Nicholas Micallef highlights the considerations for those looking to set up PIFs investing in virtual currencies in Malta in the 'HFM: Malta 2019 Special Report'

Q: There seems to be considerable interest in the seeing up of funds investing in virtual currencies in Malta. What are some of the key points that need to be considered and taken into account by those who are looking to set up Professional Investor Funds (PIFs) investing in virtual currencies?

A: That is very true. With the recent drive by the Government of Malta and the Malta Financial Services Authority (MFSA) to establish Malta as the 'Blockchain Island', coupled with regulation being published on this subject matter, interest in establishing crypto funds, or funds investing in virtual currencies, in Malta has increased considerably over the second half of 2018. The key theme for fund managers looking to set up a virtual currency PIF in Malta, which is targeting qualifying investors (those investing a minimum of €100,000), is that of competency. The MFSA requires that the parties involved in the fund, and any third parties providing services to the fund, have the necessary knowledge and experience in the fundamental technologies behind the fields of virtual currencies and information technology such as, for example, distributed ledger technology.

Q: Who are the relevant parties when considering establishing a fund investing in virtual currencies, and what is the level of competency required for these parties?

A: The parties involved in the fund would predominantly include the investment manager, the fund administrator, the depositary/custodian and the auditor. It is vital that the service providers engaged by the fund have the required business organisation, systems, experience and expertise deemed necessary by the MFSA to ensure investors are protected appropriately. In the case of the manager of the fund, it is essential that the appointed manager has an internal investment committee consisting of a minimum of three members. It is also crucial for this investment committee to have a minimum of one member who is considered to have the obligatory proficiencies for managing a virtual currency PIF. The necessity for competency in the field of virtual currencies however applies across all service providers, including the administrator, custodian, and auditor, and is examined and reviewed by the MFSA in advance of issuing a licence for a virtual currency PIF and approving the appointment of such service provider.

Q: You mentioned the term distributed ledger technology earlier. Could you please elaborate on what this is exactly?

A: Distributed ledger technology (DLT) is a technology based around the storage of transactional records with the relevant information that is shared, and coordinated across a system of a number of nodes. The technology is underlined by strong cryptography that ensures that the ledger cannot be tampered with by any one node. A DLT asset, under the new Virtual Financial Assets Act published in Malta, can be made up of either electronic money, a virtual token, a virtual financial asset(or VFA) or a financial instrument. These DLT assets are traded on a DLT exchange.

Q: Clearly investor protection is an area of importance for the MFSA. What steps are therefore taken to ensure that quality control requirements are met for those setting up PIFs in virtual currencies?

A: The manager is responsible for carrying out suitable analysis (referred to as quality assessments) to determine the standard of the virtual currencies being invested into, and thus ensure they are of a sufficient quality. The fund will make sure that the manager that has been appointed maintains records of the quality assessments that were undertaken, and ensures that they are accessible for the fund's governing body. There are various criteria used for assessing quality of virtual currencies, including an assessment on the issuer, the fundamental infrastructure, the reliability of information and its readily availability, the third-party service providers appointed and the exchanges where the virtual currency trades.

Q: Given the risk profile of this particular asset class, are there any specific risk management processes required to be in place for PIFs investing in virtual currencies in Malta?

A: The risk management element of virtual currency PIFs is one of the cornerstones of the regulation issued by the MFSA. It is the responsibility of the fund to ensure that the manager that is appointed implements a suitable, recognised and frequently updated quality assessment procedure when investing on the fund's behalf. This quality assessment procedure must also be in line with the investment objectives and policies of the fund, as well as its risk profile. It is essential that the manager also ensures that the risks accompanied with each of the fund's investments (and the entire effect of these positions on the portfolio of the fund) can be appropriately recognised, and observed on an ongoing basis. There are several methods of ensuring that these risks are being monitored accordingly, including, for example, through the use of suitable stress testing processes. In addition, it is the responsibility of the manager to ensure that the fund's risk profile relates appropriately to its scope, investment objectives, and structure, as stated in its offering and constitutional documentation.

Q: Similarly, are there liquidity management systems required to be in place to ensure investors are able to redeem their funds invested in a timely manner?

A: Yes. The manager appointed is required to put in place a suitable liquidity management system, and must adopt measures which allow the manager to affectively measure the fund's liquidity risk, while also making sure that the investments within the fund liquidity profiles adhere to their primary requirements. In addition, there is also an obligation for the appointed manager to habitually undertake stress testing,in both ordinary and unexpected liquidity conditions, which allow the manager to appropriately evaluate the fund's liquidity risk. The regularity of these stress tests is determined on the grounds of the complexity the fund's investments in virtual currencies, and their general nature. The appointed managermust also confirm that the liquidity profile, and their procedures on redemptions are consistent for the fund.

Q: Are there any additional peculiarities in the regulation for funds investing in virtual currencies, which may be different to traditional funds in Malta?

A: The MFSA has specifically catered for the verification and valuation function of virtual currency PIFs, which can be executed by an external valuer, autonomous from the fund. The process can also becarried out by the manager, as long as the valuation task is entirely separated from the function responsible for portfolio management, and so long as there are certain measures in place to ensure that conflicts of interest are alleviated. As mentioned previously, it is of course essential that the party carrying out the verification and valuation process has the expertise necessary to perform the verification and valuation of the PIFs investments in virtual currencies.

Q: Have any virtual currency funds been licensed in Malta to date, and are there adequate service providers to entertain requests for fund promoters who are interested in incorporating and licensing virtual currency funds based in Malta?

A: With the regulation for funds invirtual currencies having been published on 29 January 2018, traditional fund service providers have had the time to invest in gaining the competence and systems to cater for virtual currency PIFs. This, together with the drive from the government of Malta and the MFSA in DLT and VFAs in the second half of 2018 has resulted in numerous licences being issued to virtual currency PIFs, and has made Malta an attractive European location for fund promoters to establish and licence funds to invest in virtual currencies.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.