acquisition costs.

In the case of broken unit economics, is the increased revenue per customer possible, or they will not pay more? Is it possible to cut costs in the future with significant investments, for example, software that reduces operational expenses, or marketing that raises the credibility, reducing acquisition cost?

In other words, investors will look at the factors that will make the investment justified.

What is the growth strategy? How is the growth engine validated? Does it suit the business model?

To make the investment feasible, a project should have a certain growth potential that matches the risk. For an operational profitable business growth expectation is lower compared to a startup. The company with the potential of viral growth prospects differ significantly from the B2B company that should employ sales department.

Who are the direct competitors? What is the competitive advantage, if any? If there are none, what are the possible options to gain some and the expected investments? If there are some, how are they sustained?

A business does not necessarily need a competitive advantage at every point of time if the demand on the market is significantly higher than supply. However, this is not a sustainable situation, and the competition will increase. Thus, if there is no competitive advantage, you should focus on getting one. If you do have one – make sure you’re able to sustain it and adapt to the ever-changing market conditions.

Did the company use debt funding? What is the debt to earnings ratio?

Indebtedness of the company creates additional risks for anyone engaging in business with it, resulting in less favourable collaboration or a lack thereof.

Who are the major company shareholders? How will they impact company direction? Do they support profitability or growth? Do they participate in operational management?

Shareholders are a source of information about the business that will be looked upon. In the financial industry or when offering securities to the public, major shareholders and directors should pass fitness and properness checks. The company should be cautious and make its due diligence when accepting investments not only regarding the legal background of the investor but also the broader impact it will have on the company’s strategy.

Conclusions

If a project is looking into engaging serious partners, attracting significant funding round or raising public and media awareness, it will definitely become a subject to thorough scrutiny that will target not only superficial financial parameters and the quality of the idea, but also the non-sexy things, such as taxes, intellectual property, cybersecurity, and supply chain resilience. Answering those questions in advance makes you not only well-prepared for the due diligence, but also more able to succeed in the fierce competition on the market, and should be undertaken as early as possible.

Due diligence requires asking hard questions. But it is critical to ensure that we devote our time and money to what will have a real impact on the world.

Spread the love
Continue Reading

Regulation

Firsthand Overview of Digital Securities Legislation in Malta

mm

Published

on

Firsthand Overview of Digital Securities Legislation in Malta

When it comes to choosing a jurisdiction for a digital securities offering, Malta is among the first on the list. In the course of the past several years, Malta has taken a unique position as the “blockchain island”, fostering technological innovation by introducing advanced blockchain legislation, friendly tax policies and progressive approach to regulation. 

This article provides a comprehensive overview of the legal status of digital securities in Malta, based on the months of research and personal communication with Maltese regulator and local lawyers, while we have been structuring our platform for digital securities offering on the island. 

Regulation overview

Digital securities on Malta are regulated, first and foremost, by traditional legislation on financial instruments and services, the most important of them being the Companies Act and Investment Services Act. These acts incorporate themselves into provision of the EU legislation, namely MiFID II, Prospectus Regulation and others.

Apart from the existing set of laws, Malta has also introduced a specific legislation on innovative blockchain-based financial instruments that defines what should be regulated by the traditional legislation and what falls under the scope of the new ones.

This approach is different from the one adopted by countries with a common law system that don’t require a specific legislation to define the legal status of an innovative object, relying on the existing one instead. 

There are three main acts referring to the digital securities particularly: 

  1. Virtual Financial Assets (VFA Act), which defines DLT-based assets and the rules governing them
  2. Malta Digital Innovation Authority (MDIA), which established MDIA as a governing entity and its role in regulating blockchain companies
  3. The Innovation Technology Arrangements & Services (ITAS), which introduced the term “innovative technology arrangement”, the procedure and conditions for the licensing 

A separate act regarding STOs as a fundraising method is currently under development. 

Apart from that, there are several guidelines and strategies. The most relevant of them are the MFSA STO Consultation Paper that outlines the MFSA approach to STO and MFSA Fintech Strategy, which, inter alia, discusses plans to establish regulatory sandbox for fintech ventures.

Below, I am taking a closer look at the most important aspects of the existing legislation. 

Competent Authorities

There are two main regulatory bodies governing digital securities on Malta: The Malta Financial Services Authority (MFSA) and The Malta Digital Innovation Authority (MDIA). 

MFSA is the single regulator of financial services in Malta, which regulates both financial services providers and issuers of any types of financial instruments. This has two implications for digital securities issuers:

  1. They need to work with MFSA-licensed service providers
  2. Their offering has to be approved by the MFSA

The role of MDIA is to set and enforce rules and standards for technological innovation. In digital securities regard, the regulator reviews and authorizes the technical infrastructure of crypto and security token exchanges and other infrastructural projects to make sure they are reliable and secure. 

In order to get an MFSA (prevailing financial authority) license, you do not necessarily need MDIA authorization – in most cases, system audit is enough and MDIA opinion remain voluntary. However, if transaction volumes exceed certain levels, the authorization by the latter becomes mandatory.

Obviously, MDIA has limited bandwidth and cannot check every application for authorization itself, so the regulator attracts third-party MDIA-licensed system auditors to review the technical blueprint of the suggested system. There are currently five of them, including consulting giants KPMG and PwC. Once the audit is done, MDIA makes the final decision to grant the authorization based on the auditor assessment, business model, senior management personalities and qualifying shareholders of the innovative technology company. 

The competent authorities are pursuing three priority goals: protecting investors, supporting 

Malta’s reputation of the “center for excellence for technological innovation” and promoting healthy competition and choice.

The strong focus on reputation makes Malta different from other blockchain-friendly jurisdictions, such as Estonia. Although Malta does much to promote blockchain-based business by establishing clear legislation, creating regulatory fintech sandbox and so on, getting licenses here is more difficult. To get licensed, a company needs to comply with strict requirements, pass systems audit to ensure the resilience of infrastructure, defend its business model. 

One of the necessary requirements to get authorization for any regulated activity on Malta are so-called “fit and proper checks” for all qualifying shareholders (>25% stake) and senior management – another mechanism to prevent fraud, protect investors and good reputation of Malta.

Such measures create an additional credibility for a company licensed on Malta, which in its turn creates incentives for decent companies to establish business activities there. 

Virtual Financial Assets Act: providing classification

VFA Act introduced the legal framework for virtual financial assets and asset offerings in November 2018.  The Act defines four types of DLT-assets:

  1. electronic money –  common money, accounted for on DLT 
  2. virtual tokens – units that have value only inside a system, for example, loyalty points 
  3. financial instruments – assets defined by MiFID II regulations which include, inter alia, transferable securities and units in collective investment undertakings
  4. virtual financial assets – everything that does not fit into any of the above 

The beauty of the Act is that when an asset does not fall into conventional forms, it is dealt with on a case-by-case basis. Many jurisdictions don’t adopt such a granular approach, preferring to qualify DLT-based assets broadly as security, utility and payment tokens with the same rules for every group of assets.

While it might seem like a good idea to create a separate category for cryptocurrencies, the problem is that, as we know, they can be very different by their essence: some are native tokens of a blockchain, others are not, some are anonymous, some are not, some are decentralized, and some are not. 

VFA Act is mostly focused on procedures regarding the issuance or offering of virtual financial assets. However, it is unclear from the act itself how security tokens should be qualified depending on their nature. Thus MFSA has issued further guidelines and is working on a specific legislation for digital securities, which is going to cover all specific use cases in the industry.

STO Consultation Paper: defining digital securities

STO Consultation Paper divides security token offerings into traditional and non-traditional. 

Units, offered during traditional STO, are classified as financial instruments under MiFID. Thus, they are regulated mostly by MiFID and Investment Services Act. At Stobox we call such units “digital securities”, and mostly work with them.

All other exotic types of investment units fall under the definition of non-traditional STOs. The most common example may include a unit that provides a right to a revenue share but does not represent a company’s equity, thus being some sort of a derivative contract. Many of the security token offerings conducted so far have been of such nature, although the regulation they fall under differs depending on the jurisdiction. Most security token offerings conducted so far have been of that nature. 

MFSA has not yet issued an opinion on non-traditional STOs.

Prospectus regulation: offering & trading digital securities

The offering of digital securities is regulated mainly by the Prospectus Regulation, which requires issuers to register a Prospectus when making a public offering. However, European legislation courteously offers exemptions under which the offering can be conducted without registering a Prospectus. 

The two most widely used include:

1) offering targeted solely on accredited investors (private sale)

2) offering with a total consideration under EUR 5 million in the European Union during a 12 months period.

Nonetheless, if the issuer is seeking to get listed on a trading venue it has to comply with the listing rules and prepare a Prospectus-like Admission Document, thus reducing the benefits of an exempted offer. 

However, there are secondary market arrangements that do not fall under the definition of a regulated trading venue and, thus, can introduce less strict admission rules. One of them is bulletin board, which is a market at which participants can place their buying and selling interests, but there is no automated matching. Instead transaction is initiated when another clients agrees with the proposed terms and chooses to become a counterparty of the trade. Although there is no precedent of a kind on Malta yet, UK’s Financial Conduct Authority, which is subject to the same EU legislation, does not consider such arrangement an MTF: 

In our view, any system that merely receives, pools, aggregates and broadcasts indications of interest, bids and offers or prices should not be considered a multilateral system. That means that a bulletin board should not be considered a multilateral system. This is because there is no reaction of one trading interest to another other within these types of facilities.” 

For this reason, we at Stobox are building our secondary marketplace in the form of a bulletin board to reduce requirements for companies to be onboarded and have access to liquidity.

Final thoughts 

Malta has introduced one of the most progressive legislative frameworks for digital securities in the world, which finds balance between investor protection and facilitating innovation. Creating comprehensive legislation from scratch is an non trivial task and takes a lot of time –– it explains why the majority of digital securities offerings to the date took place in other jurisdictions. However, exactly due to the fact that Malta has put so much time and effort into it, Maltese providers and companies can be trusted from both the perspective of long-term regulatory stability and correspondence to prudential standards.

Spread the love
Continue Reading