An appraisal of the MFSA’s proposed ‘Financial Instrument Test’

Pursuant to the ‘Discussion Paper on Initial Coin Offerings, Virtual Currencies and Related Service Providers’, the MFSA has released a consultation document in respect of the ‘financial instrument test’ (the “Test”).

The purpose of the Test is to determine the applicable regulatory framework for initial coin offerings, as well as other services related to distributed ledger technology (“DLT”) assets. 

In essence, the Test is composed of the following principal stages: 

i.    Stage 1 – determination of whether a DLT asset qualifies as a virtual token; 
ii.    Stage 2 – If the DLT asset does not qualify as a virtual token, a further determination of whether the DLT asset qualifies as a financial instrument under MiFID; 
iii.    Stage 3 – If the DLT asset does not qualify as either a virtual token or a financial instrument, then the DLT asset would qualify as a virtual financial asset (“VFA”).
 
Virtual Token Test 

In accordance with the draft legislation, a virtual token is defined as a DLT asset 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…”. 

One would therefore have to look at both the purpose of the DLT asset as well as its exchangeability when determining whether or not it qualifies as a virtual token. 

MiFID Financial Instrument Test 

The definition under MiFID of a financial instrument includes: (i) transferable securities; (ii) money market instruments; (iii) units in collective investment schemes; (iv) financial derivatives; and (v) emission allowances consisting of units recognised for compliance with the requirements of Directive 2003/87/EC (Emissions Trading Scheme). 

Transferable Securities 

To establish whether a DLT asset qualifies as a transferable security one would have to look at the following considerations:

i.    A maturity at issuance greater than 397 days; and
ii.    Does not qualify as an instrument of payment; and 
iii.    Has features of a transferable security, which require the element of negotiability on the capital markets and any of the rights normally attached to transferable securities. 

Money Market Instruments 

Money market instruments are defined in the Investment Services Act as “those classes of instruments which are normally dealt in on the money market, such as treasury bills, certificates of deposit and commercial papers and excluding instruments of payment”. 

Pursuant to the above definition, to establish whether a DLT asset qualifies as a money market instrument, such instrument should: 

i.    Have a value that can be determined at any point in time;
ii.    Have features that are similar to those of other instruments falling within the definition’s scope, such as treasury bills, certificates of deposit and commercial papers;
iii.    Are not derivatives or instruments of payment; and 
iv.    Have a maturity at issuance of 397 days or less. 

Units in Collective Investment Schemes 

To establish whether a DLT asset qualifies as a unit in a collective investment scheme, such instrument should have the following attributes: 

i.    The undertaking should constitute a scheme or arrangement which has as its object or as one of its objects the collective investment of capital; and 
ii.    The raising of such capital should be done through offer of DLT assets for subscription, sale or exchange. 

Additionally, for a DLT asset to qualify as a collective investment scheme unit, one of the following requirements must be met: 

i.    The contributions of the participants and the profits or income out of which payments are to be made to them are pooled; or
ii.    The DLT assets are to be repurchased or redeemed out of the assets of the issuing entity, continuously in blocks at short intervals, at the request of the holders of the DLT assets; or
iii.    The DLT assets are, or have been, or will be issued continuously or in blocks at short intervals.

Financial Derivatives 

Financial derivatives include the following: 

i.    Securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement determined by reference to transferable securities, currencies, interest rates or yields, commodities or other indices or measures;
ii.    Options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, emission allowances or other derivative instruments, financial indices or financial measures which may be settled physically or in cash; 
iii.    Options, futures, swaps, forwards and any other derivate 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;
iv.    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 multilateral trading facility, or an organised trading facility, except for wholesale energy products traded on an organised trading facility that must be physically settled; 
v.    Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in point (iv) and not being for commercial purposes, which have the characteristics of other derivative instruments;
vi.    Derivatives instruments for transfer of credit risk; 
vii.    Financial contracts for differences; 
viii.    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 list, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are traded on a regulated market, organised trading facility, or a multilateral trading facility. 

In general, in order for a DLT asset to qualify as a financial derivative, a thorough examination of the contract type/ purpose, the underlying assets and the settlement method would have to be carried out. 

Emissions Allowances consisting of units recognised for compliance with the requirements of Directive 2003/87/EC (Emissions Trading Scheme) 

An emission allowance refers to an allowance to emit greenhouse gases during a specified period in accordance with the requirements of Directive 2003/87/EC.

For a DLT asset to qualify as an emission allowance, the applicable test should focus on the identification of the following characteristics:

i.    The issuer: for a DLT asset to qualify as an emission allowance, it should be issued by the national competent authority in accordance with article 18 of Directive 2003/87/EC;
ii.    Definition: the DLT asset should in substance be equivalent to an emission allowance in terms of article 3(b) of Directive 2003/87/EC, in addition to satisfying other requirements such as transferability, in accordance with the same Directive. 

Conclusion 

The financial instrument test seeks to establish the VFA as a new category of DLT asset. With the future enactment of the Virtual Financial Assets Act, such DLT assets will be subject to a unique regulatory ecosystem, allowing prospective participants to navigate the space with legal certainty. 

It is proposed that the financial instrument test be the first of many steps involved in obtaining regulatory approval in Malta. Interested persons, such as promoters of ICOs and related service providers would be well advised to pay attention to this step, in particular, due to the implications surrounding an incorrect assessment of the regulatory profile of a DLT asset.

Author: Alain Muscat Related Practice Area: Blockchain

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