ESMA and MFSA warn against investing in virtual currencies

ESMA Statements

The recent widespread use of Initial Coin Offerings (ICOs) and the increasing investors’ interest towards investments in Virtual Currencies (VC) and their underlying technologies has created innovative investment opportunities on one hand and high risks on the other. ICOs and VC risks are among the main objective of new statements and regulatory proposals adopted by the EU as well as Maltese Authorities (i.e. ESMA and MFSA). 

On November 13, 2017, following a similar investor alert of the U.S. Securities and Exchange Commission, the European Securities and Markets Authority (ESMA), issued two statements aimed at: 

(i) alerting investors on the risks arising from ICOs, and 
(ii) reminding EU firms involved in ICOs to comply with their regulatory obligations. 

ESMA defines ICOs as an “innovative way of raising money from the public” through the offer of tokens which are usually purchased in exchange of fiat currencies such as Euro or other virtual currencies such as Bitcoin or Ethereum. Additionally, ESMA specifies that tokens are usually created and distributed throughout the Digital Ledger Technology (DLT) also known as blockchain technology. 

In its first statement (issued for investors) ESMA outlines the following list of ICOs’ key risks: 

(i) ICOs, depending on their structure, might fall outside the EU regulatory framework and may be consequently used for fraudulent purposes, including money laundering; 

(ii) ICOs’ proceeds are commonly collected by start ups which are characterized by a high risk of failure, increasing, therefore, the risk of losing all the invested capital;

(iii) the impossibility to exchange tokens with other currencies or products and services can create a lack of exit options as well as a risk of inability to redeem; 

(iv) given the industry’s use of the so called “white papers”, which put emphasis on the benefits rather than the risks, information provided to the investors is limited; 

(v) the technology underpinning ICOs can be subject to hacking or malfunction. 

Moreover, in the second statement (issued for firms using ICOs) ESMA reminds EU firms to comply with the EU regulatory framework especially where tokens fall under the definition of financial instruments and/or transferable securities, since such transactions may be classified as “regulated activity”. 
ESMA calls for compliance with the following EU Directives: 

(i) Prospectus Directive, 
(ii) Markets in Financial Instruments Directive (MiFID), 
(iii) Alternative Investment Fund Managers Directive (AIFMD) and, 
(iv) Anti-Money Laundering Directive (AML). 

Finally, ESMA establishes that the list of applicable legislation is not exhaustive and shall be integrated with the national legislation.

MFSA Consultation

In line with the government strategy to embrace blockchain innovation and considering the risks associated with VCs, the Malta Financial Services Authority (MFSA) recently issued a consultation document on the proposed regulation of collective investment schemes investing in VCs. This consultation document contains a draft of the rule book that once approved would apply to collective investment schemes investing in virtual currencies and, more specifically, to Professional Investor Funds (PIFs). Such set of rules is aimed at ensuring investor protection and market integrity. 

Furthermore, the MFSA is considering whether Alternative Investment Funds (AIFs) and Notified Alternative Investment Funds (NAIFs) should also be allowed to invest in VCs. However, for the time being, the only legal structures admitted for PIFs wishing to invest in VCs are SICAV and INVCO, which usually have a board of directors responsible for the overall conduct of business of the collective investment scheme. 

The rule book outlines, in the context of VC, a series of additional rules that would apply to PIFs and, where applicable, to their service providers. The most innovative provisions are those related to the investment manager with respect to the quality assessment and the risk management tools to be applied considering VCs’ special nature. The main proposed requirements that would apply to PIFs and in certain instances to its providers are outlined as follows: 

(i) Competence – The PIF and where applicable its service providers must have sufficient knowledge in the sector of information technology, VCs and their underpinning technologies, including but not limited to DLT;

(ii) Clear Risk Warnings – The PIF must include in its offering documentation clear risk warnings of the proposed direct or indirect investments in VCs;

(iii) Quality Assessment – The PIF and where applicable its service providers must ensure that the appointed Investment Manager carries out appropriate research to assess the quality of the VCs being invested into;

(iv) Risk Management – The PIF and where applicable its service providers must ensure that the Investment Manager assess before an investment on behalf of the scheme whether the risk profile of VCs falls within the scheme’s risk management policy;

(v) Valuation - The PIF must ensure that the appointed service providers have the business organisation, systems, experience and expertise necessary to conduct the required verification and valuation of the scheme’s investment in VCs. 

It is noteworthy to mention that the requirements proposed by the MFSA are not yet binding and are subject to the prior consultation with industry operators. Moreover, it remains to be seen whether the authorities will be able to ensure the right balance between investor protection and investor rights, when classified as professionals, to invest in high risk assets.

Warnings against investing in virtual currencies

Giacomo Di Marzo
GANADO Advocates