For most of us 2017 was the year when we first heard the word "blockchain". That year also saw the value of bitcoin grow 1,300 percent and increasing interest in "digital assets" such as cryptocurrency and initial coin offerings (ICO) using blockchain technologies. The intervening period has seen a steep learning curve for regulators, banks and insurers as they seek to understand the new digital assets industry and the risks that come with it.
Many digital asset start-ups view offshore financial centres (OFCs) as natural domiciles for their nascent businesses: most of these ventures have no attachment to any particular jurisdiction, are inherently mobile, do not require large numbers of employees or extensive office space and typically engage with investors and counterparties from around the globe. Therefore, the tax neutrality offered by OFCs is an obvious attraction, leaving investors and digital asset holders subject to the taxation regimes in their home jurisdictions without exposure to additional taxes and further red tape in a second jurisdiction.
Start-ups are also attracted by the relative ease of access to OFCs' government representatives and regulators. Typically, there is only one relevant regulator in an OFC, unlike in onshore jurisdictions where multiple regulatory bodies give rise to multiple compliance environments. Offshore regulators and legislatures are not only accessible but they can be more receptive to the individual needs of start-up businesses, crafting bespoke legislation to facilitate innovative business models, and granting accelerated regulatory approvals when justified to ensure start-ups can get off the ground.
The battle for critical mass
By late 2017 several OFCs were scrambling to position themselves as the jurisdiction of first choice for emerging digital assets businesses. These OFCs perceived there to be great value in being the first to establish the necessary "critical mass": once a particular jurisdiction establishes itself as the leading domicile, with the most responsive and knowledgeable regulator and expert service providers on hand, it then becomes much harder for other OFCs to displace the lead jurisdiction's dominance. This is what Bermuda achieved as the dominant offshore centre for insurance and Cayman has secured as the leading jurisdiction for offshore investment funds.
The desire for early critical mass led to several OFCs embarking on marketing campaigns to attract new digital asset businesses to their shores, offering incentives such as work permit waivers and licenses to purchase local property. To accommodate these new businesses, legislatures pushed through new statutes and regulations, governments appointed ministers with special responsibility for the digital assets sector and "sandbox" initiatives were announced to encourage start-ups and innovation.
But these strategies were not without risk and the push to attain critical mass was a veritable egg and spoon race for most OFCs who had to balance the desire to be "first to market" with the need to proceed with due caution to minimise the risk of reputational harm if the attendant risks were not clearly identified and managed. With lack of transparency and traceability being hallmarks of digital assets, the start-ups carried with them obvious risks that they would be used to promote money laundering and other criminal activity.
In recognition of the risks presented by digital assets businesses (including to third parties), OFCs produced extensive legislation and codes of practice requiring detailed business plans and risk assessments for licensing applications, prospectus filing for offerings, written AML, conflict of interest and outsourcing policies, the presence of non-executive directors (in most cases), enhanced customer due diligence for specified categories, qualified compliance officers and AML compliance officers.
Then in 2018 bitcoin and other cryptocurrencies plummeted in value, widespread theft and fraud was reported and in one well-publicized case the CEO of a digital asset exchange died without sharing the all important exchange password. Media investigations into crypto-promoters revealed that all that glitters is not gold and regulators realised that, while politicians are happy to appear in pre-launch photo opportunities, it would be the regulator in the spotlight when financial scandals result.
Much to the irritation of government officials, bankers - converted to conservatism after years of financial scandals - refused to offer banking services to the crypto-industry. Insurers, whose capacity was needed for the various first and third party risks (from theft cover for the digital assets to D&O and E&O covers) shared the concerns of the regulators and bankers and had limited appetite for these unfamiliar risks.
By the end of 2018 the future of the digital assets sector was not looking bright and enthusiasm in the OFCs and insurance markets had waned.
Overcoming the obstacles
Despite the setbacks of 2018 and increased skepticism, cryptocurrencies as a means of exchange and asset holding and ICOs as a source of funding will not be consigned to history. Far from it: many see the problems of 2018 as mere teething troubles as regulators and commercial counterparties get to grips with the unique challenges presented by these emerging businesses and predict that confidence and growth will return. Indeed, the recent announcements that Google intends to launch a cryptocurrency in 2020 and that a number of major US retailers – including Crate & Barrel, Nordstrom and Whole Foods – will accept certain cryptocurrencies, will have boosted confidence in the future of digital assets.
The challenge of "getting to grips" with digital asset businesses is one that is shared by regulators, banks and insurance companies, all of which are trying to figure out how to identify the well-run, responsible and legitimate businesses from the cowboys and crooks. Although each will have a different perspective, when looking at digital asset start-ups all three look for comfort-inducing features such as:
- The identity and track records of the individuals behind the start-up
- The presence of independent directors on the board
- The identity of service providers and auditors
- The presence of qualified compliance and anti-money laundering personnel
- The profile of the investors.
When considering proposals for insurance, underwriters should have a high level of current data available to them including the detailed risk assessments and other information that accompanied licensing applications to the regulatory authorities in the OFC. Cautious insurers may wish to limit their risk appetite to those OFCs with the most stringent regulations on the basis that the less reputable and higher risk businesses may prefer to avoid those jurisdictions in favour of those OFCs with the lightest regulatory touch.
A bright future?
However, comparisons between the rapid growth of the insurance and funds industries in Bermuda and Cayman and the emerging offshore digit assets sector are inappropriate. Unlike digital asset businesses, the insurance and funds industries were already highly developed industries when they moved offshore. Insurance start-ups and offshore funds were, for the most part, run by experienced individuals, backed by sophisticated capital and assisted by experienced service providers. Whilst these industries may have been new to the OFC, offshore regulators were able to hire experienced personnel from overseas and could adopt tried and tested onshore regulations and practices.
This type of environment simply does not exist for fledgling crypto-currency and ICO risks and there is little if any actuarial data available to assist loss analysis or insurance pricing.
However, the stakeholders have a shared interest in seeing the digital asset sector succeed and, in time, a combination of robust risk management by the industry and sophisticated analytics and oversight by the regulators, bankers and insurers (combined, no doubt, with some learning from mistakes) should create an environment conducive to the steady growth of the industry. Whilst it seems likely that much of this growth will be offshore, it remains to be seen which OFC will be the first to establish the necessary critical mass and solid regulatory reputation.
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. Kennedys operates in Bermuda in association with Kennedys Chudleigh Ltd.