Human existence is marked by several instances which had a prolonged and lasting impact and were predominately led by innovation. Within this context, the Maltese government is seeing innovation in the regulation of new innovative industries so that it would be at the forefront in technologies such as digital ledger technology.

Distributed Ledger Technology of which blockchain is a member, like the world wide web/internet, is a foundational technology and intrinsically can have foundational elements, regenerative elements as well as distinctively disruptive elements. This innovative technology might not only create novel niches of economy, morph or eradicate existing ones but it can also change the social fabric of our society, putting the citizen at the heart of a decentralised and disintermediated ecosystem.

Santander, which is one of the most prominent international banks, is one of the many institutions to embrace this technology and has launched a blockchain-based foreign exchange service that uses Ripple’s technology. The service, called Santander One Pay FX, uses technology developed by blockchain firm Ripple and is currently live in Spain, the UK, Brazil and Poland. Lately following the publication of the bills aimed at regulating the crypto sphere, and the laying out of the foundations for legislative framework around blockchain and the crypto environment, including licencing of crypto exchanges, Malta is fast becoming a hub for some of the world’s biggest cryptocurrency exchanges.

But what is an exchange in the first place and how does the new block-chain paradigm change the legacy notion of an exchange?

An exchange is a medium which facilitates the business of buying and selling, and thus the activity of transacting. The latter is one of the oldest activities of mankind. Transactions are essential to attain ownership, possession or other usage rights which in civil society assumes a multiple significance bearing on the usefulness, the quantity, the future use, and the legal control of the thing which is being transferred.

The origin of future trading is thought to trace back to ancient Babylon, with France in the middle ages also having water wheel rights being traded. Following which in 1695 the sporadic trading also took place in Amsterdam. The first recorded use, however according to most historians was in Japan in 1697, and it was legalised in 1730. In England, the first known transaction on a futures basis, a purely incidental trade, was in 1826. In the United States, the claim is that they began trading in futures in 1867.

By the end of the 1800s, there were five commodity exchanges in the world, and these were all connected by transatlantic cable: New York, New Orleans, Liverpool, Le Havre and Alexandria. It was in this time that these exchanges became global markets, so whatever was happening in Alexandria began influencing New York and New Orleans. The Malta Stock Exchange, originally known as the Casino della Borsa, became a reality upon enactment of the Malta Stock Exchange Act in 1990, and commenced its trading operations on January 8, 1992.

The origin of future trading is thought to trace back to ancient Babylon, with France in the middle ages also having water wheel rights being traded

In their current format, stock exchanges are centralised, and this ensures some level of security of trading information. We have witnessed change on these centralised institutions, from the financialisation of futures exchanges: they changed from member-holding institutions (the equivalent of a Credit Union) to exchange-listed companies (the equivalent of an investment bank) to technological innovation with electronic tracings, ETFs and index funds.

Aside from the stock exchange however, we also have a Fiat Foreign Exchange Market or Forex which is decentralised, where traders, central banks, and everyone in between meet to exchange the fiat currencies of the world. These forms of trade are also regulated under financial services regulation.

Like the printing press decentralised knowledge in the 1400s, the advent of blockchain dispersed the ability to create value through crypto tokens, which could be crypto currencies, asset class tokens etc. Once these are created they need to be traded, sold or exchanged. This activity can either happen over the counter (OTC) or through an exchange.  OTC is not an exchange because the buy and sell orders are not out in the public but rather a service where large buys and sells happen without moving the order books within an exchange.

The first crypto exchange came about with bitcoin. It can be construed as an IP layer over the existing blockchain layer – simplistically speaking, like a website which allows the trading and exchange of crypto assets, thus acting as a virtual exchange. These usually are centralised protocols providing a service of exchange and governed by a single centralised company. By aiming to regulate this sphere, the Maltese legislator paves the way for the future innovation of the 21st century.

The Virtual Financial Assets (VFA) Act aims to regulate these crypto exchanges established in Malta to protect investors from fraud, from market abuse, to combat money laundering and financing of terrorism activities and to ensure that the exchange operates on sound technology. This is going to be no easy feat as there are some intrinsic elements which need careful consideration here.

Let’s start with the premise that there are different forms of crypto exchanges with different appetites for risk, token access requirements, security parameters, how they hold persons’ funds and construe the custody element as well as operational transparency. The balance of these factors is of paramount importance for market stability and consumer protection. These, along with robust mechanisms against market manipulation, pump and dump, restrictions on margin trading, cornering, KYC and AML provisions will be the cornerstone of regulatory intervention in this space.

Crypto exchanges, given their innovation and diverse nature as well as inherent risks associated with their operation, could be somewhat risky and also difficult to trust. To better understand the risks, we need to imagine them as a centralised application like Facebook on the internet, an application, which aside from offering the facility to trade and exchange virtual assets, is also a centralised repository of these assets which belongs to users and consumers, and hence a palatable target for hackers.

Added to this, contrary to a hack in a financial institution, where the latter is responsible and as an intermediary can come to the rescue, and in certain instances also reverse unlawful transactions, in a crypto exchange in the realm of crypto assets there is no intermediary to come to the rescue and the irreversible nature of crypto asset transactions would also make it very difficult to stop.  We have seen several instances of this main point of failure in the past years, just to mention a few, Mt. Gox Hack, DAO Hack, Bitfinex one and NiceHash Hack.

Until blockchain and innovation allow for full cross-chain atomic swaps, and decentralised exchanges take over, we need to make sure that the use of the existing centralised crypto exchanges is safe and that it propels us to a new realm of innovation.

Ian Gauci is a partner at GTG Advocates and Afilexion Alliance, lectures Legal Futures and Technology at the University of Malta and is a legal advisor on the National Blockchain Strategy Taskforce.

This publication is provided for your convenience and does not constitute legal advice.

This publication is protected by copyright © 2018 GTG Advocates.

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