Bahrain: Crypto Markets: The Crypto-Asset Exchange Ecosystem In Bahrain

This article provides an overview of the Central Bank of Bahrain's regulations that govern crypto-asset exchanges' establishment as licensed platforms incorporated in Bahrain. This article further highlights Bahrain's progressive stance by considering its alignment with other international financial hub jurisdictions.

Introduction

In order to buy or sell cryptocurrency, e.g. Bitcoin, Ethereum, or another cryptocurrency, you'll need to create an account on a crypto trading platform to exchange your Bahraini Dinars or U.S. Dollars (or other currencies) for digital assets.

A crypto-asset exchange ("CAX") (e.g. Kraken, Coinegg, Gemini, Binance) is a platform on which you can buy and sell cryptocurrency. One can use a CAX to trade one Crypto-Asset (i.e., virtual, digital assets, or tokens operating on a blockchain platform and protected by cryptography) for another (e.g., Converting Bitcoin to Litecoin, or to buy crypto using regular currency, like Bahraini Dinar (BHD) or U.S. Dollar (USD)). CAX reflect the current market prices of the cryptocurrencies they offer. One can also convert cryptocurrencies back into any currency on an exchange, to leave as cash within ones own account (if one wants to trade back into cryptocurrency later) or withdraw to their regular bank account.

The Central Bank of Bahrain ("CBB") has successfully implemented the crypto-asset module in 2019 under Volume 6 of the CBB Rulebook, providing potential CAX platforms with all the necessary regulations to set up and run their operations in Bahrain.

The Crypto-Asset

In ascertaining the suitability of a Crypto-Asset, the CBB will consider, amongst other factors, the issuer's technological experience or reputation and the traceability and volatility of the Crypto-Asset.

The activities confirmed by the CBB that constitute regulated Crypto-Asset services include:

• The reception and transmission of an order to trade and execute accepted Crypto-Assets,
• The dealing on one's own account,
• Portfolio management,
• Safeguarding, storing, holding, and maintaining custody of clients for accepted Crypto-Assets,
• Offering investment advice.

Licensees can combine two or more regulated Crypto-Asset services, provided that such a combination does not give rise to a potential conflict of interest.

It is worth noting that the following activities fall outside the remit of regulated Crypto-Asset services:

• The creation or administration of Crypto-Assets,
• The development, dissemination or use of software to create or mine a Crypto-Asset,
• Loyalty programmes.

Depending on the type of regulated Crypto-Asset service they wish to undertake, an applicant may successfully obtain a license under one of the four categories put forth by the CBB. It is imperative to note that the legal status of categories one to three must be one of the following:

• Bahraini company with limited liability,
• Bahraini joint-stock company,
• Branch resident in Bahrain of a company incorporated under the laws of its territory of incorporation.

It is worth noting that the fourth category (as referred to in the table below) does not require the licensee to attain the status of a Bahraini stock company.

Relevant Fees

The applicant must pay a non-refundable fee of 100 BD to the CBB. Once the application is approved, licensees will be required to pay a variable annual license fee calculated on 0.25% of the operating expenses.

Licensing Requirements

A mandatory obligation imposed on licensees is to ensure that they have a designated place of business in Bahrain. Otherwise, overseas CAXs must maintain a local management premise in the Kingdom, subject to the CBB's prior approval. The application must further be annexed with a business plan and application forms for all shareholders, subsidiaries, and controlled functions. Additionally, the CBB has necessitated the appointment of an independent third party to undertake a readiness assessment on the licensee's risk management system, organisational structure, and operational manuals.

Given that Bahraini-based licensees must preserve a certain level of financial resources, overseas CAX licensees are required by the CBB to demonstrate that their platforms are adequately resourced for the number of risks undertaken. Besides appointing a licensed external auditor, licensees must indicate that their substantial shareholders pose no undue risk towards the platform.

In attempts to impede the misuse of system errors, licensees must further maintain adequate segregation amongst staff arrangements to ensure that control is not transferred or appointed to a sole individual.

Client Portfolio

Licensees must ensure that their clients are above 21 years of age, are not agents acting as a third party on behalf of another organisation, and maintain a designated bank account with a licensed retail bank. Licensees should be aware that charitable funds, sporting, social, religious, cooperative, and professional societies cannot be registered as clients. A licensee must further ensure that all information supplied by the client remains confidential and that they disclose to them all the relevant terms, conditions and transactions associated with its service.

Keyman Risk Management and Compliance

Keyman risk management procedures are another requirement imposed by the CBB to ensure that the necessary measures (such as insurance covers) are in place where information becomes unavailable due to unforeseen circumstances. This includes instances where encryption keys or passcodes to stored assets such as wallets become unattainable. Additionally, licensees ought to be incorporating permanent compliance functions which effectively adhere to the responsibilities and conditions put forth by the CBB Rulebook.

Security Measures

In attempts to impose effective measures that comply with network security practices, licensees are urged to implement firewalls and regularly change passwords and data encryption in transit and at rest. The CBB strongly advises licensees to implement competent cybersecurity programs to warrant the availability and functionality of the licensee's electronic systems and protect those systems from unauthorised access. In doing so, licensees must ensure that the board, management, employees and third parties report any cybersecurity risks, emerging trends, and potential breaches to initiate immediate recovery plans.

Other Relevant Requirements

It is worth noting that an applicant is entitled to appoint a legal representative, such as a law firm or a professional consultancy, to prepare and submit the application on their behalf.

Licensees must further ensure that, in dealing with accepted crypto assets, their proprietary affairs do not exceed 50% of the paid-up capital or net shareholders' equity (whichever is lower).

The CBB further urges licenses to use a well-designed Business Continuity and Disaster Recovery plan and maintain a professional indemnity coverage at a minimum amount of 100,000 BD from the CBB's licensed insurance firm.

Among other obligations, licensees ought to ensure that all regulated financial services are provided without discrimination and that their activities are undertaken in a fair, orderly, and transparent manner.

Once Approval is Issued

Licensees must begin their operations within six months after receiving the CBB's approval. Additionally, licensees are urged to notify and report to the CBB of any proceedings against them, any breaches committed, or whether their entity is susceptible to insolvency.

Crypto Wallets

The CBB has added two types of crypto wallets within their Rulebook. The first is the custodial wallet, where clients do not retain complete control over their crypto-assets, noting that they may lose their Crypto-Assets where the wallet provider is hacked or no longer operates. The second type is the non-custodial crypto wallet (hardware, mobile, desktop or paper wallets), where clients are given total control of their Crypto-Assets. Where alternative types of Crypto-Assets are being provided, licensees are advised to contact the CBB.

Crypto-Asset Custody Services

In relation to Crypto-Asset custody services, the CBB has introduced three acceptable types of custodial arrangements:

• In-house custodian: Where the licensee is wholly responsible for the custody of the client's accepted Crypto-Assets and provides 'in-house' services through its own Crypto-Assets wallet solution.
• Third-party custodian: Where the licensee retains full responsibility for the custody of the client's accepted Crypto-Assets but outsources this service to a third party Crypto-Asset custodian.
• Self-party custodian: Where the licensees authorise clients to 'self-custodise' their accepted Crypto-Assets. In this case, clients must source and use their own third-party Crypto-Asset custodians, which the licensees have no responsibility or control over.

The CBB has noted that a licensee is prohibited from trading, assigning, lending or dealing with accepted Crypto-Assets, save where the client has directed otherwise. Additionally, all potential clients must further be well informed of the use and function of custody wallets.

Growth of CAXs in Bahrain

The proliferation of CAXs in Bahrain can be evidenced by the CBB's initiative in approving well-recognized and Shari'a compliant cryptocurrency platforms.

Following a regulatory process lasting two years, Rain became the first Crypto-Asset Brokerage to be licensed by the CBB, providing investors with four leading cryptocurrencies (Bitcoin, Ethereum, Litecoin and XRP). The Category 3 platform has implemented bank-grade security procedures by undergoing strict financial auditing in attempt to impede incidents of hacking and other unsolicited infiltrations.

Additionally, CoinMENA was reported to have met all of the operational, technical and security requirements outlined by the CBB Rulebook in 2021, thereby attaining the license to operate its trading CAX services in Bahrain. Other services proffered by CoinMENA include portfolio management, Crypto-Asset custody and investment advice. The platform offers retail and institutional investors five major cryptocurrencies (Bitcoin, Ethereum, Ripple, Litecoin and Bitcoin Cash) and incorporates security measures which include firewalls, encryption, and penetration testing.

Comparative Analysis with International Regulations

The CBB's comprehensive regulatory framework concerning CAX is further elaborated when considering its alignment with other international jurisdictions. Compatible the CBB's provisions, United Kingdom (U.K.) regulations require CAX based in the U.K. to register with the Financial Conduct Authority (FCA) and adhere to several compliance rules, including AML/CFT obligations, Customer Due Diligence and Enhanced Due Diligence.

The CBB's alignment with European regulations is further demonstrated by referring to the European Union's Fifth and Sixth AML (Anti-Money Laundering) Directives, where cryptocurrency service providers must thoroughly train their employees to identify risks associated with illicit financial activities.

Analogous to the FCA report, the CBB broadly recognize three types of crypto tokens.

• Payment Tokens or Exchange Tokens: Known to be decentralized tools designed as a means of exchanging or acquiring goods and services.
• Utility Tokens: Intended to provide access to specific applications or services. However, they cannot be accepted as a means of payment for other applications.
• Asset or Security Tokens: Represents assets such as debt or equity claims and are analogous to the economic functions of equities, bonds, or derivatives.

However, the CBB recognizes an additional Hybrid Token that possesses features of one or more types of tokens.

Conclusion

Recently, cryptocurrency markets have been rocked after a popular token lost 99% of its value, dragging down a so-called "stablecoin" with it. The Terra Luna token fell from a high of U.S.$118 last month to U.S.$0.09. The collapse had a knock-on effect on a linked token, TerraUSD, which is usually stable.

Tether, the most popular stable coin, also fell off its U.S. dollar peg - to an all-time low of U.S.$0.95. As a result, many countries have called for stable coins to be regulated. Bahrain, a financial hub in the Middle East region, has witnessed the prominence of Crypto-Assets and their impact today. Therefore, in addition to issuing comprehensive regulatory guidelines for CAXs, Bahrain's provisions are proven to be on par with other international financial hubs' governing legislation, paying heed to emerging financial trends. The Crypto-Asset module also encouraged stakeholders within the region to trade and invest securely, making it likely for other CAXs to be established in Bahrain and incorporating the following essential elements that secure the growth of CAXs in Bahrain.

• Accessibility
• Security
• Fees
• Coins Offered
• Educational tools
• Storage
• Tax information

At Al Doseri Law, we can assist clients in navigating through the regulatory and transactional ecosystem of CAXs in Bahrain.

Originally published 18 May 2022

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.