Cayman Islands introduces regulatory regime for virtual asset service providers

In mid-2020, the Cayman Islands government introduced a new framework for regulating virtual asset businesses, known as “virtual asset service providers” (VASPs). The framework implements Financial Action Task Force (FATF) recommendations for registering and licensing VASPs, clearly defines what virtual assets are and which constitute securities, enables funds to use virtual assets as representations of equity interests, recognises virtual asset trading exchanges and introduces a regulatory sandbox licence. The new framework is not yet in force.

This means that all VASPs will be subject to licensing or registration, and regulatory requirements beyond compliance with Cayman’s AML rules (covered in our previous blog post). The framework makes Cayman an attractive destination for VASPs, as it demonstrates Cayman’s commitment to international standards, provides legal and regulatory certainty and supports innovation.

What are virtual assets?

The Virtual Asset (Service Providers) Act, 2020 (the VASPAct) implements the FATF definition of a virtual asset: “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 definition is broad and focuses on transferability and exchangeability. According to the FATF, the definitions of virtual asset and VASP are intended “to capture specific financial activities and functions (ie, transfer, exchange, safekeeping and administration, issuance, etc) and assets that are fungible—whether virtual-to-virtual or virtual-to-fiat”.

Any token technically capable of transfer or exchange is a virtual asset under the VASP Act, regardless of programmed properties or intended use. No distinction is made between what are commonly known as utility tokens, security tokens and stablecoins.

The term ”digital representations of fiat currencies”, subject to any further guidance from the Cayman Islands Monetary Authority (CIMA), is likely only intended cover central bank digital currencies. In our view, the Tether token, for example, is a virtual asset because it is backed by redeemable US dollar reserves held by the Tether company, rather than being a digital representation of the US dollar itself.

What are not virtual assets?

The VASP Act excludes “virtual service tokens”, which are “a digital representation of value which is not transferrable or exchangeable with a third party at any time and includes digital tokens whose sole function is to provide access to an application or service or to provide a service or function directly to its owner”.

The second part of the definition may seem to describe conventional utility tokens, but they are only virtual service tokens if they are also “not transferrable or exchange with a third party at any time”.

The FATF offers more guidance on what is intended: this definition captures digital assets which are “closed-loop items that are non-transferable, non-exchangeable, and non-fungible. Such items might include airline miles, credit card awards, or similar loyalty program rewards or points, which an individual cannot sell onward in a secondary market”.

What is a VASP?

The VASP Act defines a VASP as:

• a Cayman entity
• which provides a virtual asset services
• as a business or within the course of a business in or from within the Cayman Islands
• And is registered or licensed in accordance with the VASP Act or is an existing licensee that is granted a waiver

A virtual asset service is any of the following businesses provided for or on behalf of another party:

• virtual asset exchange (whether to or from fiat or other virtual assets)
• transfers of virtual assets
• custody services
• participation in, and provision of, financial services related to a virtual asset issuance or the sale of a virtual asset

Interestingly this definition does not explicitly cover decentralised finance businesses. That said, these businesses may be subject to Cayman’s banking, securities investment business or other financial services acts depending on their activities.

The VASP Act licenses and regulates those engaged in relevant financial business involving virtual assets for or on behalf of a third party. Virtual assets themselves, and those using virtual assets or VASPs for their own private purposes or as principals, are not affected.

Registration and licensing requirements

As of the date of this alert, we are yet to see full details of CIMA’s regulatory regime, licensing and registration requirements and any rules.

VASPs other than custodians and trading platforms

All VASPs - including businesses acting as VASPs on an occasional or limited basis - must be registered with CIMA. VASPs must already comply with Cayman’s anti-money laundering, proliferation financing and countering the financing of terrorism regulations under changes that were made to the Proceeds of Crime Act during 2019.

VASPs already licensed under any other regulatory acts may not need to be registered. However, they will need to notify CIMA of the details of their VASP activities and the need for separate licensing or registration may be waived by CIMA on a discretionary basis.

Investment funds wishing to accept subscriptions in virtual assets or make redemptions-in-kind must take structuring advice to determine whether they or their service providers may fall within the framework.

All VASPs will be subject to ongoing requirements, including regulatory audits by CIMA, preparing audited financial statements, appointing and maintaining compliance officers, and obtaining CIMA’s written approval before issuing or transferring equity interests representing 10 per cent or more of its total equity interests. Further requirements may also apply but are not yet available.

Custodians and trading platforms

VASPs providing custodial services and trading platforms must be licensed by CIMA.

Custodial services must demonstrate that they meet capital, disclosure and safekeeping standards.

Trading platforms must do the same for disclosure, onboarding, trading supervision, operational and clearance and settlement standards.

Detailed standards are not yet available.

Issuing virtual assets

The framework doesn’t seek to create a licencing regime around issuances of virtual assets (previously through unregulated initial coin offerings or ICOs). However, issuers will be subject to basic registration requirements. These include registration with and notification of an issuance to CIMA, content and accuracy requirements for issuance documentation, fit and proper persons to be in control of the issuer, and CIMA approval prior to issuance. Details of these requirements are not yet available.

Licensed trading platforms may facilitate the issuance of virtual assets to the public.

Virtual assets may be issued directly to the public below a threshold which has not yet been published. Any issuance above the threshold must be through a suitably licensed trading platform.

Fees

Registration and licensing fees will be assessed by CIMA within a prescribed range and determined by factors such as the nature, size, scope and complexity of the VASP. Details are not yet available.

Regulatory sandbox

A time-limited regulatory sandbox licence will be available to both VASPs and FinTechs. Cayman is following the approach taken by regulators such as the Financial Conduct Authority in the UK.

The flexible sandbox licence will permit CIMA to tailor restrictions, monitoring covenants, limits on the offering of the service or specific obligations. This helps CIMA adequately supervise the innovative activity and decide on further regulatory action or recommend changes in regulatory acts as needed.

The sandbox licence is intended for VASPs whose virtual asset activity is not properly supervised by an existing regulatory act, or may pose substantial market, systemic or AML/CFT risks. For FinTechs, the sandbox licence can help accelerate adoption of the innovative technology or delivery channel they have developed.

Changes to other act and regulations

Several other Cayman acts and regulations (as revised and amended from time to time) have been updated to reflect the new framework:

• Anti-Money Laundering Regulations (2020 Revision) – VASPs must carry out due diligence for all one-off transactions, regardless of value, and provide transaction information for every virtual asset transfer as if it were a wire transfer of funds.
• Mutual Funds Act (2020 Revision) – funds can convey equity interests using virtual assets or any other innovative form. This permits rapid fund formation and investor subscriptions, general fund administration and transfer of fund interests through new technology platforms and tokenised interests if or when these become available. Service providers may themselves need to be licensed and funds must take structuring advice if they wish to avoid being registered or licensed as VASPs.
• Securities Investment Business Act (2020 Revision) (SIBL) - virtual assets that represent, are derivatives of, or can be converted into, securities set out in Schedule 1 of SIBL will themselves be deemed to be securities. This approach provides regulatory certainty (unlike the Howey test used in the USA), clearly distinguishing between virtual assets that are securities and those that are not (such as virtual service tokens, virtual utility tokens, and stablecoins).
• Stock Exchange Company Act (2014 Revision), as amended – the Cayman Islands Stock Exchange will not have the sole and exclusive right in the Cayman Islands to list virtual assets which are securities. This important amendment allows virtual assets securities exchanges to be licensed and operate under the framework.

What is the impact on VASPs?

All Cayman-based VASPs will need to register with or be licensed by CIMA depending on their activities. As noted above, VASPs must already be operating in compliance with the Cayman AML/CFT regime, including appointing AML officers and performing customer due diligence.

All potential and existing Cayman-based VASPs should begin preparing internally so that they are ready to apply for licensing or registration.

Harneys’ Regulatory and Digital Assets team is well versed in all aspects of Cayman regulatory law. We are closely monitoring the development of the framework and will publish a detailed client guide once regulatory standards and requirements are available.

Where can I read the new acts?

• Virtual Asset (Service Providers) Act, 2020
• Monetary Authority (Amendment) (No. 2) Act, 2020
• Securities Investment Business (Amendment) Act, 2020
• Mutual Funds (Amendment) (No. 2) Act, 2020
• Stock Exchange Company (Amendment) Act, 2020

Please contact your usual Harneys representative if you would like advice on how to prepare for the new framework. If you have any other questions, visit harneys.com/Cayman.