The first in our new legal frontiers series explores the considerable opportunities available to companies that utilise offshore structures in the Cayman Islands. The articles feature best practice approaches to structuring such vehicles while maintaining full regulatory compliance.
As Cayman Islands fine-tunes its position at the apex of a new generation of transparent offshore investment destinations, we ask Cayman Finance chief executive officer Jude Scott for a progress report on strategies to protect and develop the jurisdiction’s finance industry
A: The Cayman Islands actually is a great premier global financial hub. It efficiently connects law abiding users and providers of investment capital and financing from around the world, benefiting developed and developing countries. Where it works really well is we are really an extender of value for countries, so that businesses or individuals can access investment financing opportunities globally through the Cayman Islands.
In addition to that, because the Cayman Islands is home to about 70% of global hedge funds, that also means there’s a huge amount of pooled investable capital in Cayman that’s available to be supporting the inward investing as well as supporting IPOs, for example, for Chinese businesses, and maybe listing in the Hong Kong stock exchange. When we look at the Belt and Road Initiative, Cayman has been uniquely positioned to support that. Whether it’s direct investing or accessing financing, it’s able to actually connect China with this large pool of investable capital from the global marketplace.
As we look at the types of transactions, the type of investment capital, and infrastructure transactions that are going to be taking place going forward, Cayman is well positioned to be supporting China as well as the other countries that China is working with, to be able to access that global capital in a way that is sensitive to the different requirements that are necessary for each of the countries.
In the Japanese market, we’re the primary jurisdiction for Japanese pension funds. Investing through Cayman entities, generally they’re going to be a unit trust as the preferred structure, but again, being able to access that global talent of investment, manager expertise and so on, to derive strong returns. Also, when we look at India, Cayman is really emerging as a top jurisdiction for supporting foreign direct investment into India and we’re seeing those trends replicated in other jurisdictions around Asia as well.
Q: How does Cayman balance compliance with the highest global transparency standards while also respecting investors’ privacy?
A: We understand our important role because we are so integral to the global financial system. We’re constantly working and enhancing our transparency measures. So whether it is the US Foreign Account Tax Compliance Act, whether it is common reporting standards as an early adopter, or BEPS country-by-country reporting, we take a very pragmatic approach to it. We look to understand what the international standards of direction are, and then we look to apply technology and pragmatism to create solutions that help our clients be able to comply with those, but in the most efficient way possible.
If you look at things like beneficial ownership, Caymans has had in place for, over 15 years, a world-class verified ownership regime. Our professional service providers are licensed and regulated, and they have responsibilities subject to criminal sanctions for collecting necessary information for anti-money laundering (AML) and protecting the jurisdiction from these offences.
Where there are appropriate investigations, we have proper co-operation channels in place, whether it be regulatory, tax investigations or anti-money laundering investigations. So we have three main platforms for that, and then agreements that allow countries around the world to be able to request the information they need to properly pursue investigations.
We believe that law-abiding users of the jurisdiction also have a right to appropriate privacy. So our verified ownership regime is not publicly available. We don’t believe that that’s appropriate, it’s not the global standard. And, in particular, when you look at the trends we’re seeing from a data protection perspective, human rights perspective, as well as a privacy perspective in various conventions that have historically been in place, we believe that there will be a balancing with regard to that. The approach that we’ve taken, which is to properly collect the information for it to be available for appropriate investigations, but for it to be also properly protected as private for legitimate parties and transactions, is really the model that will be sustained globally.
Q: We know that Cayman has a neutral tax system. What does “neutral” mean in this sense?
A: Cayman has never had income taxes and it operates based on fees and other types of direct taxes. So, for example, we have work permit fees, we have import duties. We are an island nation, so we import in excess of 95% of what we consume, so it makes it very, very efficient. And the collection of those types of fees and taxes probably raise in excess of 20% of our GDP.
What we’re really focused on is leveraging that platform and also ensuring that we don’t have a platform that supports tax evasion, because we have all the transparency measures in place. We also do not support aggressive tax avoidance. As you know, for countries to support aggressive tax avoidance they need to have in place legal mechanisms that shift tax base from one country to another. Things like double taxation agreements. Cayman doesn’t have any double taxation agreements.
We technically have one with the UK that’s called the double taxation agreement, but it’s really the form or the tier that they requested to be in that form, and it provides no benefits to Cayman. Cayman is very efficient in that we do not add an extra layer of tax to transactions. In a typical pooling of investments through Cayman the investee entities are going to report and pay their taxes as they would normally. And investors into the Cayman entities report and pay their taxes as they would normally. But Cayman does not add any additional taxes, so it allows us to be very neutral from that perspective.
Q: What are some key aspects of Cayman’s progress in terms of fintech research and regulatory updates?
A: It is an area where we are investing a lot of time. We believe this amazing technology is going to be tremendously disruptive, and it will be the mainstay of global financial services going forward. We also recognize that there are many challenges with being able to apply this technology, which was developed outside of financial services, to global financial services transactions.
In Cayman, and through Cayman Finance, we’ve been interacting with countries around the world, looking at how governments are dealing with it; taxing authorities, regulators, looking at the risks and looking at traditional models, for example, where, maybe 20 or 30 years ago, when there were complex derivatives coming into the marketplace, they would first come into offshore jurisdictions before they would go into regulated jurisdictions.
We are investing the time, using those models to understand things like, for example, cryptocurrencies. How do we understand how to deal with things like the risk of existence and valuation, and those aspects where we encountered similar types of risks when new derivative products were issued, so we leveraged that knowledge. And we’ve also focused on the technology side of it as well.
We believe that currently around the world, most countries are focused on what are referred to as “wave two” of seeking to adopt this amazing technology into their global financial system marketplace. From a Cayman perspective, we believe that the appropriate wave is “wave three”. Wave one would be where countries sought to take the technology with the good aspects and some of the inherent challenges, adopt it into their jurisdictions with existing laws and regulations, and as a result that created significant problems in many countries.
Wave two is where we are in most countries now, where they’re still seeking to bring the technology on board with the good attributes and the challenging attributes, but change their laws or regulations to be able to have the technology fit. We believe we need to move to what we refer to as a smart fintech regulation environment.
We actually take the best of the technology, the speed, the low cost, the peer-to-peer, the borderless aspects of the technology capability, and bring that across, but we leave behind things like anonymity and not being regulated, and anonymous nodes, and instead we’re working on an environment, wave three, which would be a closed or permissioned environment, which would be scalable so countries are able to bolt into it, via digital exchanges and the like.
And access into that environment would be through a certified digital ID, which is a big project that Cayman Finance working groups are working on to create an effective, efficient but regulated regtech platform that actually does certifications that result in certified digital IDs that can be used in this closed, permissioned environment, which then allows parties who are pre-certified for anti-money laundering to be able to transact.
Financial technology, or fintech, in the broadest sense of the word involves the use of software in the provision of banking and financial services. The transformative nature of the fintech sector is the manner in which fintech companies use financial technology to disrupt the way traditional financial companies do business.
The fintech sector has rapidly developed with innovation in multiple sub-categories, driving adoption in sectors such as insurance and regulation as well as the continued development of blockchain technology within distributed ledger technologies, digital currencies and other digital assets, and there has also been the emergence of entirely new models of funding. The utilization of initial coin offerings (ICOs), the tokenization of assets, and other token funding methods have created complex legal and regulatory challenges in many jurisdictions.
The offshore space has long been recognized for its efficient and flexible structures to facilitate overseas investment, and it can also play a key role in developing successful structures for fintech businesses.
The major challenge from a global perspective is to develop sensible regulation and clarification regarding the fintech sector. Key offshore jurisdictions have recently either enacted legislation to specifically address certain categories within the fintech sector, or have engaged in a “wait and see” approach before introducing key legislation.
In Bermuda, we have already seen the introduction of a prudential regulatory framework for digital assets with the Initial Coin Offering Act and the Digital Asset Business Act 2018 (DABA). The DABA became effective on 10 September 2018. The initial application fee for any “digital asset business” conducting its business in or from Bermuda is US$2,266, and additional fees are payable upon the granting of a licence.
DABA regulates the provision of any or all of the following activities to the general public:
- Issuing, selling or redeeming virtual coins, tokens or any other form of digital asset;
- Operating as a payment service provider business utilizing digital assets, which includes the provision of services for the transfer of funds;
- Operating an electronic exchange;
- Providing custodial wallet services; and
- Operating as a digital asset services vendor.
- Unless exempt, digital asset businesses must apply for one of two licences under DABA:
- Class F: The applicant is licensed to provide any or all of the digital asset business activities; and
- Class M: The applicant is licensed to provide any or all of the digital asset business activities for a defined period determined by the Bermuda Monetary Authority (BMA), which may be extended upon application to the BMA.
The Class F licence is a full digital asset business licence, and the Class M licence is a “sandbox” licence, affording start-ups to experiment with new products or services for a limited period of time.
Securing banking services has been a global and common challenge for Fintech businesses. From a banking perspective, Bermuda is tackling this issue by creating a new banking regime for fintech businesses. The new banking bill, the Banks and Deposit Companies Amendment Act 2018 (Restricted Banks Act), approved by the House of Assembly on 27 July 2018, amends Bermuda’s existing bank licensing framework and is intended to establish a restricted banking licence, encouraging banks to provide banking facilities locally to blockchain-related businesses.
The British Virgin Islands (BVI) recently introduced changes to its Anti-Money Laundering and Terrorist Financing Code of Practice, 2008, which permit entities in the BVI to use digital verification of identities and receive electronic copies of documents, instead of the “wet ink” paper-based processes. The amendments, which came into force on 1 August 2018, are further evidence of regulators in the BVI embracing the blockchain revolution, and will set a new standard for know-your-client verification in the region. The BVI has also seen the emergence of leading fintech companies being incorporated in the BVI.
These changes present an opportunity for BVI entities to adopt forward-thinking and technologically supported anti-money laundering policies, with the comfort of regulatory backing. A number of entities will turn to blockchain’s distributed ledger technology, for its immutable and instantaneous qualities, and the ability to encrypt data. These changes will also provide comfort to the increasing numbers of token issuers wishing to incorporate in the BVI.
While most utility token issues will not fall within the scope of the BVI financial services regulations, it is advisable that issuers align their due diligence process with the code as much as possible, in anticipation of changing legislation, and to generally protect issuers from falling foul of the Proceeds of Criminal Conduct Act, 1997.
With a large proportion of token issuers utilizing the services of third parties to electronically verify the identity of participants, the amendments to the code validate this approach and provide a useful gauge of the BVI legislator’s forward thinking in this area.
The Cayman government has not as yet introduced key legislation targeted at the fintech sector, but has recently recommended an adaptable, technology-neutral, regulatory sandbox-type framework to the relevant Cayman minister. The government is collaboratively engaged in the process of resolving the necessary legislative changes to implement such a regulatory sandbox.
The government is open to, and the ministry is actively exploring, how regulated digital identification systems could help revolutionise and streamline anti-money laundering compliance, locally and globally.
In June 2018, the Financial Services Legislative Committee’s fintech subcommittee was formed in the Cayman Islands. Through a series of consultations, this group, together with the Digital Assets Working Group, have been creating a framework that the Cayman Islands should adopt to promote and regulate new financial technologies such as crypto assets and fintech solutions.
Challenges still remain in terms of how certain aspects of the fintech sector will be regulated. This is a global challenge to be tackled, and not a challenge just within the offshore space.
Trends in Asia-Pacific
The Asia-Pacific region contains a mass base of fintech start-ups, service players, suppliers, consumers and investors. The region has already seen a rush for certain key jurisdictions to position themselves as the fintech hub in Asia-Pacific.
Certain trends have developed in the region in the past year. The utility token model appears to have been surpassed by security tokens (albeit, we are now seeing more in the way of sophisticated utility token projects). In a nutshell, security tokens are token-based fundraising, which are compliant with securities regulation.
Security tokens have a number of advantages over ICOs, given that investors have rights of recourse and so are better protected and can mitigate regulatory risks from an issuer’s perspective. However, there are numerous issues that the sector is still considering with regard to how security token offerings will actually work in practice.
In addition, only private placement security tokens are in existence, and there is the problem of lack of liquidity in the market, given that there are not many digital exchanges licensed to list and trade security tokens. From a cost-based perspective, security tokens tend to be more costly for the issuer, as they are undertaken via private placement and fall within the ambit of regulatory scrutiny, and so are more geared towards professional investors and established start-ups.
From an offshore perspective, the regulatory sandboxes in Bermuda (and in the future, Cayman) could prove to be a useful testing ground for digital asset businesses seeking to launch security tokens or exchanges. In Bermuda, it could also be useful for insurtech-related start-ups.
In respect of crypto-focused funds, Cayman’s longstanding reputation as a leading investment funds jurisdiction has led to an increase in crypto-focused fund-related activity, under which investment managers are seeking to raise funds for investments in crypto assets and/or into blockchain technologies.
We expect that 2019 will bring more regulatory clarity around digital assets, but a key challenge will be whether the approaches adopted by different jurisdictions will be consistent, or co-ordinated on a global level.
In the meantime, while waiting for regulators to catch up with the technology, the industry and legal advisers could work together to create a self-regulatory set of unified principles for security tokens that could apply to cross-border offerings.
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