Crypto Funds in the Cayman Islands

Cayman’s flexible business-orientated legislation enabled the Islands to pivot away from retail crowdfunded models towards security tokens and stablecoins, which provided greater value stability and more predictable investment returns. This same flexibility means that Cayman is already taking advantage of the latest shift towards securitising common assets and decentralised finance (DeFi) products.

Importantly, there are no restrictions on the types of assets in which a Cayman Islands fund may invest, including virtual assets. The usual considerations should be addressed including the need for regulation of the fund with the Cayman Islands Monetary Authority as a mutual fund (open ended) or private fund (closed ended) unless an exemption applies (see our overview for further details). A virtual asset fund should consider the need for compliance with the VASP Act which may require the fund to register or obtain a license if it provides virtual asset services which fall outside traditional fund activities, such as the issuance of virtual assets, custody of virtual assets or the transfer/exchange of virtual assets, for or on behalf of others.

What kind of asset is a virtual asset?

The VASP Act defines virtual assets as “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”. This wide definition captures all cryptocurrencies, security tokens, utility tokens or other digital assets that are tradeable or transferable, with the exception of digital fiat currencies.

Whether virtual assets are considered “property” may be relevant to a Cayman Islands fund in circumstances where the fund may want to grant security over its virtual assets or where the fund needs to pursue claims against its custodians for the recovery of its assets.  Where security is to be taken over virtual assets appropriate measures, such as taking custody of private keys, would be advisable to secure these charges effectively.

Where the equity interests of a Cayman fund are tokenised and the fund’s investors want to grant security over those tokens security should also be taken over the underlying equity interests by way of equitable share mortgages or charges.

Subscribing and redeeming in kind using virtual assets

This is permissible in Cayman but any subscription made to a Cayman fund is required to be subject to detailed customer due diligence (CDD) processes. The Cayman Islands has long been committed to implementing best international practices and is compliant with the anti-money laundering and anti-terrorist financing requirements of the OECD and FATF. As a member of the Caribbean FATF, the Cayman Islands implements recommendations promulgated by the FATF. All Cayman Islands-incorporated entities are subject to the Proceeds of Crime Act which sets out the principal money laundering offences. Certain “relevant” businesses (which would include registered mutual funds, registered private funds, VASPs, entities registered or licensed for investment management or advisory services and other entities thought to be at a higher risk of money laundering) are further subject to the Anti-Money Laundering Regulations which prescribe certain identification, record keeping and internal control procedures for such businesses.

Businesses in the Cayman Islands need to adopt a risk-based approach to the collection of CDD information. Under the risk-based approach, the latest guidelines from the FATF permit the digital verification of identities and receipt of electronic copies of documents instead of traditional “wet ink” paper-based processes. Given Cayman’s stringent CDD requirements, a number of service providers have adopted technologies to enable the onboarding of clients and the collection of CDD information digitally.

Trades on virtual asset exchanges generally require each participant to have completed KYC checks although certain exchanges are more stringent on these requirements than others and Cayman funds may want to limit the receipt of subscription funds from exchanges to only those with strong anti-money laundering policies.

Whether subscriptions in specie are transferred via virtual asset exchanges or from digital asset wallets additional information may be sought by a Cayman virtual asset fund to evidence the source of investor funds including tracing transactions back to fiat currencies and evidence of sources of investor wealth.

The redemption of an equity interest in a Cayman fund will require the same considerations relating to CDD as a subscription in kind. Full investor CDD should be obtained before redemption payments are made whether in cash or in kind by the transfer of virtual assets and payments should be made only to accounts or wallets in the investor’s name.

Tokenised funds

Tokenised funds have proved increasingly popular in recent years. In a tokenised fund, an investor’s interest is represented by a cryptographic token, as opposed to shares or other interests or units offered to investors in a more traditional fund structure. Cayman’s company legislation and the wide choice of corporate vehicles available allows for a great deal of commercial flexibility and lends itself well to tokenised equity issuances.

Cayman’s Companies Act and Exempted Limited Partnership Act each provide flexibility for Cayman funds to determine the manner for passing investor resolutions and the process for transferring their equity securities, both of which can be conducted electronically, with the instruments of transfer completed digitally. Under Cayman law, legal title to a share or exempted limited partnership interest is transferred when the name of the transferee is entered into the fund’s register of members or partners. For a Cayman-exempted company or exempted limited partnership that register may be held electronically, provided the company can produce legible evidence of its contents and, consequently, could be held encrypted on a private blockchain and accessed when required. Smart contracts built into the tokens can govern those transfers once any pre-set conditions have been satisfied and also ensure that the register of members or partners is updated simultaneously with any transfer. Regulatory concerns over AML, CDD and jurisdictional restrictions can be alleviated in the same way and a tokenised fund is likely to appoint a smart contract auditor and/or a third party CDD service provider to assist with the CDD process for subscribers.

Depending on the redemption rights relating to the equity interests, token holders may redeem their tokens for cash and/or payments in-kind (or a combination thereof) or transfer their tokens with the consent of the fund’s operators. The attraction for holders of these tokens is that they also have the potential to offer liquidity through an exchange.

Alternatively a Cayman tokenised fund may facilitate tokenisation through depository receipts rather than the equity securities themselves. In such cases, the Cayman fund would issue the equity securities to a licensed depository which in turn would issue tokenised depository receipts, representing those equity securities, to investors. The depository will hold the underlying equity securities on trust for token holders on the terms set out in the depository agreements.

The recently published Virtual Asset (Service Providers) (Amendment) Bill confirms that virtual assets as defined under the VASP Act does not include the equity interests of Cayman registered funds and anticipates that the Cayman Islands Monetary Authority will issue a statement of guidance or rule in relation to Cayman registered funds that issue tokenized equity interests.

Custody of virtual assets

Cryptocurrency exchanges remain among the most popular digital asset custodians in the industry offering sophisticated custody solutions across multiple digital asset classes. Many of these exchanges operate under comprehensive regulatory frameworks across global jurisdictions. In additional traditional financial players such as established banks are also beginning to offer virtual asset custody services bringing substantial resources and custody expertise.  Some institutions outsource to sub-custodians for virtual assets whilst others maintain direct control.

Security of digital assets held in custody on exchanges or through custody wallets are at risk from malware, hacking, scams and phishing attacks and robust cybersecurity should be an essential pre-requisite in the selection by a Cayman fund of custody service providers.

Valuation of virtual assets

Managers of Cayman funds may trade across multiple exchanges and counterparties in private transactions and also directly on chain through decentralised finance protocols. In these circumstances virtual assets trading and pricing information for the fund will need to be collated from multiple sources and analysed through traditional accounting principles that are capable of audit. Order management systems might be used to access and transact across multiple exchanges and protocols via established accounts at multiple trading venues providing managers trading access without the need to open their own individual accounts.

Due to the potential for extreme volatility in the value of virtual assets, Cayman funds should provide for their operators and/or managers to adopt methods of valuation other than pricing obtained through the above sources if they consider that it would better reflect the fair value of those assets.

Appleby

With technological innovation transforming businesses and markets and with a number of offshore jurisdictions vying to become technology hubs, Appleby led the way amongst the offshore firms by establishing a dedicated, multi-disciplinary Global Technology and Innovation Group in 2017 to support leading technology companies and start-ups across a broad range of emerging technologies.

Working closely with the Technology Group, our Cayman Investment Funds team has carved out a true niche in the digital assets space making Appleby the go-to firm for the establishment of funds investing in cryptographic assets, and the creation of tokenised funds and other bespoke pooled structures in this fast-moving space.