Despite – or perhaps even because of – the Covid-19 pandemic, the fintech sector in Cyprus exhibited strong progress in 2020. During the year, and throughout the beginning of 2021, the regtech and cryptocurrency clusters have also grown and the Cypriot government has played an important role in enabling the evolution. It aims to secure Cyprus’s place as a leading international financial centre and as a result, it has promoted a properly regulated fintech sector, as well as research and innovation.
Cyprus has established the Deputy Ministry of Research Innovation and Digital Policy to promote, guide and develop the digital transformation of Cyprus and to facilitate the start-up of innovative businesses. There is also a generous EU and state financial support package in place to fund specific projects in the next few years. However, funding gaps remain, and with a historic lack of a venture capital or business angel culture in Cyprus (or Europe), it is far from surprising, given the rapid advance of technology, that a number of ‘crowdfunding’ platforms have emerged to fill the void.
While in many respects this is a welcome development, it has raised legitimate concerns that some aspects of the operations of such platforms fall outside existing investment and banking regulations and may require specific regulation to ensure transparency and the protection of investors.
Cyprus legislative initiatives
CySEC crowdfunding directive
As a clear example of the effort to attract fintech companies whilst simultaneously promoting itself as a bona fide, well-regulated destination for investors, Cyprus chose to take action to regulate the crowdfunding sector in advance of any legislation on the part of the EU. In January 2020, following stakeholder consultations, the Cyprus Securities and Exchange Commission (CySEC) published the ’Directive DI87 - 10 on the provisions of crowdfunding services in respect of transferable securities’ (the crowdfunding directive).
CySEC’s crowdfunding directive relates solely to investment-based crowdfunding through transferable securities and excludes loan-based, reward-based and donation-based crowdfunding. The crowdfunding directive comprises a set of secondary rules for investment-based crowdfunding under the law. It is complementary to MiFID II’s obligations, including but not limited to: conduct of business rules; management of conflict of interests; holding clients’ money and financial instruments and product governance. Under the crowdfunding directive, if offering cross-border transferable securities via investment-based crowdfunding, crowdfunding service providers and their platforms are subject to prospectus thresholds governing the marketing, sale and distribution of securities across the EU.
The crowdfunding directive also imposes additional provisions aimed at ensuring investor protection on Cyprus investment firms (CIFs) acting as crowdfunding service providers. Briefly, the most significant of these include:
Measures to prevent conflicts of interest
CIFs are subject to neutral intermediation through licensing and activities restrictions. CIFs are not allowed to receive order routing benefits in respect of crowdfunding projects in general. CIFs are not allowed to acquire (equity or debt as the case may be) participation in crowdfunding projects on a platform or allow ’involved persons’ to act as project owners.
Measures to implement due diligence procedures
Additional customer and financial due diligence in respect of both the crowdfunding project (including credit risk) as well as the project owner, must be implemented before a project can be listed on a platform. Identity verification and anti-money laundering checks must be performed on both the end-investor and project owner.
Measures to ensure transparency
Project owners must produce a standardised pre-contractual document (under the responsibility of the project owner), including the natural persons effectively conducting the project owner’s business. This must be detailed in a key investment information sheet (KIIS). Certain procedures are in place to ensure that the content of KIIS is up to date and for rectifying errors or omissions. CIFs acting as crowdfunding service providers must ensure that the content of KIIS is clear, complete and accurate before accepting a project on their platform. Marketing communications must be clear, accurate and not misleading, and consistent with the content of marketing communications and the KIIS.
Measures to safeguard clients’ funds and financial instruments
All monies raised via the crowdfunding platform must be transferred by the CIF to the project owner only after the successful closing of the relevant offer. Financial instruments (i.e. transferable securities (TS)) are subject to safekeeping, and must be divided into custodial and non-custodial transferable securities. CIFs acting as crowdfunding service providers may only release the funds to the project owner where the TS have been physically delivered or where sufficient evidence is provided by the project owner to the CIF that the ownership of the TSs has been transferred to the respective investors, in line with their contributions.
Measures to promote investor exit opportunities
CIFs which are crowdfunding service providers may operate a bulletin board through which crowdfunding clients of the CIF may advertise their interest to buy or sell (as the case may be) transferable securities that had been made available through the CIF’s platform. Such bulletin boards are to operate as information exchanges only, they are not to be used as a trading venue.
CySEC’s crowdfunding directive was introduced whilst the European Commission’s proposal for an EU Bespoke Crowdfunding Framework (the framework) was still subject to an ongoing legislative process. It was viewed as a bridging step necessary for the protection of potential investors. Its contents took into consideration the content of the proposed framework, without prejudice to the overall investor protection offered by the MiFID II regime. The intention was to provide interim protection in a manner designed to facilitate a smooth legislative transition at the appropriate time.
EU legislative initiatives: Regulation 2020/1503
On October 5 2020, with a view to facilitating cross-border corporate financing, the European Parliament approved Regulation 2020/1503 ‘on European collective financing providers for business’(Regulation2020/1503). Regulation 2020/1503 incorporates the framework. It enters into force on November 10 2021.
The new EU framework is a key element in the EU’s strategy for a capital markets union. It aims to eliminate the fragmentation of the legal framework for crowdfunding and to promote cross-border corporate financing, while improving investors’ protection and the efficiency of the single capital market. In future, crowdfunding platforms operating in more than one member state will be able to organise their activities according to uniform rules - they will no longer have to comply with national rules separately in each EU member state.
In contrast to the crowdfunding directive, the scope of Regulation 2020/1503 captures both lending-based crowdfunding (facilitation of lending not the provision of loans) and investment-based crowdfunding, with a ceiling of €5 million (approximately $6.1 million). As with the CySEC crowdfunding directive, reward and donation-based crowdfunding is excluded.
Key provisions of Regulation 2020/1503
The regulation introduces the concept of authorised crowdfunding platforms and makes it clear that such platforms are only permitted to facilitate the conclusion of loan agreements between investors and project owners. At no time may the platform act as a creditor to the project owner.
Accordingly, as is currently a common occurrence in Europe, if the platform wishes to issue a loan to the project owner and, after issuing it, offers the claims related to such a loan to investors it cannot be authorised as a crowdfunding platform under Regulation 2020/1503. If offering such a service a platform might meet the characteristics of a credit institution or investment brokerage company, in which case it would require a separate authorisation before it could operate. The same would apply if, through the platform, third parties offered investors to purchase the loans they had originally granted by transferring them.
Crowdfunding as a payment service
The framework clarifies one of the key issues that has so far been regulated and interpreted differently across the member states. Namely, whether the acceptance of funds from investors and the creation of virtual accounts are subject to the regulation of payment services. Regulation 2020/1503 states that the authorisation to provide collective financing services is not comparable to the authorisation to provide payment services.
In the event that a platform provides payment services, such as offering to set up a virtual account, then the platform must be licensed as a payment institution or cooperate with a third-party platform provider who holds such a license already. If the platform provider decides to cooperate with a third-party payment institution, then the platform is likely to be registered as an agent of the payment institution.
Reducing risks for investors
Regulation 2020/1503 stipulates that crowdfunding platforms must carry out a due diligence check on project owners and provide investors with a key project information sheet. Unlike a prospectus, the information sheet does not necessarily have to be approved by the competent authority (i.e. CySEC in Cyprus).
Crowdfunding platforms planning to operate cross-border under the regulation will need to develop a business continuity plan to ensure that, in the event of the platform ceasing to operate, critical services related to existing investments are not interrupted and contracts between the platform and its customers are properly managed.
In addition, platforms will need to integrate the compliance measures to prevent conflicts of interest, ensuring that they do not participate in any project on their own platform, nor do they accept projects from related parties. At the same time, related parties are not prevented from investing through platforms, provided that it is ensured that they are subject to the same rules as any other investor. In this case, the platform must disclose information about the acceptance of investments from related parties. For their part, loan facilitation platforms will be required to publish project default rates for at least the previous 36 months on an annual basis, as well as quarterly expected and actual default rates for all loans.
As with other regulated market participants, crowdfunding platforms will need to provide prudential safeguards in the form of equity, insurance policies or a combination of both. The platforms must have a reserve of at least €25,000 of own funds or an amount which is equivalent to 25% of the platform's fixed expenses for the previous year. If the platform executes payment transactions related to transferable securities, it must use the services of a custodian bank.
Regulation 2020/1503 stipulates that the authorisation and supervision of platforms is entrusted to the competent authority of each member state (in Cyprus, this is CySEC). These competent authorities are required to maintain close cooperation with the European Securities and Markets Authority (ESMA). In turn, ESMA is tasked with setting up a dedicated register where the general populace will have access to a wide range of information on all authorised crowdfunding platforms in the EU.
Regulation 2020/1503 facilitates the provision of cross-border services. It requires an authorised platforms to provide its home competent authority with a list of member states, where it intends to provide crowdfunding services. Following this, the home competent authority will inform the competent authorities of those member states of the intention of the platform to passport its services into that member state and the information will be included in ESMA's register. Significantly, Regulation 2020/1503 prohibits member states, other than the member state where the platform is authorised, from requiring the physical presence (office) of platforms in their territory.
Sophisticated and non-sophisticated investors.
As with investment funds and alternative investment funds, Regulation 2020/1503 distinguishes between sophisticated and non-sophisticated investors. It introduces different levels of investor protection measures that are appropriate for each of these categories. In the case of non-sophisticated investors, Regulation 2020/1503 requires that the platform must perform an investor engagement test. This requires the investor to provide various types of information and to ensure that the investor simulates their ability to bear losses calculated as 10% of its net asset value.
In case the investor refuses to provide such information or, the platform considers that the investor's knowledge, skills and experience are insufficiently sophisticated to assess risk, then Regulation 2020/1503 requires the platform to inform the investor that its services may not be suitable, issue a risk warning and receive confirmation from the investor that he/she understands this risk. Such risk warning procedure, including explicit confirmation from the investor must be followed each time a non - sophisticated investor makes a new investment in excess of €1,000 or 5% of the net asset value of the investor calculated in the above simulation.
Crowdfunding in Cyprus: The way ahead
It is clear that the current crowdfunding regime in Cyprus, whilst narrower in scope than Regulation 2020/1503, overlaps closely with the majority of its provisions. This is a significant boost for the crowdfunding sector in Cyprus. It confers a high degree of legitimacy on the current regime and offers comfort to existing and potential crowdfunding investors.
Regulation 2020/1503 provides for transitional arrangements so that persons providing crowdfunding services in accordance with their national law, and which now fall within the scope of the Regulation can adapt their business activities over time to ensure compliance. Such persons may continue to provide crowdfunding services that are included within the scope of the regulation in accordance with the applicable national law until November 10 2022.
In the case of crowdfunding platforms already authorised in Cyprus the transitional requirements should be minimal and low cost. Additionally, despite the fact that fintech is a rapidly changing sector, both crowdfunding platforms and potential investors can take comfort in the fact that they are unlikely to be caught off-guard by sudden legislative change.
In Cyprus, the CySEC established ‘Innovation Hub’ is mandated with determining the future requirements for new legislative and supervisory priorities. It regards consultation with the relevant stakeholders as a crucial part of this process and recognises that both businesses and investors value stability and that can only be good news for Cyprus’s prospects as a crowdfunding hub.
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