The scope of regulatory requirements in the Cayman Islands has increased significantly in recent years and requires Cayman-domiciled entities to meet ongoing regulatory filing requirements, in addition to other obligations as set out by the regulatory...
The below is an update on the cryptocurrency and blockchain industry.
Cryptocurrency and Blockchain Technology in the Funds Industry – A brave new world?
Blockchain technology offers an exciting and unprecedented innovative opportunity for the investment funds industry and there are now at least 50 hedge funds dedicated to Cryptocurrency.
We, as Cayman Islands specialist funds attorneys, have advised several investment funds and administrators on the utilization of Blockchain technology and the implementation of smart contracting into their business model. We have also been instructed in connection with the establishment of ‘crypto funds’ and the holding of Cryptocurrencies.
With so much attention and significance being placed on Cryptocurrencies, we have set out below a short summary of what Cryptocurrencies and Blockchain technology are, how they can interact with the funds industry and how we can use our experience to assist with such matters.
What is a cryptocurrency?
The definition of a Cryptocurrency is ‘a digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank’.
Bitcoin was the first and is perhaps the most well-known of the Cryptocurrencies and now has a Market Cap of approximately US$65 Billion, there are however, many other Cryptocurrencies, such as Ether which operates using a different underlying software platform known as Ethereum. By way of an example, Ether has reportedly increased in value by some 3,300% between 2016 and the end of August 2017 and, due to its seemingly superior underlying technology (referred to below); it appears to be a real focal point for the crypto funds.
What is Blockchain?
In its most basic form, Blockchain technology is a decentralized digital ledger in which transactions made in Bitcoin or another Cryptocurrency are recorded chronologically and publicly.
The Blockchain operates in a similar way to a spreadsheet and is a shared and continually reconciled database. When a transaction occurs and is verified by the network, the ledger records one fixed and highly secure copy of the transaction that all users are able to see at the same time.
The funds industry is now looking at Blockchain technology as a way to provide a fast, streamlined method of communicating with investors or recording and transferring shares or other securities.
Blockchain technology could offer a higher level of transparency because the distributed ledger reflects the real-time ownership and movement of a company’s shares or other securities. The Blockchain system could therefore be used to quickly distribute a share dividend or implement a share split and to correct the Register of Members of a fund contemporaneously with the underlying transactions.
Ethereum is a platform based on Blockchain technology and features the Ethereum Virtual Machine (“EVM”), which can execute scripts using an international network of public nodes. EVM provides the environment in which so-called “smart contracts” can operate.
What is a “smart contract” and how does it work?
Aside from the obvious potential for value creation, perhaps the most interesting application of Blockchain technology for the legal market is the ability to generate "smart contracts". A “smart contract” is defined as a “computer protocol intended to facilitate, verify or enforce the negotiation or performance of a contract”. In the context of Cryptocurrencies and Blockchain, smart contracts are self-executing software programs running on Blockchain databases that enable transactions to be executed based on specific rules or triggers.
EVM and Ethereum is the leading platform for smart contracting and describes such smart contracts as applications that run exactly as programmed without any possibility of downtime, censorship, fraud or third party interference. It is easy to see how these contracts offer a convenient solution where fast transaction speeds are critical.
Smart contracts are already in daily use by the general population although few of us realise it. The purchase of music on Apple’s iTunes platform involves a smart contract so that the “purchaser” can only listen to the music file on a limited number of Apple devices.
Once encoded onto the Blockchain, a smart contract can then be definitive in the sense that, if one party performs their end of the bargain, the other contracting party's performance is automatic and guaranteed. The lack of human interaction required in executing the terms of the smart contract therefore limits the ability for error or disputes to arise. However, this automation also means that ensuring the contractual terms are accurate and correct in the first instance is of vital importance.
How are Cryptocurrencies and Blockchain technology being used in the funds industry?
As mentioned above, we are seeing funds being established in the Cayman Islands which will focus entirely on Blockchain and Cryptocurrency strategies.
In addition, we are seeing funds seek to innovate by accepting Cryptocurrencies as a payment mechanism for subscription proceeds. We have advised on the difficulties associated with this (particularly, in the context of compliance with all applicable anti-money laundering legislation) and have worked closely with our fund client, and their administrators, to ensure that the legitimate use of Cryptocurrencies is not discouraged but, more importantly, the credibility and integrity of the fund and its service providers is preserved.
We expect smart contracts to become more mainstream in connection with subscriptions into and redemption out of funds. Such technology would enable investors to set parameters for those transactions without needing to take specific additional action each time they requested such a transaction to take place.
It is, of course, an ever-changing and fast-paced market and we expect funds to continue to adopt smart contracts and Cryptocurrencies (particular where the funds are focused on the technology sector) in order for the funds to remain competitive and attractive to potential investors. Our primary role, as fund counsel, is to work with the fund and its service providers to ensure that such measures function properly from a legal perspective and that any additional risks in accepting Cryptocurrencies are appropriately managed.
Is Hacking a Real Concern?
If someone wanted to hack into a particular block in a Blockchain, a hacker would not only need to hack into that specific block, but all of the proceeding blocks going back the entire history of that Blockchain. In addition, the hacker would need to make the same change on every ledger in the network (numbering in the millions) simultaneously. Blockchain technology is therefore far less susceptible to hacking attacks than existing and centralised databases such as those used by intermediaries such as banks.
What is Cayman’s involvement in Cryptocurrencies?
Cayman's existing legal framework provides the flexibility to allow technologies like Blockchain to flourish. In particular, the Electronic Transactions Act (2003 Revision) (the "Law"), provides that information, documents and contracts (or any provision thereof) shall not be denied legal effector validity solely because it is in electronic form. Similarly, evidence of a contract (or provision thereof) shall not be denied admissibility solely because it is in electronic form and electronic signatures are also expressly permitted.
The effect of the Law is that it provides a lot of latitude for new technologies meaning that new legislation should not be necessary to enable new products and services to be developed.
Blockchain raises a wide range of legal issues including data protection, document retention, changes to participants and service providers once a Blockchain is launched and verification of source of funds to name a few. Legal advice will also be critical to the process of development and launch of Blockchain products, including smart contracts.
The Funds Group at Stuarts Walker Hersant Humphries has an in depth market knowledge and understanding of the funds industry and they are working to incorporate these innovative products, like Blockchain and cryptocurrencies, into Cayman Islands funds whilst also finding the creative solutions to counteract the issues which may accompany the use of such products.