How effective regulation unlocks the potential of the virtual assets economy

Risk and reward of virtual assets

Many governments see the growth of the crypto ecosystem as a potential tailwind for innovation and economic activity, while they also recognize the risks of a fast-growing sector that has developed largely outside the perimeters of financial regulation or even credible understanding.

Some of the greatest potential benefits of virtual assets — their ability to transfer value securely and rapidly around the world, anonymously and outside the traditional financial system – have attracted some bad actors, inclusive of money launderers or those hoping to evade comprehensive sanctions programs.

Moves toward regulation to address the misuse of cryptocurrencies for financial crime are happening around the world. With the support of the G20, the Financial Action Task Force, the dirty money watchdog, has issued global standards to guard against money laundering and terrorism financing in the cryptosphere, comprising the same safeguards required in the traditional financial sector.

The Basel Committee on Banking Supervision, made up of regulators from the world’s leading financial centers, has proposed global rules for digital assets with differing risk weightings. Tokenized traditional assets and stablecoins backed by fiat currencies would be treated the same way as loans and deposits. For cryptocurrencies not linked to any underlying asset, such as bitcoin, the Basel rules would require banks to hold capital at least equal in value to their crypto exposures to ensure they could absorb a write-off.

Regulators tasked with overseeing a sustainable crypto ecosystem will seek to build legal and supervisory frameworks that will enable them to detect and prevent financial crime, establish sound corporate governance standards and require beneficial ownership disclosures, and also to take appropriate enforcement actions, as they seek to protect both consumers and the stability of the financial system.

To build and maintain fit-for-purpose regulatory frameworks, authorities will need the tools, skills and technology to identify, understand and supervise all the service providers within the evolving crypto asset space.

DAB, VASP and DARE Acts

The Bahamas, Bermuda and the Cayman Islands have each built a legal and regulatory architecture that seeks to strike a balance between encouraging innovators, while demonstrating soundness, safety, and the protection of investors’ interests and the entire financial ecosystem.

The DAB Act in Bermuda, VASP Act in the Cayman Islands and DARE Act in the Bahamas essentially emphasize the need for service providers to, among other things:

• Exercise due care, skill and diligence.
• Establish and maintain effective security systems.
• Establish and maintain effective corporate governance and robust resilience systems.
• Have appropriate systems, policies, processes and procedures for the prevention, detection and disclosure of financial crime, and to ensure compliance with Anti-Money Laundering (AML) and Combating the Financing of Terrorism (CFT) laws.
• Establish and maintain adequate and effective systems for the protection and segregation of customer assets and data.

Pay due regard to the interests of their customers and treat them fairly.

A virtual asset, as defined by the VASP Act, is “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.”

The VASP Act, which took effect October 31, 2020, empowers the Cayman Islands Monetary Authority to supervise all virtual asset service providers, including issuers, custodians, trading platforms and dealers. A full licensing regime was launched in July 2021. The law implements the Financial Action Task Force’s guidance on a risk-based approach for VASPs and its recommended AML/CFT standards.

The next phase of regulation will require VASPs to obtain and hold originator and beneficial ownership information on all transfers of virtual assets under Part XA of the Anti-Money Laundering (Amendment) Regulations of the Cayman Islands. Known as the “travel rule,” which took effect July 1, 2022. Its successful implementation is critical to investor confidence and security, and to demonstrate the Cayman Islands’ ability to effectively supervise virtual assets and those who provide certain services in relation to them.

The DARE Act, which came into force December 14, 2020, regulates Bahamas-based entities involved in the issuance, sale and trade of digital assets, defined as “any digital representation of value distributed through a distributed ledger technology platform where value is embedded or in which there is a contractual right of use, including a contractual token.”

Digital asset businesses within the scope of DARE include token issuers or exchanges, or digital assets payment service providers, as well as those who provide financial services to them. The Act requires the Securities Commission of the Bahamas to regulate and maintain a register of digital asset businesses and initial token offerings.

The scope of Bermuda’s DAB Act is similar. Having made clear its intentions to attract and grow a FinTech industry, Bermuda has built a regulatory framework using a risk-based approach.

The DAB regime, overseen by the Bermuda Monetary Authority, caters to digital asset businesses at differing stages of development, offering the F (Full) license; the M (Modified) license, for those planning to expand operations for a limited period; and the T (Test) license for those seeking to test their proof of concept.

Mindful of deterring bad actors and reducing reputational risk to the island, Bermuda incorporates prudential rules into its regime, with requirements including cybersecurity audits and customer due diligence.

Regulators in all three jurisdictions run efficient registration and licensing regimes. When delays occur, they are often a result of incomplete applications. Compliance is a new challenge for many in a hitherto unregulated sector.

EY regulatory advisors in the region and integrated around the globe can help crypto businesses assess what information regulators need. Eligible crypto businesses can also draw on legal advice from EY Law, as well as support from EY consulting, data and analytics, technology, audit, and tax teams.