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The Build-up

All start-ups face the same determining issue: financing. The main routes to finance are debt and equity. The former includes borrowing capital from a bank or third parties, and the latter means giving away a part of your company in return for funding. At infancy stage, a company would seek financing from a smaller group of sources, namely accredited and early investors. Once the business is up and running, further financing is usually sought from the larger public. Traditionally, a business would run an Initial Public Offering (IPO) where it offers new or existing securities, being shares or debt instruments, to retail investors. After an IPO, the company would be publicly listed on a recognised stock exchange.

Back in 2013 we saw the emergence of an alternative mode of large-scale financing: Initial Coin Offerings (ICOs). This crowdfunding method sees the public offering of business-specific digital tokens developed on blockchain technology and which give the investor the right for future usage of a service within a specific network. As opposed to an IPO, no securities are offered. ICOs remain largely unregulated worldwide.

In the wake of the 2018 crypto winter, which brought the bull run of the crypto market to a halt, the industry realised it was time to look at more regulated applications of blockchain technology to finance businesses. This led to the concept of tokenisation of securities and the emergence of STOs. In a nutshell, STOs can generally be described as the blockchain version of IPOs and other securities offerings. And whilst the fact that it mirrors something traditional may make it seem less appealing than the ground-breaking ICOs, STOs still have the potential to revolutionise the capital markets.

As opposed to the utility tokens issued in ICOs, security tokens represent actual assets tokenised by the issuer. They can be asset-backed tokens, or a representation of shares, debentures, derivatives, and other types of financial instruments. Security tokens can be used to tokenise anything from real estate, art and stakes in a company.

The STO Climate in Malta

In an industry where the regulation lags behind economics, Malta has proved to be at the forefront of the blockchain regulatory space with the publishing of the Virtual Financial Assets Act, through which it regulated ICOs. Keeping stride, the MFSA has published a consultation document on Security Token Offerings, wherein it highlighted the main regulatory issues it foresees in an effort to garner feedback from the industry stakeholders. This puts the MFSA in a better position to effectively and innovatively adapt current securities regulations to STOs.

The main legal hurdles foreseen include the following:

Determining the nature of the token: The question whether a security token is actually a transferable security as defined in the MiFID II is particularly relevant for the application of the Prospectus Regulation which is limited to transferable securities. The MFSA published a Financial Instrument Test which analyses the rights emanating from the token to determine its nature.

Limitations in the Companies Act: For instance, an automated register of members stored on the blockchain is not yet catered for.

Risks to market integrity: This is mainly due to the anonymity made possible on the blockchain.

Regulation of trading venues and transaction reporting: The move from a centralised clearing and reporting system to a decentralised system presents various challenges to be addressed.

The ultimate vision is the migration of traditional capital markets to the blockchain where smart contracts facilitate automatic, transparent and fully reconciled updates of registries. This would make the capital markets more efficient, less costly and generally more accessible to investors and businesses alike.

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