THE RISE OF FINTECH
The financial services industry has seen drastic technology-led innovation over the past years. Undoubtedly, the accelerating pace of technological change has become the driving force in the financial services ecosystem. Fintech disruptors have been striving to get in the traditional ecosystem. These so-called disruptors are fast-moving companies, often start-ups, focused on particular innovative technologies.
As an industry traditionally comprising banks, insurers and asset managers, Malta's finance sector has recently seen new operators entering the market. New challenges in the post-crisis financial landscape, pressure on banks to cut costs and changing market dynamics driven by technology-savvy consumers have created a fertile environment for fintech.
Malta's small size makes it the ideal test environment for new technologies and ventures. Currently, financial institutions are being witnessed taking a secondary intermediary role rather than managing transactions from end to end they are just one node in a network. This evolution is driven by P2P transactions, enabled by a new breed of fintech companies. This is already witnessed with P2P lending platforms, often in partnership with traditional banks.
In spite of regulation and other potential barriers to entry, the industry has seen exceptional demand for fintech-related services in areas such as consumer banking and wealth management. For instance, the rise of "robo-investing platforms" offered by both online-only and traditional wealth management companies is being repeated across virtually every sector within financial services. Disruptors in retail banking are using this online-only model to grow market share by offering a highly customised user experience combined with lower fixed costs. The industry is seeing new high-tech companies with potential to drive down costs and offer better customer experience in the marketplace lending arena.
Future of money – the raise of digital currencies and payments
Digital currencies, cryptocurrencies, online payment systems, cashless society movements are rapidly changing the world of money by shifting it towards dematerialisation.
Cash, the most common means of payment, is becoming less popular in today's fast, technology driven lifestyles. Massive environmental impacts of its production and costs associated with its storage and transportation, the fact that it enables tax evasion and fuels criminal activity are the strongest and most common arguments against it nowadays.
The last decade has seen the rise of electronic money, which is slowly but surely replacing cash payments. However, also being witnessed is the rise of cryptocurrencies such as Bitcoin and Ethereum, which, due to their high volatility, unpredictable transaction costs and AML/CFT risks, have until now failed to gain widespread adoption. However, these deficiencies seem to be unravelled by newly emerging stablecoins, Libra being the most well-known one.
The Libra Project
Facebook's Libra project was formally announced in June 2019 with its main goal being "to enable a simple global payment system and financial infrastructure that empowers billions of people". The initial idea was for Libra coin to be pegged to a basket of traditional fiat currencies (50% USD, 18% EUR, 14% JPY, 11% GBP, 7% SGD) and its value would depend on the evolution of the whole basket. As a result of the accusations made by the governments and regulators, Libra's whitepaper was changed in April 2020 to reflect the new strategy of issuing several stablecoins, referred to as Libracoins, which would be pegged to single currencies such as LibraUSD, LibraEUR, LibraGBP and LibraSGD. This approach will "allow people and businesses in the regions whose local currencies have single-currency stablecoins on the Libra network to directly access a stablecoin in their currency".
Taking into consideration that Facebook has over 2.4 billion users, who would be given an alternative to the current banking system, it is only understandable that the governments and regulators fear the impact Libra could have on the monetary sovereignty.
In his speech given at the ECB Legal Conference in September 2019, Yves Mersch, member of the Executive Board of the European Central Bank, stated that because money is a public good, money and state sovereignty are inexorably linked. He further warns of the risk related to the digital currencies issued by the private companies:
"When it comes to money, centralisation is only a virtue in the right institutional environment, which is that of a sovereign entity and a central issuance authority. Conglomerates of corporate entities, on the other hand, are only accountable to their shareholders and members. They have privileged access to private data that they can abusively monetise. And they have complete control over the currency distribution network. They can hardly be seen as repositories of public trust or legitimate issuers of instruments with the attributes of money".
Central bank digital currencies
As a response to this new reality, the central banks started looking into creating their own digital currencies (CBDC). Bank of England, defined CBDC in its discussion paper "Central Bank Digital Currency – opportunities, challenges and design" as "an electronic form of central bank money that could be more widely used by households and businesses to make payments and store value". CBDC will be issued and regulated by the central banks and supported by the monetary reserves of the issuing central bank.
The Bank for International Settlement (BIS) defines three types of CBDCs:
- Retail CBDC, general purpose based on central bank accounts;
- Retail CBDC, general purpose based on digital tokens; and
- Wholesale CBDC, based on tokens or accounts and used for interbank payments or securities settlement.
Aside from countering the aforementioned challenges presented by Libra, the following are some of the other reason to launch CBDC: increase of the payment system efficiency and maintenance of competitive systems, cross-border payments, higher seigniorage, prevention and tracing of illegal transactions, money laundering and funding of terrorism, crime and tax evasion, financial inclusion, development of cashless society, countering competition from foreign CBDCs, etc.
BIS recently conducted a survey among 66 central banks which shows that more than 80% are working on developing their own CBDC, European Central Bank being one of them. The People's Bank of China (PBOC) is already conducting trials of its digital yuan in in Shenzhen, Suzhou, Chengdu and Xiongan. On 21 January 2020 the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Sveriges Riksbank and the Swiss National Bank, together with the Bank for International Settlements (BIS), announced that they have created a group to share experience as they assess the potential cases for central bank digital currency (CBDC) in their home jurisdictions.
There is no doubt that the digitalisation of money is on a fast track with private companies leading the way by issuing their own stablecoins. The Central banks are left with no choice but to follow the trend and work on issuing CBDC which will be supported by a strong framework providing for inter alia consumer protection and efficient payment systems.
Tokenisation of Assets
The evolution being experienced is not just about the money. Tokenisation of assets promises to completely revolutionise the concept of ownership. Anything from ideas to paintings to buildings can be represented in tokens and freely traded on blockchain systems. Asset tokenisation has become one of the most prominent use-cases of distributed ledger technologies (DLTs) in financial markets, for assets including securities (eg, stocks and bonds), commodities (eg, gold) and other non-financial assets (eg, real estate).
Tokenisation is the process of issusing a token that digitally represents a real tradeable asset. A security token can be used to create a digital representation – a security token – of an asset, meaning that a security token could represent a share in a company, ownership of a piece of real estate, or participation of an investment fund. These security tokens can be traded on the secondary market.
This method of converting rights to a real-world asset into digital tokens that can be moved, traded, recorded or stored on a blockchain system. Blockchains offer a way to revolutionise traditional paper markets, dramatically reducing costs and paperwork. There are key benefits that tokenisation offers to both investors and sellers: faster and cheaper transactions. Transactions are completed by means of smart contracts so certain parts of an exchange are automated. Fewer intermediaries are needed, leading to not only faster execution, but also lower transaction fees.
Another advantage is accessibility as tokenisation opens up investment in assets to a much wider audience. There is also more transparency. A security tokencan have the token-holder's rights and legal responsibilities embedded directly onto the token, along with the immutable record of ownership. These characteristics promise to add transparency to transactions, allowing users to know with whom they are dealing with, their rights and who has previously owned the token.
Applying DLTs and smart contracts
The application of DLTs and smart contracts in asset tokenisation has the potential to deliver a number of benefits including efficiency gains driven by automation and disintermediation; transparency; improved liquidity potential and tradability of assets with near-absent liquidity; faster and potentially more efficient clearing and settlement. It allows for fractional ownership of assets which, in turn, could lower barriers to investment and promote more inclusive access of retail investors to previously unaffordable or insufficiently divisive asset classes (eg, real estate) allowing global pools of capital to reach parts of the financial markets previously reserved to large investors.
At the same time, the adoption of asset tokenisation at a large scale would face a number of challenges related to technology (scalability; settlement finality; interoperability; network stability; cyber-risks); governance; risks related to AML/CFT; issues around digital identity; issues around data protection and privacy; as well as around the legal status of smart contracts.
Another point to consider is governance. If ownership of an asset (such as a building) is split among thousands of people, there is little incentive for owners to bear the costs associated with that asset such as maintenance.
Tokenisation of Securities
With regard to financial assets, tokenisation of securities (equity and/or debt) is seen by the market as the sector with the most imminent potential for growth as it would involve the mere replacement of one technology with another.
Security token are nothing more than a digital representation of real tradeable assets that are found on blockchain-based platforms. As a step forward in this direction, in July 2019, the Malta Financial Services Authority (MFSA) issued a consultation document to establish the legal framework for security token offerings (STOs).
According to consultation document, in order to determine whether a DLT asset is in fact a financial instrument or not, one would need to apply the Financial Instruments Test to determine whether it qualifies as electronic money, financial instrument, virtual financial asset or a virtual token. If it qualifies as a financial instrument, one will need to analyse whether it is equivalent to a transferable security as defined by MiFID II and whether they are negotiable on the capital market. The MFSA issued its feedback however no legislative framework has been developed and the MFSA is expected to issue a dedicated rulebook to STOs in the next months.
In essence, tokenised securities could be seen as a form of cryptography-enabled dematerialised securities that are based and recorded on a decentralised ledger powered by DLTs, instead of electronic book-entries in securities registries of central securities depositories. The use of DLT expediates trade clearing and settlement to nearly real-time, reducing counterparty risks and freeing up collateral, producing capital efficiencies for participants in the trade. The post-trade process is simplified, and the back-office administrative burden is lowered significantly. The use of a uniform and equivalent central securities depositary system for securities based and powered by DLTs will need to be addressed at a European level as the DLT will need to be structured to work around the EU Central Securities Depositary Regulation.
Other key benefits with security token offerings is that anti-money laundering and know-your-customer checks are quicker because they are automated and the fact that tokens can be traded globally, the investor as long as he or she has a wallet, will be able to trade wherever he or she wishes.
Clear guidance from regulators is fundamental since there is usually uncertainty as to how a security token should be considered within the law. It is crucial to provide a safe legal framework in which the technology can thrive. Having said this, as with any technology, some questions need addressing.
Malta DLT Framework
The Maltese Government and the Malta Financial Services Authority have together made a huge leap forward in their fintech journey. The first step in the right direction was the creation of a Distributed Ledger Technology (DLT) legal regime which consists of the: Malta Digital Innovation Authority (MDIA) Act (Chapter 591 of the Laws of Malta); Innovative Technology Arrangements and Services (ITAS) Act (Chapter 593 of the Laws of Malta); and the Virtual Financial Assets (VFA) Act. The three acts work together to regulate: DLT; investment services activities concerning VFA's; and issuers offering VFA's to the public or wishing to admit VFAs on a DLT exchange, in or from within Malta.
Under the DLT framework, specifically the VFA Act, the MFSA has been given the power to introduce a Financial Instrument Test. The objective of the FI Test is to determine whether a DLT asset, based on its specific features, is encompassed under: the existing EU legislation and the corresponding national legislation; the VFA Act; or is otherwise unregulated.
The FI Test sequentially assesses the features of the DLT Asset against a set of predetermined criteria to determine whether a DLT Asset qualifies as:
- a Virtual Token (as defined under the VFA Act to mean any 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 (excluding DLT exchanges) or in relation to which it was issued or within a limited network of DLT platforms); or
- a Financial Instrument (as defined under section C of annex I to MiFID II); or
- Electronic Money (as defined under the Electronic Money Directive 2009/110/EC); or
- a VFA (as defined under the VFA Act to mean 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 - (a) electronic money; (b) a financial instrument; or (c) a virtual token).
Malta fintech strategy
in January 2019, the MFSA embarked on a wider, cross-sectorial "fintech strategy' (Strategy) supported by six pillars, namely: regulations (to adopt regulatory and supervisory initiatives to support innovation and improve regulatory efficiency), ecosystem (to foster community, demand and collaboration and enhance access to finance), architecture (to encourage collaboration through the adoption of Open APIs and shared platforms), international links (to build international links across jurisdictions to foster collaboration and trust), knowledge (to cultivate deep talent pools and stimulate research and collaborative ideation. and security (to establish an environment that is resilient to cybersecurity threats).
The Strategy's ultimate goal is to establish a holistic and robust fintech sector, to enable fintech start-ups and scale-ups, technology firms and established financial services providers to develop viable fintech solutions which drive innovation and enhance access to financial products, increase competition whilst promoting market integrity, deliver better customer experiences, and ultimately, contribute to the long-term success of the Maltese financial services sector.
The key elements set-out in the Strategy concern the introduction of a "Fintech Regulatory Sandbox" (to promote innovation and experimentation) and "Fintech Innovation Hub" (to further stimulate collaboration and innovation). The Sandbox would provide a platform where firms may explore and test their business concepts and solutions with proportionate safeguards, in a contained environment for a well-defined duration. This space will allow the MFSA to monitor the innovative business with contained risk. It will also allow the MFSA to build capacity and experience in regulating and supervising this field.
Malta's fintech sandbox
Following the launch of the Strategy, the MFSA, in January 2020, took the position of issuing a Draft Rule ("Rule") which attempts to establish a Sandbox which would not require a standalone framework or any additional changes to the existing legislation.
The below listed criteria would all need to be satisfied for the applicant and its fintech solution (ie, a specific utilisation of fintech) ("Solution") to be eligible for participation in the Sandbox:
- Innovation - the Solution shall be a technology enabled innovation which offers something new to the financial services sector.
- Need - there must exist a genuine need to test the Solution within the Sandbox.
- Benefit – a benefit must be derived, directly or indirectly to the financial services sector and its consumer.
- Readiness – the Applicant (ie, the person submitting to the MFSA a proposal for a Solution to be tested within the Sandbox) must show it has enough resources to operate for the duration of the sandbox and that the Solution functions already.
The Sandbox lifecycle will consist of six stages, namely: proposal, selection, application, testing, evaluation and exit. It is important to note that only where the MFSA determines that the proposed Solution: would not require a licence or authorisation from the MFSA; or is an activity which the Applicant is already licensed or authorized by the MFSA to carry out, may such Applicant proceed to the "Testing Stage".
AML compliance considerations
Malta has transposed the fifth AMLD into the following legislative instruments:
- the Prevention of Money Laundering Act (Chapter 373 of the Laws of Malta) (PMLA); and
- the Prevention of Money Laundering and Funding of Terrorism Regulations (Subsidiary Legislation 373.01). (PMLFTR)
Any fintech business (including VFA Issuers and VFA Licencees) which carries out either a "relevant financial business" or "relevant activity" is defined as a Subject Person under the PMLA and the PMLFTR. Subject Persons are required to take steps, proportionate to the nature and size of its business, to identify and assess the risks of money laundering and funding of terrorism that arise out of its activities or business, taking into account risk factors including those relating to customers, countries or geographical areas, products, services, transactions and delivery channels and shall furthermore take into consideration any national or supranational risk assessments relating to risks of money laundering and the funding of terrorism.
Moreover, Subject Persons must implement any guidance measures issued by Malta's Financial Intelligence and Analysis Unit.
How does Malta's framework compare to the UK's fintech position?
The UK has by far the largest fintech business community in Europe. In the UK there currently exits no regulatory framework specifically for fintech enterprises or DLT for that matter. However, the UK have moved quicker than Malta in embracing fintech as in 2014 the Financial Conduct Authority (FCA) created "Project Innovate" which established:
- a "Regulatory Sandbox" to support fintech innovation and allow various firms to test their products and services in a controlled environment with real customers;
- an "Innovation Hub" to assist fintech firms understand the regulatory environment and apply for any required authorizations; and
- an "Advice Unit" which provides regulatory feedback to firms developing automated models that seek to deliver low cost advice to consumers.
It is important to note that simply because a firm is offering a fintech solution in the UK it would not necessarily mean that such solution would fall outside traditional financial services regulated activity. A firm which intends to utilise a fintech solution to carry out regulated activities would still be required to apply for a licence with the FCA or Prudential Regulatory Authority (PRA).
Unlike Malta, the UK is yet to create a DLT legal framework. Thus, one would need to assess, on a case-by-case basis, whether a DLT asset's characteristics and activity would fall under traditional financial services legislation.
The FCA, in July 2019, issued a Policy Statement (PS19/22) which serves as a guide in assessing the different characteristics of DLT assets and the rights attached to them. The Policy Statement sets out in categorising DLT assets under a number of classifications, namely: exchange tokens and utility tokens falling outside the regulatory environment; and security tokens and e-money tokens falling within the regulatory environment. Furthermore, the Policy Statement stipulates the various permissions which would be required to: issue security and e-money tokens; or offer services in relation to security and e-money tokens.
With Brexit now a reality, one would need to evaluate the pros and cons of such an exit on the UK fintech environment. UK laws, as a result of Brexit, would eventually divert from EU law. This could be problematic for licensed financial services businesses operating in multiple EU Members states as they might not be able to benefit from the passporting regime which enables firms that are authorised in an EU Member State to provide regulated services, to also provide those same services in any other EU Member State with minimal additional authorisation.
Malta is well positioned to attract UK based fintech firms that wish to target the EU market. It is a jurisdiction that has a robust and innovative framework in place, while offering a very attractive business environment and infrastructure that is crucial for such firms to grow. To do so, Malta will need to find the right balance between reducing bureaucracy and maintaining a high degree of regulatory oversight in order to offer a safe, stable and reputable option for the fintech business community.
Originally published by Chambers Global Practice Guides: Doing Business In...
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