The Cayman Islands is facing somewhat of a dilemma. Although its regulatory regime is not tailored to cryptocurrencies, token offerings or distributed ledger technology, Cayman became home to the world’s largest initial coin offering this year.
In an initial coin offering, or ICO, start-ups sell cryptocurrency to early investors in a project. The process provides companies with an alternative, less onerous capital raising method than the more rigorous and costly public or private offering of shares.
To fund its blockchain platform EOSIO, Cayman start-up Block.one raised $4 billion in June after a six-month coin offering. The sum exceeded the biggest initial public stock offerings on global stock markets.
At the time of the fundraising, the EOS platform had neither gone live, nor did investors know what all the funds raised were going to be used for.
It shows why ICOs are widely considered high-risk investments. Issuers often lack an established track record; they may not have a viable product or service, or they may not have the necessary infrastructure to defend against certain risks like cyberattacks. In some recent cases, the coin offerings were quite simply frauds.
Yet, coin offerings or token sales have raised more than $10.3 billion in the first six months of 2018, exceeding the total of $4 billion raised in all of 2017.
While some jurisdictions, like Bermuda, have started to roll out new legislation and regulations quickly to attract this type of new business and the technology companies using it, Cayman is biding its time.
In May, Minister of Financial Services Tara Rivers announced that some form of new regulation will be issued soon.
One reason for the hesitant approach is that it is far from clear what the industry requires to thrive and how to regulate it effectively. Blockchain and bitcoin were designed for users who want to be completely anonymous, while their transactions are transparent. This is at odds with most corporate transactions, where the parties need to know who they are trading with but typically want to keep their dealings private.
The potential anonymity of the users poses a problem, because regulators tend to rely on a centralized point of control in financial transactions – exactly the opposite of the decentralized blockchain environment.
However, digital assets promise to become the future of financial transactions and, if done properly, represent an innovative way to access the capital markets.
At the Cayman Islands Digital Economy Conference in June, Jason Blick, CEO of EQI, said the blockchain space is without question a revolution.
“Unfortunately, there are aspects of the industry usually around ICOs and cryptocurrencies that are attracting perhaps more adverse attention than the technology itself. Some of the noise around that is due to lack of awareness and there is a huge disconnect between financial services providers and regulators and the true nature of a decentralized, trustless ecosystem,” Blick said.
He believes the goal needs to be to design appropriate regulation.
“So perhaps we need to avoid some of the regulatory arbitrage issues we are seeing, especially in the ICO space, where under-regulation or no regulation is not the answer but appropriate regulation,” he said.
Currently, initial coin offerings and other crypto ventures in Cayman must comply with existing legislation, especially anti-money laundering laws and regulations and, depending on the circumstances, they are subject to the Securities Investment Business Law, the Mutual Funds Law and other laws.
None of these were designed with the new blockchain businesses and transactions in mind. And the size and number of Cayman-issued ICOs carries a significant reputational risk for the jurisdiction.
Alexandra Simonova, senior manager of Risk Advisory at Deloitte, said many companies and ICOs have come to Cayman because of the good infrastructure, both technically and in terms of the legal framework and the access to highly qualified accountants and lawyers.
But Cayman needs to be able to screen the companies it is attracting, she said.
“From a jurisdictional perspective it is important to attract the right businesses that have the capability of managing the risks.”
These risks include the inadvertent facilitation of money laundering. The token assets used in an ICO are very similar to a bearer share, an anonymous security that is owned by whoever holds it. Actual bearer shares have been phased out in most jurisdictions to avoid money laundering abuses.
To prevent money laundering in ICOs, the token sales need to be in some way integrated with a vetting mechanism for investors. Compliance companies are used by many but not all ICOs and at times the process will not meet regulatory requirements, said Peter McKiernan, co-founder of RiskPass AML+Compliance Ltd.
McKiernan said he had tested some of the systems by using fake ID and was able to circumvent the controls to buy shares in Cayman ICOs. A similar test using a fake ID in the name of someone listed on Interpol’s Most Wanted list was unsuccessful, he said.
“That one failed, probably because of a name check but whether or not the jurisdiction has been informed of known criminals trying to get in a Cayman ICO, I am not sure.”
Despite certain shortcomings, McKiernan believes the blockchain industry is maturing as experienced financial services professionals develop the compliance and rule engines on top of the transactional capabilities of the new technology.
As Cayman is taking a measured approach to new blockchain and cryptocurrency legislation, Bermuda introduced the Companies and Limited Liability Company (Initial Coin Offering) Amendment Act 2018 and the Digital Asset Business Act 2018.
The ICO Act provides the framework for ICOs in Bermuda and the Digital Asset Business Act governs the licensing of companies operating in the crypto and blockchain space.
McKiernan said Bermuda can be more aggressive, “because they don’t have as much to lose anymore.”
“Bermuda if you look at the economy, they are really losing the financial industry battle and now they are seeing this as their holy grail.”
This may be well be successful, but it is also risky, he said.
Cayman, on the other hand, has a reputational risk, with its vibrant hedge fund and private equity industry, McKiernan noted.
He said Cayman was developing rules in a more structured manner through industry and government working groups, which will eventually translate into new regulations.
Cayman’s advantage is that it has already attracted a critical mass of blockchain start-ups to create a small industry.
“This is going to help us to properly inform the framework, rather than making a framework that you think might be useful but not necessarily able to work,” said Paul Byles, director at FTS Consulting. “Almost 100 companies in the space will be able to inform what we do next.”
The speakers at the Digital Economy Conference pointed to plenty of opportunities for Cayman.
A first step would be to address the existing ICO market that is already in Cayman by adopting ICO legislation building on the jurisdiction’s reputation as a global innovator, Blick said.
In addition, he sees prospects for Cayman businesses in the compliance space around blockchain technology.
“The truth is today the existing systems that we use offshore are broken. We are using systems that were created almost pre-internet,” he said.
The ability to use blockchain to hash information and share it across appropriate fiduciaries presents a real solution for KYC and AML processes, he said.
Giles Watkins, founder of S4i and member of the ISO Standards Board for Blockchain, agrees.
“That is going to generate a lot of business. It’s going to need people who are experts on cybersecurity and experts at KYC and all the skills that are here,” Watkins said. “You have everything in place to enable a market and get a business like that to take off.”