Guernsey has launched its first cryptocurrency fund, and the world’s first Tier 1 Bitcoin exchange-traded fund (ETF), in October 2021. The ETF was designed by Guernsey-based regulatory consultancy Midshore Consulting, led by Managing Director, Christopher Jehan, also Head of Fund Architecture at Jacobi Asset Management which launched the fund. In an article for IFC review, he discusses how this innovative project came about.This fund is available to institutional investors and it is currently seeking approval to list, at which point it will become a Tier 1 ETF. It’s been a long road to get here but it’s been well worth it. To be able to announce a ‘first’ is  quite an achievement.
It all started with one of those very unusual personal introductions from an existing contact  in the City of London who introduced a group of gentlemen who wanted to launch a FinTech and crypto fund. Guernsey has done FinTech for many years, so that was no issue. As for crypto, we hadn’t had a fund up to that point. After many discussions they decided that we would  set it up in Guernsey.
There are a few other Bitcoin ETFs in the world. Where this one probably differs from the others is  the quality offerings around it. For example, Fidelity Digital Assets is the custodian here. They are a top tier investment firm, one of the biggest out there, so  the project has been about  creating a high-quality product, but also one that doesn’t participate in Bitcoin by buying derivatives rather than investing directly in the crypto asset itself. In that respect, it is different from many of the other products out there.
Getting Approval
Before we proceeded to substantive work in Guernsey, we had a conversation with the regulator, the Guernsey Financial Services Commission (GFSC) at a very early stage to confirm the  controls that would need to be put in place around it. Then there was a case of creating a framework around those controls and presenting it to the regulator. The GFSC asked a lot of questions early on to gain more clarity as this would be more than one world-first. Not only is it Guernsey’s first cryptocurrency fund, but  also the first ETF.
After that, it became similar to any fund process. We already knew what controls we needed to put in place, but  this project was slightly different in that an authorised fund goes through what’s known as a three-stage authorisation process. But in this case, stages one and two more or less ran together. After that,  we moved to an authorisations review panel – a group of executives within the regulator’s hierarchy that come together to review a new product proposal – then a decision committee  comprising a number of the commissioners of the regulator. Once we received approval from the committee,  we just had to pass the final authorisation stage which was only about two weeks before we got the final permission.
It wasn’t all plain sailing – there were some barriers to overcome. Current regulation was not designed necessarily to fit this product, so even things like anti-money laundering (AML) regulation, which protects the island’s financial services industry from abuse by money launderers and terrorist financing, needed to be looked at and we had to ask for revisions to be made to certain pieces of regulations and modifications of rules for this specific case.
As an example, funds that list on exchanges typically do not follow normal AML and know-your-customer (KYC) processes. That’s actually a specific exemption allowed within AML rules, but it only applies to closed-ended funds. ETFs like this are open-ended and are not allowed within that exemption. So we looked at the original sources the regulation was drawn from, then at  International Organization of Securities Commissions (IOSCO) documents and we drew parallels. We wrote to the GFSC suggesting that we needed to change the rules to allow this and they agreed. It was logical and it wasn’t increasing Guernsey’s risk profile. Thanks to very rapid consultation, we managed to get a rule modified within six to eight weeks.
Putting Systems In Place
There were five key control areas of concern the GFSC might have had with crypto investing funds over other types. They were mainly interested in two areas that related to AML. One was that if investors were allowed to bring cryptocurrency, like Bitcoin, how would we do due diligence on that Bitcoin coming into the fund? In this case, we would not allow that, so that was not an issue. However, when the fund itself buys Bitcoin, how do you make sure you’re not buying the proceeds of crime, or something that could be used for terrorist financing? There’s a firm involved called Flow Traders who are the authorised participants. They use a tool which actually looks at the provenance of the Bitcoin and the wallets it has been through to perform that level of due diligence, so that gave the Commission a level of comfort.
There were three other key areas to consider:It is a fund for institutional clients only – the GFSC did not want retail clients in the fund, so we needed to put controls in place to ensure retail clients weren’t allowed in.Making sure of the valuation of the fund so the share price of the fund was robust.Custody of the fund – Fidelity Digital Assets, the custodian for the fund, is a big name in the investment world and is in a temporary permissions regime for crypto firms in the UK and fully regulated by the Department of Finance in New York.
So again, it was making sure we had the right firms, the right controls and the right processes in place. Those five areas were identified a very early stage, and because of that, they flowed right through the whole project, and sat in place in the final product.
ETF Potential
The potential of this type of ETF is huge. At the moment, Bitcoin, as with any crypto asset, is highly unregulated. So, we’ve created a regulatory product around that unregulated asset to give more certainty to institutional investors. For example, if you invest in Bitcoin directly yourself, you hold it in a wallet and you have a key;  if you lose that key, then you have lost your Bitcoin. Here, the onus for ensuring safe custody of that key is placed on Fidelity so it provides more certainty because the fund is backed by a quality custodian which is responsible for the safekeeping of those assets. The fund can also benefit from discounts in trading higher values of Bitcoin.
We are currently looking at a number of potential feeder ETFs or other vehicles in other jurisdictions to invest into this fund. This fund will not directly sell around the world. One of the areas we’re looking at is a South African Feeder ETF which will be listed on a number of African stock exchanges and made available to investors in those jurisdictions without us having to think about directly selling the Guernsey fund there. So it creates another layer effectively, allowing investments for more domiciles and  broadening the investor base of the funds.
Why Guernsey?
When this project came to me, it was new and exciting, which convinced me that this was one to work with. We discussed different domiciles at great length, and the recommendation to put it in Guernsey was driven by the desire for the island to maintain its place in the world, remaining at the forefront of innovation. It was felt that, given the connections we have here in Guernsey, we can talk to the regulator about making a modification to the rules and speak to government if there’s intervention necessary at that point. We were aware of the appetite within government for a cryptocurrency-type investment vehicle. Plus, we can achieve modifications to the rules that apply to our fund only. An open-ended Guernsey scheme like this normally requires a Guernsey custodian, but we received a derogation or modification allowing us to use a non-Guernsey custodian, Fidelity. The flexibility of Guernsey’s regulator lends itself to any sort of new product. Previously, it was private equity which became something Guernsey does as standard. Now, it’s areas like cryptocurrency that demonstrate innovation. We’re well aware that not every fund will get through the regulatory process, but for funds of the right quality with  the control framework being properly explained to the regulator, with early engagement, this is a case study to show we can do it.
We are already seeing people interested in establishing other crypto products in Guernsey;  not just those related to financial services but pure crypto structures. I don’t think we’ll necessarily see a deluge but we will see more interest because we know it can be done. That allows us to extend our financial services and other digital offerings beyond what we’ve done before into exciting new areas.
This article first appeared on IFC Review, 19 January 2022.

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