Cayman Islands: Governing The Digital Asset Revolution

Last Updated: 2 September 2018
Article by John D’Agostino and Paras Malde

Crypto 101

Distributed ledger (DL) technology is the foundation on which crypto-currencies (or crypto-assets, depending on where one falls in the debate) lie. Bitcoin, the most well-known use case for DL, is an attempt to solve the problem of storing and transferring value in a digital, decentralised system.

Bitcoin is a means to compensate people/servers for the effort required to "mine" (confirm) blocks of transactions and add them to the global ledger/chain (block+chain). Bitcoins are gifted to these miners upon completion of their efforts (without which the system couldn't function) The increasing secondary value of Bitcoin can then be considered as increasing the confidence in the long-term viability of distributed ledger technology as well as the desire for a store of value that is (a) modern, (b) easily stored/transferable, (c) secure and (d) somewhat anonymous.

Put simply, if Sam wants to transfer two bitcoin to Jennifer, he sends a transaction request to the bitcoin blockchain – software running on thousands of computers worldwide. Miners check to make sure Sam has the bitcoin, and race against each other to solve a complex and energy intensive mathematical formula so they can be the ones to officially place the transaction in a block of other transactions. Once a majority of miners agree a block is verified, the miner who did the work gets paid in Bitcoin for their effort. At that point the blockchain has been irreversibly amended, and Jennifer now owns those Bitcoin.

The modern-day gold rush

There are over 1700 crypto currencies in the market today with a total market capitalisation of USD300 billion+ according to CoinMarketCap. With more popping up each day, crypto-currencies are the modern-day gold rush. The amount of attention that crypto currencies are generating on a daily basis has created a "fear of missing out" amongst investors and consumers alike. With this level of growth, crypto currencies have found a place as an asset class in investment portfolios (mostly retail more than institutional at this stage) as an alternative to the traditional alternative assets such as real estate and commodities.

This has further sparked the rise of crypto currency hedge funds. Autonomous NEXT, a FinTech analytics firm, has counted 75 crypto hedge funds that have raised about USD800 million to date and who aim to raise USD1.2 billion more in the near future. The crypto funds strategies range from investing in initial coin offerings, widely known as 'ICOs', which raise money by selling investors digital tokens in exchange for crypto currencies, to buying and holding traditional crypto currencies such as Bitcoin, Ethereum and Litecoin.

Volatility

Much has been made of Bitcoin's volatility. Certainly, compared to more established asset classes like equity long short, the daily price moves can seem volatile. The relative lack of breadth and depth in the Bitcoin market, regulatory uncertainty and the presence of significant players with the ability to shift market sentiment no doubt contribute to this sense of risk.

However, observing the daily historical volatility of Bitcoin shows that, in general, it's daily vol ranges between 4 and 7 – not particularly shocking when compared to many options markets. It is the vol of vol that is striking – with sudden gap ups to 10, 20 or 40 that quickly recede. Until recently, most of these shocks have been to the upside, and as actual or short positions have been impossible until recently, have not hurt anyone aside from a regretful seller. As margin and shorting comes into play, this vol of vol will have greater potential impact, but should, if the market develops gradually, recede in magnitude and frequency.

Regulations

Many countries like Bangladesh, Bolivia, Thailand, and Vietnam (among many others) have tried to ban crypto currencies like Bitcoin. Other countries like China and South Korea have entirely banned ICOs. But there are some countries like Australia, Russia, Japan, and Venezuela which have made Bitcoin an official legal tender and are regulating it.

The surge in crypto currencies has led to an abundance of scams, prompting global regulators to warn investors of fraudsters. The US SEC, UK FCA, Singapore MAS have all released statements warning investors of inherent risks involved with crypto currencies. As part of its effort to fight cybercrime and protect retail investors from cyber threats, the US SEC announced the creation of a new cyber task force. Among other things, the unit will target ICOs and other violations involving distributed ledger technology that run afoul of SEC regulations.

Cryptocurrencies seems to straddle the boundaries between commodity, security and currency. Earlier this year the US CFTC approved the first Bitcoin options exchange. Subsequent to this announcement, the SEC issued an investigative report which concluded that tokens offered and sold by a "virtual" organisation known as "The DAO" were securities and therefore subject to the federal securities laws.

Given the trading and clearing mechanism, there is also a notion in the regulatory industry that a crypto currency system may be deemed as an Automatic Clearing House ("ACH") and hence ACH rules would be applicable.

Regulators globally have been working on determining appropriate crypto currency regulations for several years however it has only been until recent surge in crypto currencies that they have dedicated large amount of resources to find appropriate resolutions.

Service providers & challenges

One thing that the digital asset markets currently lacks is a vibrant community of service providers willing to engage with it. While a few have taken on this business many are adopting a wait and see approach. DMS has begun a Digital Asset Working Group to attempt to formulate industry best practices around DL strategies, including crypto. The group includes representation from all parts of the ecosystem including:

Banking – the transition from fiat currencies to crypto currencies sounds exciting to many enthusiasts and hedge funds (somewhat alike) however the full transition and wide acceptability of crypto currencies will take time and will require an entirely new banking infrastructure. It is imperative that a banking partner is identified that fully understands banking rules and regulations and is committed to ensuring compliance with this fast-evolving asset class. Fortunately, the advances in FinTech industry have resulted in several banking projects that look to provide crypto currency friendly services. It has, however, yet to be determined if they will be widely accepted by global regulators.

Auditor – each of the key areas of audit focus as with a traditional alternative fund such as transaction testing, valuation, custody and existence of assets will have unique challenges for funds investing in cryptocurrencies. Funds that will trade in multiple crypto currencies on multiples exchanges will have to establish a strong valuation policy that will support the volatility, liquidity, treatment of forks and pricing of each currency. Tools such as Block Explorers may assist auditors to perform transaction testing however it may prove to be a cumbersome process. Funds that will not use a custodian for crypto assets will need to ensure the auditors get fully comfortable with the self-custody mechanisms and controls. The funds will rely heavily on the administrator during audit so it will be essential that the auditor and administrator have a good existing relationship or prove that they will able to work together seamlessly.

Administrator – administrators will be doing some of the heavy lifting of ensuring investor and accounting records are accurately tracked. When selecting an administrator, crypto funds should ensure that the technology and blockchain/crypto experience of the administrator matches the structure and investment strategy of the fund. Also, ensuring that the administrator has a comprehensive AML/KYC programme that satisfies regulatory requirement in applicable jurisdictions will be highly essential. Funds should strongly consider avoiding in-kind subscriptions/redemption (opting for fiat in/fiat out instead) to avoid complex AML issues at least in the current early days of the industry.

Legal counsel – Law firms have embraced the crypto trend and are rapidly getting up to speed. It is imperative that a fund select domestic and offshore legal counsels that are at the forefront of cryptocurrency regulatory developments, market trends, and technology developments. Ensuring sufficient investment and risk disclosures in a fund's foundational and offering documents are going to be a crucial safeguard against any future action against a fund. One should be cautious, however, as legal support in establishing a crypto is not an implicit endorsement that the strategy or that the structure will withstand future regulatory scrutiny. Everyone here, including lawyers, are in speculative mode at this point.

Tax advisor – identifying and engaging a knowledgeable tax advisor will be important to assist a fund in navigating the cryptocurrency space full of legal uncertainties. A fund should amongst other matters adopt a well-advised policy on calculation of capital gains, in-kind transactions and related party transactions. Funds that have an open and transparent approach towards tax will be less likely to draw in regulatory scrutiny.

Compliance – investment manager CCOs will have their hands full thinking through the myriad new compliance issues and regulatory requirements that will arise over the next 12-18 months. Investment managers should ensure that they engage appropriate compliance experience to avoid a serious regulatory nightmare. To keep an open dialogue for good actors, DMS is in active conversations with Cayman, US and EU regulators either directly or through representation on industry working groups

Governance – while there are many governance similarities between a traditional alternative asset fund and crypto fund, engaging independent directors with the knowledge of crypto assets are essential for crypto funds given the highly specialised nature of this investment strategy. DMS has been in the business of governance for over 17 years and can provide a comprehensive governance solution with the appropriate knowledge of the crypto industry and breadth of relevant crypto industry contacts.

Summary – thoughts on the way forward

With all the unknowns, one has two options: 1) wait for regulatory clarity OR: 2) make a good faith effort. We have outlined some options that address option two:

  • Selection of the most suitable jurisdiction to incorporate.
  • Carrying out in depth due diligence on the trading exchanges is pivotal as is ensuring all necessary document is in place.
  • Start with a simple approach of first ensuring acceptance of fiat currency for subscriptions and redemptions.
  • Avoid crypto in-kind capital transactions.
  • Clearly document all research and trading processes.
  • Identify the most suitable key service providers.
  • Clearly understand taxation responsibilities and ensure correct documentation of them. Provide sufficient oversight and governance.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Authors
John D’Agostino
 
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