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How effective regulation unlocks the potential of the virtual assets economy

Chris Maiato

Principal, EY Bermuda Ltd.; and Regional Consulting Leader, EY Region of the Bahamas, Bermuda, British Virgin Islands and Cayman Islands

9 minute read 30 Aug 2022
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EY Region of the Bahamas, Bermuda, British Virgin Islands and Cayman Islands

EY regional teams can help virtual asset businesses determine what regulators in the Bahamas, Bermuda and the Cayman Islands need for registration and licensing.

In brief

  • The Bahamas, Bermuda and the Cayman Islands each have their own regulation architecture fostering a secure environment for virtual asset innovation.
  • Virtual asset investor confidence is high in the long-established international business jurisdictions that were among the first to adopt crypto regulation.

Virtual asset entrepreneurs seeking a supportive environment for innovation, where they can develop ideas into products and services quickly, are gravitating toward jurisdictions with legislative frameworks designed for their fast-growing industry. This article will evaluate the virtual asset regulatory environment in the Bahamas, Bermuda and Cayman Islands.

Investors seek regulatory certainty to protect their interests, while crypto startups are increasingly in search of defined parameters, within which they can innovate, and with more clarity for virtual asset businesses, efficient licensing and registration.

How EY can help

The Bahamas, Bermuda and the Cayman Islands are all early movers in crypto regulation, signaling their intent to embrace the new digital economy. Bermuda, with the passing of the Digital Asset Business (DAB) Act in 2018, created one of the first FinTech-specific regulatory regimes. The Cayman Islands, with its Virtual Asset (Service Providers) (VASP) Act, and the Bahamas, through its Digital Assets and Registered Exchanges (DARE) Act, passed their legislation in 2020. Accompanying the legislation in each jurisdiction is a consistent “voice campaign” from senior officials, articulating their current and future intent to embrace the new digital economy.

 

Each of these jurisdictions provides a long-established international business environment, offering sophisticated financial and legal services that support the effective functioning of these young digital business regimes.

 

The blockchain and distributed ledger technology at the root of virtual assets has the potential to disrupt the entire financial services landscape. In the Bahamas, Bermuda and the Cayman Islands, financial services innovators are already taking advantage of the progress made, and the environment can be characterized as one of rapid growth relative to the technology.

 

Background of virtual assets regulation

 

Consumers and businesses have increasingly evolved to capitalize on the promise of decentralized finance solutions, since the launch of the bitcoin network in 2009. In recent years, crypto assets have attracted growing allocations from institutional investors and venture capital sources, helping to drive up the market capitalization of cryptocurrencies to over $3 trillion at its peak.

 

Blockchain technology has the capability to transfer value around the world quickly and efficiently. Traditional banks, faced with the prospect of disruption of their business models, are having to adapt, and some are building out trading and custody solutions for crypto assets to meet growing customer demand.

 

Beyond cryptocurrencies, a developing trend is tokenization, the movement of real-world assets, such as real estate, commodities or licenses for content use, onto the blockchain. Tokens reflect full or partial ownership of an asset, with provenance enhanced by blockchain’s irrefutable transaction history.

 

With its enhanced security, built-in record-keeping and transferability, tokenization has significant advantages over traditional means of holding and transferring assets. Its capacity for creating units representing ownership of a small fraction of an asset could open the door to a broader investor base, for example allowing investors to own a $1,000 stake in a hotel or an apartment block. Tokenization, if combined with efficient exchange mechanisms, may significantly improve the liquidity of assets traditionally regarded as illiquid.

 

Tokens can be fungible or non-fungible. Fungible tokens can be divided or exchanged for an identical item. Non-fungible tokens (NFTs) represent something unique, whether it be an item of sports memorabilia, a piece of digital artwork such as a video, a ticket to a venue or event, or a plot of land in a game’s virtual world.

 

For asset managers in the Cayman Islands, one of the world’s leading hedge fund hubs, tokenization offers opportunities to increase investor participation and expand the universe of investable assets.

 

Another strengthening trend is the wide interest in Central Bank Digital Currencies (CBDCs), digitized forms of fiat currencies. Over 86% of the Central Banks, including the United States, the United Kingdom and China, are exploring or piloting CBDCs. That being said, the Bahamas was the first mover, having launched the world’s first CBDC, known as the Sand Dollar, in October 2020.

 

The Central Bank of the Bahamas achieved a pivotal milestone in March 2022, when it completed the initial integration of the Sand Dollar with the Bahamas Automated Clearing House system. In practical terms, this allows Sand Dollars to be transferred from digital wallets to any deposit account held at a Bahamian clearing bank, effectively bridging the gap between the digital currency and the real economy.

Risk and reward of virtual assets

Many governments see the growth of the crypto ecosystem as a potential tailwind for innovation and economic activity, while they also recognize the risks of a fast-growing sector that has developed largely outside the perimeters of financial regulation or even credible understanding.

Some of the greatest potential benefits of virtual assets — their ability to transfer value securely and rapidly around the world, anonymously and outside the traditional financial system – have attracted some bad actors, inclusive of money launderers or those hoping to evade comprehensive sanctions programs.

Moves toward regulation to address the misuse of cryptocurrencies for financial crime are happening around the world. With the support of the G20, the Financial Action Task Force, the dirty money watchdog, has issued global standards to guard against money laundering and terrorism financing in the cryptosphere, comprising the same safeguards required in the traditional financial sector.

The Basel Committee on Banking Supervision, made up of regulators from the world’s leading financial centers, has proposed global rules for digital assets with differing risk weightings. Tokenized traditional assets and stablecoins backed by fiat currencies would be treated the same way as loans and deposits. For cryptocurrencies not linked to any underlying asset, such as bitcoin, the Basel rules would require banks to hold capital at least equal in value to their crypto exposures to ensure they could absorb a write-off.

Regulators tasked with overseeing a sustainable crypto ecosystem will seek to build legal and supervisory frameworks that will enable them to detect and prevent financial crime, establish sound corporate governance standards and require beneficial ownership disclosures, and also to take appropriate enforcement actions, as they seek to protect both consumers and the stability of the financial system.

To build and maintain fit-for-purpose regulatory frameworks, authorities will need the tools, skills and technology to identify, understand and supervise all the service providers within the evolving crypto asset space.

DAB, VASP and DARE Acts

The Bahamas, Bermuda and the Cayman Islands have each built a legal and regulatory architecture that seeks to strike a balance between encouraging innovators, while demonstrating soundness, safety, and the protection of investors’ interests and the entire financial ecosystem.

The DAB Act in Bermuda, VASP Act in the Cayman Islands and DARE Act in the Bahamas essentially emphasize the need for service providers to, among other things:

  • Exercise due care, skill and diligence.
  • Establish and maintain effective security systems.
  • Establish and maintain effective corporate governance and robust resilience systems.
  • Have appropriate systems, policies, processes and procedures for the prevention, detection and disclosure of financial crime, and to ensure compliance with Anti-Money Laundering (AML) and Combating the Financing of Terrorism (CFT) laws.
  • Establish and maintain adequate and effective systems for the protection and segregation of customer assets and data.

Pay due regard to the interests of their customers and treat them fairly.

A virtual asset, as defined by the VASP Act, is “a digital representation of value that can be digitally traded or transferred and can be used for payment or investment purposes, but does not include a digital representation of fiat currencies.”

The VASP Act, which took effect October 31, 2020, empowers the Cayman Islands Monetary Authority to supervise all virtual asset service providers, including issuers, custodians, trading platforms and dealers. A full licensing regime was launched in July 2021. The law implements the Financial Action Task Force’s guidance on a risk-based approach for VASPs and its recommended AML/CFT standards.

The next phase of regulation will require VASPs to obtain and hold originator and beneficial ownership information on all transfers of virtual assets under Part XA of the Anti-Money Laundering (Amendment) Regulations of the Cayman Islands. Known as the “travel rule,” which took effect July 1, 2022. Its successful implementation is critical to investor confidence and security, and to demonstrate the Cayman Islands’ ability to effectively supervise virtual assets and those who provide certain services in relation to them.

The DARE Act, which came into force December 14, 2020, regulates Bahamas-based entities involved in the issuance, sale and trade of digital assets, defined as “any digital representation of value distributed through a distributed ledger technology platform where value is embedded or in which there is a contractual right of use, including a contractual token.”

Digital asset businesses within the scope of DARE include token issuers or exchanges, or digital assets payment service providers, as well as those who provide financial services to them. The Act requires the Securities Commission of the Bahamas to regulate and maintain a register of digital asset businesses and initial token offerings.

The scope of Bermuda’s DAB Act is similar. Having made clear its intentions to attract and grow a FinTech industry, Bermuda has built a regulatory framework using a risk-based approach.

The DAB regime, overseen by the Bermuda Monetary Authority, caters to digital asset businesses at differing stages of development, offering the F (Full) license; the M (Modified) license, for those planning to expand operations for a limited period; and the T (Test) license for those seeking to test their proof of concept.

Mindful of deterring bad actors and reducing reputational risk to the island, Bermuda incorporates prudential rules into its regime, with requirements including cybersecurity audits and customer due diligence.

Regulators in all three jurisdictions run efficient registration and licensing regimes. When delays occur, they are often a result of incomplete applications. Compliance is a new challenge for many in a hitherto unregulated sector.

EY regulatory advisors in the region and integrated around the globe can help crypto businesses assess what information regulators need.

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Summary

Decentralization and the creation of an alternative to the traditional financial system in the wake of the global financial crisis of 2008 were motivations of the founders of early crypto assets. However, today it seems clear that regulation to address the financial crime and custodial security weaknesses of the cryptosphere is key to increasing public trust and achieving the broader participation necessary to unleash the full potential of the digital economy. The regulatory frameworks in the Bahamas, Bermuda and the Cayman Islands are leading global examples in this space. This does not mean that these are the only jurisdictions providing such frameworks.  Holistic aspects of other jurisdictions can also be considered. While these are first and notable steps in fostering growth, even more interesting will be to bear witness to the increasing pace of change, and the responsibilities that introduces, as the financial services disruption not only continues, but gains pace.

About this article

Chris Maiato
Principal, EY Bermuda Ltd.; and Regional Consulting Leader, EY Region of the Bahamas, Bermuda, British Virgin Islands and Cayman Islands
Experienced innovator and transformational leader with a passion for business and technology.
Related topics
EY Region of the Bahamas, Bermuda, British Virgin Islands and Cayman Islands

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