Funds and the Emerging Digital Asset Class – Gibraltar
By Philip Vasquez, Head of Compliance & Strategy
Off the back of Gibraltar’s front and center global attention in relation to regulating Distributed Ledger Technology (“DLT”) institutions, Gibraltar is increasingly being seen as a potential jurisdiction from which to set-up investment funds investing in blockchain, distributed ledger technologies, cryptocurrencies and tokens. Cryptocurrencies and tokens are increasingly being recognised as a new alternative asset class in their own right as ‘Digital Assets’. This brief article touches upon a personal opinion and view on how such funds may be approached from a Gibraltar perspective and a macro view on investments in the DLT space generally. The below is also largely an oversimplified synopsis.
The different facets of investing in DLT
Generally and more increasingly there will be two faces to investment into DLT technologies and their development.
- 1) On the one hand you have the typical private buy side of equity in projects, initiatives, technologies and companies. This will more likely be populated by institutional capital in the form of private equity, ‘accredited’ (Experienced) investor funds and other hedge funds.
- 2) On the other hand you have the public buy side of ‘crowd sale’ participation into projects on the basis that individuals will purchase cryptocurrencies for use as a currency or alternatively what is increasingly referred to and oversimplified as a ‘utility token’ to be able to use a service on a tokenised platform. Participation in these cryptocurrencies or utility tokens involve public participation and easy access for retail individuals/investors.
- 2.1) This latter category also includes investing in mining activities or ‘staking’, where pooling of cryptocurrency or token investments can be used for mutual benefit and payout rewards. This particular form of investment is not wide-spread but as particular cryptocurrency and token projects move on to proof of stake frameworks this may increasingly be seen. Given the pooled nature of these investments, participation will most likely need to take the shape of Collective Investment Schemes.
Private institutions also participate in 2 and 2.1.
(For the purposes of this article I will not go into the details on how these ‘utility tokens’ should be considered in respect of being a financial instrument, a transferable security or either of these classifications)
In terms of the former category, investing in the equity of projects or companies developing technologies will not see much problem from a custodianship and execution perspective. Some predict that the value of the developing technology may best be harnessed by investing in private projects or companies developing enterprise DLT technologies as opposed to the public buy side of the latter category explained.
Others believe that there is competing or other value in participating in the public side of cryptocurrencies and tokens. The problem with the latter category is that (1) little consumer protection exists to the most vulnerable class of investor (retail) and (2) as a result of the constantly developing technologies upon which these cryptocurrencies and tokens are based arranging execution venues and regulated custodianship is a problem yet to be truly solved around the globe.
Digital Asset Fund Pain Points
Investment funds proposing to invest in the latter in or from Gibraltar over the coming months will likely see the structure of Experienced Investor Funds EIFs. The Gibraltar Funds and Investments Association in their February 2018 newsletter have announced that they will be making representations as to how the funds industry in Gibraltar will approach fund setup investing in cryptocurrencies and tokens and these proposals are eagerly awaited.
As these funds are coming through, funds and investment directors need to consider new pain points in respect of:
(i) cybersecurity – As is well known within the industry Digital Asset and Cryptocurrency exchanges, intermediaries and service providers are particularly vulnerable to cybersecurity, malware and phishing attacks. Compromised individuals or fund hardware/software can result in Fund assets being hacked and stolen. For more information on these risks, I would recommend reviewing Europol’s Internet Organised Crime Assessment (IOCTA) 2015 and 2017 ;
(ii) custodianship & physical security – custodianship of Digital Assets is a fundamental aspect of any investment into Digital Assets as these assets are protected by the privacy of what are known as ‘private keys / seed words’. The private key and/or seed word gives full control over the transfer of Digital Assets. Some Digital Asset private keys can be stored on encrypted devices which are then typically kept in secure physical environments. Funds arranging self-storage of Digital Assets can be a difficult, high risk and potentially a costly operation. Increasingly we are seeing solutions for this problem for institutional and retail investors in the form of businesses like Digital Asset Management Ltd, who are seeking regulatory approval in Gibraltar with the GFSC as a non-depositary custodian wallet provider, and Kingdom Trust in the USA who a non-depositary custodian. Other aspects to consider are the potential of ransom and kidnap, and the difficulties of obtaining adequate ransom and kidnap insurance and the complexities associated in relation to claiming under such policies;
(iii) depositary – Gibraltar’s Experienced Investor Funds Regulations under regulation 8 require that an EIF shall have a depositary unless (a) the fund is a closed fund; or (b) the GFSC makes a determination that the fund is not required to have a depositary. The only authorised depositaries in Gibraltar, at this stage appear to be banks who are not yet able to take on depositary services or facility of Digital Assets. However, other solutions may be possible where a depositary is still appointed in relation to funds investing in Digital Assets;
(iv) valuation of assets under management and investment parameters – International Financial Reporting Standards have not yet been able to provide any guidance as to how Digital Assets should be treated from an accounting perspective, nor is this expected for a while and this is frequently changing. Similarly, no regulations or guidance exist in relation to regulating all types of Digital Assets so investment directors will need to determine their own investment parameters and criteria as well as policy and philosophy.
It is clear that funds in Gibraltar will need to address and monitor these concerns by way of policy documents, processes and controls. The protection of investor’s assets is the objective but ultimately in order to be consistent with HMGoG and the GFSC’s objective in maintaining the reputation of Gibraltar in regulating DLT institutions, applying the same principled approach to these nuanced issues of investment funds should be viewed in the same approach.
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By Philip Vasquez,
Head of Compliance & Strategy