The Cayman Islands is fast becoming the go-to jurisdiction for software developers and fund managers alike as they look to establish cryptocurrency funds and ride what is, if one looks at the price of Bitcoin, a hugely volatile wave.
Funds such as EKT Active Fund, an actively traded cryptocurrency and ICO fund established by Australian hedge fund veteran Damien Hatfield in partnership with Steve Bellotti, former Head of Global Markets for ANZ Bank, have been keeping law firms busy as the demand for crypto-asset strategies builds serious momentum.
“There are various crypto-currency and digital asset strategies being implemented by the Cayman Islands investment funds that are coming to market in this space,” comments Richard Spencer, Partner, Campbells, one of the Cayman Islands’ leading law firms. “Much of the money being attracted at present is coming from family offices and HNW individuals rather than institutional or pension fund money.”
Crypto-assets have gone more mainstream over the last 12 months and although they are not quite at the stage of being an institutional play for investors, there’s definitely been enough investor interest for fund managers to want to either set up funds to invest in a broad range of crypto-assets – which may or may not include Bitcoin and Ethereum – or to use them as bolt-ons to their existing strategies.
“The reason they have not yet been a fully institutional play is because of the inability to do anything other than to hold them long,” says Matthew Taber, Partner, Harneys. “If you’d invested in Bitcoin a year or two ago, having that long exposure would be very interesting (given that quoted prices rose from USD1,000 to a high of USD19,000 in December) but that isn’t really a viable strategy for a hedge fund manager.”
That said, the likes of CME and CBOE are now settling Bitcoin futures, meaning that over time cryptocurrencies will become a part of the financial tapestry just like any other commodity, making them a more interesting trade proposition for sophisticated investors. As Taber notes, Bitcoin futures will give institutions the chance to gain exposure to the asset class without physically holding it.
“If you are an existing fund and you don’t have it as your sole strategy, crypto-assets could provide additional returns for one’s portfolio. For several US investment management clients we have set up dedicated crypto-asset funds over the past 12 months, so demand is starting to build and more products are being created,” confirms Taber.
Those considering setting up a standalone fund vehicle would typically want to choose the exempted Cayman 4(4) fund.
This is an open-ended fund structure that has 15 or fewer investors and does not have to register with CIMA, under an exemption set out in section 4(4) of the Mutual Funds Law. The 4(4) exemption is popular for funds with only one investor, friends and family funds and start-up funds.
For larger crypto fund managers with 15 or more investors, a fully registered 4(3) Cayman fund product would be the main route to market.
“We are seeing people with significant expertise in crypto-currencies and distributed ledger technology set up Cayman Islands fund structures notwithstanding that they have not managed external capital before. We are also seeing existing hedge fund managers set up new Cayman Islands fund structures and new segregated portfolios of existing SPCs to develop crypto-focused strategies.
“It is not uncommon for crypto-focused funds to invest in illiquid tokens and DLT businesses as well as relatively liquid mainstream crypto-currencies. We see side pockets and other measures being used to accommodate the differing liquidity profiles of these digital assets,” explains Spencer.
Jarrod Farley, Partner, Carey Olsen, says that the firm has been “very cautious” in terms of the work it is willing to engage in, at this stage. This echoes the views of other service providers who are staying on the sidelines and waiting to see how this asset class develops before diving in. Last year, for example, an executive at Eisner Amper said that until there is regulatory oversight for these funds, “we have taken the position that we will not audit them”.
“We are quite comfortable with regular funds that are investing in crypto as an asset class; particularly hedge funds because if they are regulated they are already subject to AML regulations, have compliance procedures in place and are used to the idea of monitoring money laundering risks,” comments Farley.
He says that even if Bitcoin blows up, the blockchain technology underlying cryptocurrencies has value to the financial system. “It is likely to persist,” adds Farley.
For Cayman’s service provider community, whilst the opportunities to support their clients in crypto-assets are growing month-on-month, there is still an awful lot of work to do understanding how the mechanics of this asset class will work.
Nick Rogers heads the Cayman Digital, Blockchain and Fintech Group at Ogier, a leading off-shore law firm. He says that within the group, they have developed specialist understanding of the particular issues that arise including around custody, intra-day dealing, valuation and regulatory and compliance issues.
“At this stage in the evolution of cryptocurrencies, there are still quite a few barriers to entry – e.g. regulatory treatment, limitations on short selling, volatility, technical complexity – but even if the Initial Coin Offering (ICO) market cools it seems clear that blockchain applications and digital currencies offer the key to future financial innovation. Institutional investors will get themselves comfortable investing in these technologies and that will unlock a huge amount of investment that will fuel their growth,” says Rogers.
Ignacio Griego is Assurance Partner, BDO, one of the industry’s leading auditing groups. He points out that newly formed crypto-asset funds have never had to go through a financial statement audit before and as such many managers don’t necessarily know how to best prepare for an audit, in terms of best practices.
“From my vantage point, there are only a handful of auditors that really know what they are doing, in terms of supporting crypto-asset funds. Doing initial due diligence on service providers, so that managers have the confidence that their service providers know what they are doing in this space, is crucial.
“It is vital that people do their homework when selecting the right fund administrator, lawyer and CPA firm, and spend sufficient time to manage that process at the pre-launch stage,” comments Griego.
He says that one key area of discussion with the fund’s appointed auditor is the valuation policy.
“A lot of these tokens or coins do trade on exchanges but as we’ve seen in the last few weeks there have been some significant spikes in volatility. There are spreads across different exchanges so coming up with a solid valuation policy to determine how the manager arrives at a fair market price for each position is important. Fund managers shouldn’t be cherry picking one exchange over another, depending on the market scenario,” advises Griego.
Another key piece of this is custody of the assets. In a normal hedge fund, it’s pretty simple. The assets might be held with Goldman Sachs, for example, to whom the auditor then sends a confirmation that they are indeed holding the assets. With respect to crypto-assets, the problem is that there are not yet many custodians in the market.
“If you wanted to buy a crypto currency there are plenty of options but when it comes to putting the crypto currency with a custodian there are limited options,” says Griego. “You can buy it on an exchange but generally you would want to move the cryptocurrency (given past cyber attacks on exchanges) to secure cold storage locations.
“With a lack of custodians, people are often forced to self-custody themselves using their own hard disk onto which they move their tokens. We will continue to see developments in this area as more custodians enter the arena and more products become available for individuals to self custody.
“As an auditor, we need to know what the custody position is for the fund, and if they do have a custodian, do they generate any sort of report on their internal controls? If the manager self-custodies, who has access to the cold storage? How are they protecting the encryption keys? What back-ups do they have in place in the event that the manager misplaces the hard drive or it gets stolen?
“A lot of these are common sense questions but they tend to get overlooked.”
If a manager is taking in crypto-assets as in kind subscriptions, then it becomes very difficult for the MLRO at a fund administrator to check the source of that subscription.
Farley says that the sensible ones who are taking this business on “are demanding the investment manager do full AML due diligence checks on investors to verify their identity and source of funds. Then at least the administrator knows the manager has done everything it reasonably can to ensure everything with the investors is above board.”
“Investors increasingly wish to use their existing crypto-currency holdings to subscribe for shares in crypto-focused investment funds, with fund administrators factoring this into a risk-based approach under the recently overhauled AML regime,” adds Spencer.
ICOs – a threat to Cayman’s institutional reputation?
Something that went largely unnoticed earlier in 2017 was the addition of issuing electronic currencies to the list of relevant financial business in the Proceeds of Crime Law, which came into effect in May 2017.
What this means is that if someone launches an Initial Coin Offering (ICO) in Cayman, and are issuing an electronic currency in the form of tokens, they will automatically be caught by the AML Regulations and will be obligated to do proper KYC on the purchasers of said currency, as well as maintain proper records, etc.
“That has actually been quite good at stemming the tide of ICOs,” says Farley, who voices certain reservations. “When you think about it, many ICOs are essentially unregulated retail funds. There’s a big concern that if you let ICOs gallop away ahead of regulation, that could come back to haunt the jurisdiction if a serious blow up occurs.”
It is to Cayman’s advantage that CIMA hasn’t tried to push through ICO regulations like they have in certain other jurisdictions such as the Isle of Man.
“Cayman has always been a jurisdiction for institutional investors and we’d all like to keep it that way,” continues Farley. “It gives us a sense that we are properly insulated from the dangers of dealing in an area that affects retail investors. It has worked for us, as a jurisdiction, for a long time and that is what makes us nervous about ICOs, in particular. People are going to lose money. If that’s the man in the street rather than sophisticated investors it is going to raise the issue to the level of national governments and the spotlight will fall on the jurisdictions and service providers that facilitated it. Cayman has to be careful in that regard.”
Not everyone is necessarily cautious. As Taber confirms, both in the BVI and Cayman, Harneys has worked on a number of ICOs for clients.
“I sit on the Cayman Finance Regulatory and Legislative working group, and I am also involved in a US-based working group involving law firms, auditors and fund administrators. For us, it’s something we cannot ignore as a jurisdiction. We are in the process of considering changes to legislation which will allow more clarity as to what these tokens are, and how they are classified,” opines Taber.
As part of the wider digital technology paradigm emerging, Cayman is also set to be well positioned to benefit from blockchain growth, as well as crypto-asset growth.
By 2020, 80 per cent of financial services will be using some form of distributed ledger technology. One survey* by Bain & Co, estimates that total savings to global financial markets could reach anywhere from USD15 billion to USD35 billion.
Thanks to the absence of any direct taxation on companies or individuals, and its proximity to the US, Cayman lends itself favourably to technology entrepreneurs. Indeed, a local ecosystem is already starting to emerge, with Campbells’ Spencer confirming that an increasing number of cryptocurrency and blockchain businesses are setting up a physical footprint in the Cayman Islands.
Spencer, and many others, thinks that blockchain will likely become more and more disruptive in the asset servicing side of the private funds industry.
Given that Cayman is home to 70 per cent of the world’s offshore investment funds, the opportunity for fund administrators to apply blockchain technologies such as smart contracts could lead to considerable efficiencies. Not only that, but the immutability of distributed ledgers means that the ability to commit fraud is vastly reduced, if not completely, making transfer agency work and fund reporting a more transparent and secure process.
Its applications to AML/KYC are also manifold. Some think that the financial services industry will fall completely under blockchain, be it consortium, private or public, while others believe it will never take off.
“I think it’s probably somewhere in the middle,” says Taber. “As one of the larger offshore financial centres, Cayman simply cannot afford to ignore it. The funds industry here, as a whole, is keen for Cayman to take advantage of opportunities as they arise.
“This technology is fundamentally changing the way companies do business. If you don’t understand how the technology works, you’re not going to be offering clients any value. If you don’t know how a blockchain environment works, how payments are made, how crypto-assets are transferred and so on, your ability to provide real value as an offshore financial services lawyer will be reduced, to a greater or lesser extent.”
If Cayman is to establish a standalone crypto fund vehicle, in future, it will need to mirror the existing investment funds suite; in other words, it will have to be an institutional play and not something aimed at the retail market. It will also depend on legislation and regulation in other countries, were one to set up a token issuer in Cayman.
“Because we have a high number of quality service providers on the Island, it is in none of our interests to take on clients wishing to launch crypto products who may not be of the quality we are used to seeing for traditional fund structures.
“Yes, it’s new technology, but in terms of the way we operate, as service providers, nothing changes. We’ve still got the same AML responsibilities as a firm, and as an jurisdiction. That piece is front and centre of everyone’s mind but what we have to make sure is that we have the right product. Just because the product itself is crypto doesn’t create risk; it’s the type of businesses operating such funds that create risk,” concludes Taber.
*www.bain.com/publications/articles/blockchain-in-financial-markets-how-to-gain-an-edge.aspx
