Setting up a Cayman Islands or BVI fund with a crypto strategy

In recent years we have seen a surge in the number of funds with crypto strategies (for the purpose of this briefing, "crypto funds"), particularly in the Cayman Islands and the British Virgin Islands.

This article highlights the five key considerations for managers or sponsors of a crypto fund, particularly first-time managers, as well as experienced managers setting up their first crypto fund.

Strategies of these funds vary, but broadly speaking these can be categorised as follows:

• Market neutral and quantitative trading strategies, which are very common among open-ended funds (where investors have the option to redeem their investment interests)

• Closed-ended funds (funds whose investors do not have the option to redeem their investment interests) investing into crypto and web 3 projects by acquiring equity and tokens by way of instruments such as simple agreement for future equity (SAFE) (nowadays commonly with token warrants), simple agreement for future tokens (SAFT) and token purchase agreements

• Funds adopting both liquid and illiquid strategies

Regulation

As with setting up traditional funds, it is important to consider the laws of the various jurisdictions to which a fund may be subject to. In terms of fund domicile, we see the Cayman Islands and the British Virgin Islands (BVI) as popular jurisdictions of choice for crypto funds. Open-ended funds are generally subject to the requirement to be registered or recognised with the Cayman Islands Monetary Authority (CIMA) or the BVI Financial Services Commission (FSC) as mutual funds and, likewise, as a private fund (in the Cayman Islands) or private investment fund (in the BVI) for closed-ended funds.

Other relevant jurisdictions include not just the jurisdiction in which the entity that will act as the manager of the fund is incorporated, but where the actual portfolio management team is located and the jurisdictions into which the fund will be marketed. It is crucial to ensure compliance with the regulatory requirements of these jurisdictions, including any licensing or registration obligations, anti-money laundering (AML) and counter-terrorist financing (CFT) regulations and marketing restrictions.

Subscriptions in crypto

To the extent that a crypto fund will accept subscriptions in cryptocurrency or digital assets, the manager should first check with its fund administrator of choice to see if this is supported and, if so, to what extent. This is because an investment fund typically relies on its fund administrator to perform AML / CFT functions with respect to its investors. This includes conducting KYC (know-your-client) and CDD (client due diligence) checks on its investors and their source of funds / wealth in compliance with the applicable AML / CFT standards in the Cayman Islands or BVI.

For example, a manager should enquire whether the fund administrator has a list of exchanges and custodians that are accepted, whether self-hosted wallets are accepted and what other additional KYC requirements might be involved for a crypto subscription. Additionally, it is important to consider the operational aspects of accepting crypto subscriptions, such as the process for converting cryptocurrencies into the base currency of the fund and managing the associated foreign exchange risks.

Given that most crypto funds are unlikely to have a cryptocurrency as a base currency (in fact more often than not crypto funds are denominated in USD), a question arises as to how the fund proposes to manage the foreign exchange fluctuations between the cryptocurrencies and digital assets accepted as subscription proceeds and the fund's base currency (such as USD). In fact, similar considerations exist in the context of a "traditional" fund that invests in traditional asset classes – a USD fund may be open to subscriptions by another "fiat" currency (such as JPY) – but perhaps with the exception that cryptocurrencies such as Bitcoin may potentially form part of a portfolio that is managed in accordance with the investment strategy of a crypto fund, while this is usually not the case for "fiat" currencies in a "traditional" fund.

Valuation of digital assets

Most offering documents of funds that invest in traditional asset classes do not set out specific valuation principles that apply to ascertaining the fair value of digital assets or cryptocurrencies. For example, valuation of assets is typically conducted at a "valuation point" which is widely defined as close of business in the last market relevant to the fund to close. Cryptocurrencies, however, are traded 24/7 so it would be very difficult, if not impossible, to define when the market "closes".

In addition, most cryptocurrencies may have different prices across different exchanges and trading platforms. Therefore, it would be important for the offering documents of a crypto fund to state where the pricing sources will be derived from for the purpose of calculating the net asset value (NAV) of the fund.

For a Cayman Islands domiciled fund, CIMA's Rule on Calculation of Asset Values for Regulated Mutual Funds and Registered Private Funds (together NAV Rules) require mutual funds and private funds to establish, implement and maintain a NAV Calculation Policy (as defined in the NAV Rules) that ensures a mutual fund’s NAV is fair, reliable, complete, neutral and free from material error and is verifiable. Such policy must be calculated in accordance with the International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP) of the United States of America, Japan or Switzerland or a non-high-risk jurisdiction (any jurisdiction not on the list of high-risk jurisdictions issued by the Financial Action Task Force).

Likewise, for a BVI-domiciled fund, the Mutual Funds Regulations and the Private Fund Regulations require a fund's financial statements to comply with similar accounting principles. It would be important to discuss with the fund administrator and auditor upfront to ensure comfort as to the compliance of the fund's valuation principles with the fund's accounting principles.

Custody / safekeeping of digital assets

For Cayman-domiciled funds, CIMA's Rule on Segregation of Assets for Mutual Funds requires a mutual fund to appoint a service provider for safekeeping of assets. The service provider should be regulated by CIMA, a "Recognised Overseas Regulatory Authority" or any other regulator approved by CIMA. In the context of a Cayman Islands private fund (the Cayman Islands Private Funds Act provides that where it is both practical and proportionate to do so, having regard to the nature of the private fund and the type of assets it holds), a custodian must be appointed to perform each of the following roles:

1. Hold the custodial fund assets in segregated accounts opened in the name (or for the account) of the private fund

2. Verify, based on information provided by the private fund and available external information, that the private fund holds title to any other fund assets and maintain a record of those other assets

Where no custodian is appointed, the fund must notify CIMA of this fact. In such circumstances, a private fund must instead appoint a person to carry out title verification in line with point b above. The overriding requirement is that fund assets must be segregated and accounted for separately.

Similarly, the BVI Mutual Funds Regulations require private funds and professional funds to appoint a custodian (unless exempted by the FSC from such requirement), while the FSC's Fund Safekeeping Arrangements Guidelines require private investment funds, approved funds and incubator funds to put safekeeping arrangements in place, depending on the particular asset type of the fund.

To the extent these rules and guidelines are applicable, they should be considered carefully in the context of asset safekeeping arrangements of a crypto fund. This is especially important where the manager intends to hold fund assets in what is generally referred to in the crypto space as "self-custody" (in this context, this essentially refers to the manager controlling the private key of the digital wallets of the fund), and whether such arrangements comply with the said rules and guidelines or whether third-party custodians who specialise in digital asset custody solutions (such as multi-signature wallets and cold storage) should be considered.

Counterparty risks

The collapse of FTX (once among the largest cryptocurrency exchanges in the world) in late 2022 presented challenges for crypto funds, especially those with significant portions of assets held with FTX (see our article on the tools and options that may be available to crypto funds in this event: Key considerations for crypto funds in the event of a crypto exchange collapse). That being said, given the digital assets market and its service providers are still relatively new, it would be advisable to plan ahead to hedge against these potential counterparty risks at the time of the fund launch, and that these risks are clearly set out in the offering document of the fund.

Managers may consider conducting thorough due diligence on all counterparties including exchanges, custodians, and other service providers. It is also sensible to diversify counterparty exposure where possible, such as by using multiple exchanges and custodians, to minimise the impact of any single counterparty failure. Additionally, incorporating robust risk management practices and contingency plans can help mitigate the potential adverse effects of counterparty risks on the fund's operations and performance.

How Ogier can help

Ogier's global multi-disciplinary Technology and Web3 team assists clients with creating, launching, funding and evolving their digital and decentralised projects and implementing blockchain and cryptocurrency related investment products. With experts across our jurisdictions, we bring a global perspective to our work with clients, which includes launching cryptocurrency and blockchain related funds, hedge and venture capital, private sales, airdrops and grants of tokens and non-fungible tokens (NFTs), and a variety of fundraising. Please feel free to get in touch with our team if you require any assistance.

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Disclaimer

This client briefing has been prepared for clients and professional associates of Ogier. The information and expressions of opinion which it contains are not intended to be a comprehensive study or to provide legal advice and should not be treated as a substitute for specific advice concerning individual situations.

Regulatory information can be found under Legal Notice