What you should consider when setting up an Offshore Crypto Fund
Flag Theory Weekly Letter – Friday, August 3rd, 2018
Despite daily ups and downs, Crypto is here to stay as a new asset class and its adoption is growing at a rapid pace. Although there are some issues to continue to make cryptocurrencies more attractive for more sophisticated investors, such as custody or derivative options – interest is growing.
This growing interest has led to a number of fund managers either incorporating blockchain assets into their existing strategy and/or establishing stand-alone funds focused on cryptocurrencies.
Besides helping fund managers, we have also been helping crypto enthusiasts who have acquired some experience and success in crypto trading and decided to establish fund structures solely focused on this asset class.
Today we will talk about some aspects to consider when structuring your fund, review two of the most popular jurisdictions to establish an offshore cryptocurrency fund and discuss some of the challenges that tokenized funds are currently facing.
Structuring your offshore crypto fund
When it comes to launching your offshore crypto fund, there are certain aspects that will determine how to structure it and the regulations and/or licenses to which it will be subject.
For instance, the type, number, and location of the investors, as well as the distribution and fees applied. Also the minimum and maximum individual investment amount and the maximum net assets of the fund.
You must decide whether it will be an open-ended or closed-ended fund.
A closed-ended fund is usually not regulated, it has a fixed capital and a fixed number of shares/interests offered by a company. Closed-ended funds may not be able to issue new shares or redeem shares on demand. The right to redeem is usually at the sole discretion of the fund manager.
On the other hand, open-ended funds sell shares directly to investors. The number of shares is not fixed and might be unlimited.
You must consider whether you are looking to structure your fund as a stand-alone fund or a Segregated Portfolio Company (SPC) to create segregated funds and apply different strategies and terms for each one.
Depending on your fund structure you would want to incorporate your fund in a different jurisdiction and different fund vehicle, for instance, a Company limited by shares or a Limited partnership issuing partnership interest to limited partners, and if you are going to establish a separate company as a fund manager.
Next, we review two of the most common jurisdictions for offshore crypto funds: the Cayman Islands and BVI.
Setting up an offshore crypto fund in the Cayman Islands
The Cayman Islands has been traditionally the go-to jurisdiction for establishing offshore funds. About 75% of the offshore funds worldwide are located in Cayman and it is also attracting a large number of funds investing in crypto.
Usually, the most common vehicle used is an Exempted Company Limited by Shares, although Exempted Limited Partnerships are relatively used and less frequently Unit Trusts.
Investment funds are regulated by the Cayman Islands Monetary Authority (CIMA) under the Mutual Funds Law (2012 Revision).
Note that closed-ended funds in Cayman are exempt and not regulated, and can conduct business without registering and obtaining a license.
These unregulated funds are established in the form of Exempted Company limited by shares and are limited to 15 investors, who may designate the directors of the fund, making them suitable for individuals, friends and family, and start-up funds.
For larger crypto funds with 15 or more investors, they have the option of being structured as a registered fund, administered fund or licensed fund.
Registered funds are regulated but do not need a license. The minimum investment per investor must be at least US$100,000 or its equity interests must be listed on a recognized stock exchange.
Administered funds must be registered but do not require a license either. However, the fund must have its main office in the Cayman Islands and appoint a Cayman licensed mutual fund administrator.
Licensed funds do not need to have a local main office or appoint a fund administrator regulated in Cayman. But, this option is only viable for reputable and experienced institutions.
The CIMA grants fund licenses after performing a strict fit & proper test to the promoters and makes sure that the administration of the fund will be carried out by managers who have sufficient knowledge and experience to be capable of managing the fund adequately, among other requirements.
Setting up a BVI crypto fund
Second to the Caymans is the British Virgin Islands to attract offshore funds. Usually, the fund vehicle used is a BVI Business Company.
Investment funds in the British Virgin Islands are regulated by the Financial Services Commission (FSA) under the Securities and Investment Business Regulations 2015 (SIBA) and the Mutual Fund Regulations, 2010.
As in the Caymans, closed-ended funds are exempt and do not need to be registered and/or licensed. However, unlike the Caymans, in the BVI the number of shareholders of unregulated funds is not limited.
If you wish to establish an open-ended fund, you have 5 options: Private Funds, Approved Funds, Incubator Funds, Professional Funds, and Public Funds.
Private Funds must be registered but do not require a license. A BVI Private Fund may have no more than 50 investors or its fund interests must be offered on a strictly private basis.
Approved Funds are private funds but subject to lower regulation and requirements. A maximum of 20 investors can participate and its net assets cannot exceed the US $100 million.
Incubator Funds are open-ended funds and are the easiest and fastest to establish. They are restricted to professional investors and the minimum amount per investor must be at least US$20,000. The fund’s net assets cannot exceed US$20M.
If after two years a successful strategy and results are demonstrated, the fund can easily become a private, professional or public fund.
Professional Funds can only invite professional investors to subscribe for shares with a minimum investment of US$100,000, except for fund managers, promoters or any employee of the fund. Professional funds must obtain a license.
Public Funds are licensed funds subject to the strictest legislation and the most onerous requirements since it can offer fund interests to retail investors.
Challenges for Tokenized Funds
So far, we have been talking about structuring a traditional fund that invests in cryptocurrencies. The offshore crypto fund issues shares or partnership interest certificates to investors who expect to obtain a profit share.
However, unlike traditional funds, a tokenized fund issues interest or equity rights through a digital token in the blockchain. Token holders are entitled to profits and obtain a return on their investment.
There is no specific regulation for this type of fund, although depending on how they are structured they may be subject to fund and securities laws of the jurisdiction where they are issued and marketed.
In any case, tokenized funds face a series of challenges:
To begin with, due to the nature of blockchain assets, which can be transferred anonymously, it opens up potential issues related to compliance.
The fund interest in form of a digital token could be transferred between individuals without the proper KYC/AML & CTF protocols and controls which could potentially lead to a sanctioned person or entity holding interests of the fund – this may expose promoters and fund managers to serious legal issues.
If the tokenized fund offers tokens to retail investors and raises capital through a typical ICO, in addition to being subject to public funds stringent requirements, the issuance should not only be registered with the Securities Commission and abide to the securities laws in the country of issuance but also potentially in all the countries where the offering is marketed.
Since ICOs are carried out online, the interpretation of the market intention and invitation to subscribe to the fund to a certain jurisdiction is very open, so the legal risks assumed if one is not duly registered are considerable.
That is why most of the serious projects that conduct Securities Token Offerings assume that they cannot do marketing and that they have to apply for registration or exemption in any of the jurisdiction the STO is sold to.
In addition, there are currently no authorized cryptocurrency exchanges to list and allow security tokens trading. This could be a barrier to the successful development of an ICO, as liquidity after the ICO might be almost non-existent.
The Bottom Line
At Flag Theory, we believe that the ICOs market will move towards securities token issuances and that new technologies will allow it to overcome the mentioned challenges and new regulations will bring clarity to specific issues related to this asset class.
However, what is clear now is that having the classic ICO approach to raising capital for a securities token offering (whether it is a tokenized fund or not) is not a good idea since you may be breaking the laws of several jurisdictions.
If you are planning to launch your offshore crypto fund, at Flag Theory, we assist promoters and managers, from the incorporation to the registration and obtaining of licenses to the opening of bank accounts and the conversion of crypto to fiat currency.
Contact us, we are happy to have a chat with you to understand your needs and explore options.
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