This piece was co-authored by Sophia Moustras and Sam Sturrock, Jersey Corporate Finance, Collas Crill.

The constant evolution of Fintech and the rise of cryptocurrencies to ubiquity has resulted in offshore regulators and legal frameworks having to continuously adapt and keep pace with change in order to ensure that the integrity of their financial services industries are not undermined.

In light of the regular international focus that offshore jurisdictions such as Jersey, BVI, Guernsey and Cayman Islands can attract on issues such as global taxation and the prevention of money laundering, how have these jurisdictions approached the new challenges?  Offshore jurisdictions are used to having to ensure they are compliant with leading international standards set by MONEYVAL, the OECD, the EU and others but are there inherent challenges presented by this current wave of technology that are going to be troublesome to overcome in the context of financial services without the next jump in evolution?

Environmental, Social & Governance (ESG) issues with cryptocurrencies

One of the key themes in financial services currently and for the foreseeable future is ESG and sustainable finance.  Between 2016 and 2018, sustainable investment assets under management grew by 34% to USD30.7trn and ESG focussed assets are predicted to exceed USD100trn by 2028. In addition, it is estimated that one in every three USD currently invested takes into account ESG factors.

What this can mean is that many asset classes that don't inherently align with ESG factors could find themselves being removed from investment portfolios, particularly at an institutional level over time as public pressure increases.  Importantly regulators and governments are expanding their focus and starting to incorporate sustainability into investment information and decision making.

As was widely reported in March 2021, Elon Musk's announcement that Tesla would no longer accept Bitcoin due to environmental concerns arising from Bitcoin "mining" highlighted the very real investment difficulties for financial institutions struggling with both the practical and publicity issues regarding ESG.

Bitcoin mining is the process by which new Bitcoins are entered into circulation by rewarding a party for validating bitcoin transactions.  This validation involves massive amounts of computer power to complete and has become an industry of itself due to the rising values of the Bitcoins received.

Staggeringly, together the network of machines used to mine Bitcoin are thought to use more energy that Sweden uses in a year, has a carbon footprint comparable to Morocco and generates electronic waste (components etc) on a similar scale to Luxembourg.  China is also by far and away the largest jurisdiction in which cryptocurrency mining is thought to occur with over a 65% share as at April 2020 and a large percentage of its energy consumption still fuelled by coal (over 60% as at 2018).

Interestingly, not all cryptocurrencies have this mining issue…but the most popular ones do – Bitcoin and Ethereum alone account for a massive combined 60% of the approximately USD1.5trn market cap as at 11 June 2021.

The nature of Bitcoin is also that investing arguably encourages Bitcoin mining through supporting its price and incentivising those who wish to mine, exacerbating the bitcoin carbon footprint.

As such, while being "modern", the current infrastructure and development of the main forms of crypto is essentially aligned with fossil fuels unless developments take place to address the source of the energy it is consuming.  On an optimistic note, Ethereum has announced plans to move to a greener model, newer coins have adopted a non-mining approach and there are apparently attempts to gradually decarbonise Bitcoin, from an ESG investing perspective at the moment, it is certainly a complex landscape that makes ESG investing difficult.

Lack of broad regulatory and governmental approval

While digital currencies seem to have stubbornly stuck around, national governments have broadly been very reluctant to endorse them and a number have actually prohibited them in some form.  The anticipated take up of cryptocurrency in relation to being able to purchase goods and services with them has not yet materialised.

The Chinese government is notoriously unsupportive of cryptocurrency trading and the trading of cryptocurrencies has been illegal in China since 2019 in an attempt to prevent money-laundering and financial crime transactions.

Indeed until El Salvador became the first country to take steps to make Bitcoin legal tender in June 2021, no other country had gone that far.

In international offshore financial services and political contexts, this level of circumspection and lack of endorsement at the highest level could well give many jurisdictions pause for thought before becoming a first adopter.

Volatility and value

Cryptocurrencies are notoriously volatile and fickle, being particularly sensitive both to market maker sentiment, institutional investor whim and the news.

By way of example, in March Elon Musk announced, in his support of cryptocurrencies, that Tesla would allow customers to purchase cars via Bitcoin which caused the Bitcoin prices to soar by 20.33%. However, his position on this drastically altered within two months due to his environmental concerns over the rapid increase of fossil fuels required for Bitcoin mining. After his statement in regards to Tesla's reversal of position, according to Coin Market Cap, the market capitalisation of cryptocurrency had dropped quickly by $365.85bn.

While there are clearly certain elements of the financial services market that embrace volatility for investment, a large segment does not and seeks a form of intrinsic long term value.  For investors and advisers used to being able to identify much more tangible value, that poses an issue, as does the fact that an adviser arguably cannot advise a client to invest without stressing that they should be aware they may well lose all their money, particularly if they are using leverage

In October 2020, Andrew Bailey, Governor of the Bank of England stated that "it is hard to see that Bitcoin has what we tend to call intrinsic value,” during a BoE question and answer session with members of the public. “It may have extrinsic value in the sense that people want it” but he was very nervous about people using Bitcoin for payments because its value was uncertain, pointing out that investors should realise its price is extremely volatile. He also previously warned that crypto investors should be prepared to “lose all their money”.

The level of volatility and specialist risks also mean that specialist expertise is required in relation to the management, administration and trading of cryptocurrency.  As offshore centres are now often conducting business where management and control of companies has to be demonstrably offshore, it is questionable whether a technical analysis, frequent trading approach which is dependant upon expert traders in major onshore financial centres will fit with the current economic substance and tax structuring approach.

As such, crypto still definitely sits in the high risk bracket for both retail investors and financial services providers and advisers.  Unless the linked aspects of volatility and usability start to resolve over time, crypto will face challenges to become more mainstream beyond a siloed tradable asset for the expert or retail speculator.

Administration and custody

A large part of financial services involves the management, administration and custody of assets for others.  Cryptocurrencies are stored in a digital wallet (a digital storage tool) which is only accessible by the possessor of the private key of the wallet.  Various methods can be used to secure the wallet including encryption, back up and 'cold storage' (i.e. storage offline on a USB stick) but none are infallible and even a computer malfunction can lead to loss of cryptocurrency, let alone hacking.

This can cause concerns for those who have invested great sums as if the private key is lost or acquired by a third party, they may be unable to access their digital wallet. There may also be little legal recourse or protection in order to obtain what has been lost and investors have little protection of their financial assets. Investors also can have technical difficulties that mean they can be delay in extracting cash from their chosen platforms.

Practical situations such as these pose significant governance and risk considerations to those considering providing a service for holding cryptocurrency or administer entities such as companies that hold crypto assets. Where are the wallets or cold storage devices kept and how are they stored? Who has access to the various passwords? What happens if the password is lost? How do you prevent hacking or data loss?  What happens if a disgruntled employee was to take the passwords? 

With volatile assets, execution timing can also be key so what are the parameters for proper instructions and execution? What happens in the case of human error or loss?  Can any of the activities be properly and fully insured?  All of these issues, while problematic for a retail investor, take on a greater significance in a commercial setting that may have a radical impact for a lot of financial services businesses in relation to their business risk.

By way of illustration, in 2019, a co-founder of a cryptocurrency exchange suddenly died, leaving all the investors without access to the private keys of crypto assets which were on an encrypted laptop to which he alone had access.  This left customers of the exchange unable to access digital assets worth USD150m and the investors had no means of recourse. One individual had as much as USD50m.

The risks that are currently inherent in this asset could well mean that many financial services businesses find the risk profile of these services just too high to embrace in the modern regulatory environment.  There has also been a contraction in the offshore financial services business market which means there are less choices of insurer and higher premiums.  Insurance complexities and costs alone may rule out all but the larger players in this market.

Reputation and anti-money laundering (AML) issues

Due to its anonymity, technical complexity, decentralised nature and ability to facilitate cross border payments, cryptocurrency is known to be used for criminal activity (such as blackmail, ransoms and a currency of choice on the dark web).   Unfortunately, the UK Financial Conduct Authority recently warned that a “high” number of crypto businesses in the UK are not meeting anti-money laundering standards.

Offshore jurisdictions face tremendous scrutiny of their AML and tax transparency standards. That scrutiny trickles down to financial services businesses through regulation and also enforcement (including imprisonment and heavy fines).  As such, there has been understandable reticence, in various jurisdictions, by many financial services business to embrace the asset class. 

In financial services, investor protection measures (particularly for retail investors) are often at the forefront and the aspects that appeal to many about cryptocurrency, pose real regulatory risk for businesses in this sphere.

Interestingly, in the UK Standard Chartered and Northern Trust have recently launched Zodia, a cryptocurrency custodian for institutional investors, in order to try and address the lack of established market infrastructure and standards between trading venues, custodians and participants.  It will be fascinating to see how that business progresses.  

Conclusion

While one of the founding philosophies of cryptocurrencies involved excluding the traditional financial services businesses such as banks, it was perhaps inevitable that where there was money to be made that attempts to blend the traditional finance approach and digital assets would be made.

While the issues above have not prohibited a certain level of growth so far, arguably for cryptocurrency to move to a different level and become more accepted offshore, cryptocurrencies or the infrastructure around them will have to adapt for a commercial setting.  As Don Ohlmeyer once said, "The answer to all your questions is: Money" and where there is a will, there is a way…