Applying the Cayman approach to virtual currency: A disruptive opportunity waiting to happen

Stop me if you have already heard the story: A financial innovation comes to prominence offering opportunities to cut transactional friction, improve financial privacy, and empower users of the innovation to craft precisely the deals they wish. All, nonetheless, is not well with this beneficial innovation. Powerful national regulators are increasingly concerned with the possibility of its misuse. The media regularly cycles through exposé-style stories of bad actors, both real and imagined, who engage in money laundering and its underlying crimes, enabled by the apparent free-for-all nature of the innovation. Despite its beneficial uses, our financial innovation risks being smothered out of existence in well-intentioned efforts to curtail abuse.

Sound familiar? One could easily replace the term “financial innovation” with the names of numerous business and legal structures available through offshore financial centers. My tale, however, is not about OFCs; it is about Bitcoin. Or more accurately, the broader category known as virtual currency of which the Bitcoin protocol is both the origin and the most widely-known exemplar. As it happens, virtual currency technology and a properly positioned offshore financial center could have the collective ability to create positive disruption in the arena of digital payments, but the ability is one that neither possesses separately.

What are virtual currencies?

Virtual currency combines the virtue of being non-counterfeitable with the ability to be part of a transaction in the absence of a bank or other financial institution. Programming technology in the form of verifiable digital signatures existed well before Bitcoin’s creation in 2008, and these protocols have allowed for electronic exchanges of currency for decades.  These electronic exchanges of value, however, required the participation of a trusted third party – such as a bank or a payment card network – to manage the transactions. Only a trusted third party could prevent the double-spending problem, the ability of a digitally-signing party to spend the same money more than once. Any currency susceptible to such electronic counterfeiting would inevitably lose its value, just as easily-counterfeited paper currency would lose its value.

The United States Financial Crimes Enforcement Network (FinCEN) has defined “virtual currency” as: “a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency. In particular, virtual currency does not have legal tender status in any jurisdiction.” In its broadest sense, “virtual currency” can encompass a variety of stores of value, ranging from physical to digital in form and from centralized to decentralized in control structure. Virtual currencies exist in contrast to government-issued fiat currency like the United States dollar, the British pound, or the European Union’s euro. As its name implies, “fiat currency” derives its value by governmental fiat, a directive that the currency shall be legal tender within its issuing jurisdiction. Fiat currency does not have any intrinsic value based on the paper on which it is printed or in its digital representation in bank account; rather, the value of fiat currency is based on trust – faith in the creditworthiness and stability of the issuing entity.

Most virtual currencies are in a cryptographically-protected digital form (hence the frequent use of “cryptocurrency” as a synonym) and most are decentralized in control. Bitcoin is a paradigmatic virtual currency in that it is (1) digital, (2) largely decentralized, and (3) not backed by the fiat of any government issuer.

Bitcoin was a revolutionary virtual currency because its programming accomplished something never done before: eliminating the trusted third party in favor of a decentralized, peer-to-peer network, while maintaining a code infrastructure allowing it to be effectively resistant to both first-party fraud and third-party hackers. The core innovation of bitcoin enabling decentralized verification functionality is the blockchain. In simple terms, the blockchain is a transaction leger accompanying a virtual currency unit that, within an acceptably small margin of error, enables the peer-to-peer network to verify that a transaction transferring currency is legitimate (i.e., not a duplicate). Each transaction requires authorization by the owner’s private encrypted key, which then creates an entry on the public encrypted key for the virtual currency’s address and creates a new and unique programming block on the block chain whose authenticity is verifiable in the public leger. Crafting a blockchain of fake transfers that could withstand verification against the public leger would be, for all practical purposes, impossible. If blocks are not properly linked together in the blockchain, then the distributed software will recognize an attempted transaction as a fake. For present technical purposes, one may fairly assume that bitcoin and its progeny work. The blockchain technology behind bitcoin has spawned numerous competing virtual currencies and even attracted the interest of mainstream financial institutions for its use in non-currency applications.

The problem of disreputable use

Bitcoin as a functioning currency, as opposed to a hobbyist’s toy or speculator’s gamble, ultimately faces the same problem as did nascent payment systems before it ‒ the challenge of achieving a critical mass of marketplace acceptance. Notwithstanding the pronouncements of bitcoin enthusiasts, virtual currencies have not broken through to broad mainstream acceptance. Virtual currencies, not without reason, suffer from a reputational problem that hinders their marketplace acceptance and raises the possibility of them being regulated out of practical existence.

The problem for virtual currency, ironically enough, is that among digital forms of payment, it most effectively replicates cash. The features of cash that it replicates include those that have traditionally made cash attractive for criminal transactions. The passage of value in bitcoin’s payment process is virtually instantaneous and irreversible. While payment through bitcoin’s distributed leger system is not completely anonymous, it is certainly pseudonymous and does not leave behind the easily traceable digital vapor trail accompanying payments processed through the banking system.

The most infamous criminal use of bitcoin to date was the Silk Road digital marketplace.  Until the arrest of Silk Road founder Ross Ulbricht in October 2013, the site facilitated illegal drug transactions in the shady and less-readily accessible “dark web” corners of the internet. The cash-like qualities of bitcoin made it the currency of criminal’s choice on Silk Road. In May 2015, Ulbricht was sentenced to life in prison, and the bitcoins seized by federal authorities became subject to civil forfeiture. While endorsement by criminal elements is certainly welcome one, the fact of criminal attraction to bitcoin transactions is considerable evidence that cryptocurrency has succeeded as a payment system, albeit one that is requiring new creativity on the part of law enforcement. The ultimate story of Silk Road, after all, is one where law enforcement eventually prevailed over the criminal enterprise.

Yet the reputational problem remains. Merchants who could benefit from the availability of electronic payments, but without the transaction fees charged by the bank card networks and issuers, are declining the benefit. The perceived and unknown risk is so great that it offsets the mathematically certain benefits. The financial innovation of blockchain currency transactions is ultimately hindered by a missing piece. Virtual currency needs an effective regime of regulation and infrastructure. It needs a regime that allows for responsible policing of financial crimes, yet simultaneously protects the legitimate interests in financial privacy to attracted many people to blockchain spending in the first place.

Taking a Cayman approach

As it happens, the Cayman Islands have significant, and quite recent, experience in threading this needle. Faced with powerful but questionable demands from abroad that it establishes a publicly accessible registry of beneficial ownership, Cayman found a better way.
Beneficial ownership data would indeed be accessible via a centralized platform overseen by Cayman authorities, but it would not be public and thus uniformly abolish owners’ financial privacy without cause.

Law enforcement agencies of competent jurisdiction would have the right to request and obtain information from the registry through a designated Caymanian authority. In short, law enforcement will have the necessary tools to fight financial crime efficiently and effectively, but private finances are not opened to the public.

The balance is thoughtful, preserving the fundamental core of two legitimate but competing interests. How would Cayman’s approach to beneficial ownership translate into the virtual currency space? Quite well, actually, given the similarity of concerns between the two areas. Although a point of pride about bitcoin is its decentralization, virtual currency is technologically capable of being maintained in a central hub. Centralization – or more to the point, the right kind of centralization – could be the key to virtual currency meeting its full disruptive potential as a payment system.

Imagine, if you will, a centralized virtual currency not yet in existence. This virtual currency would have a proven and trustworthy jurisdiction to maintain a central digital clearinghouse of its transactional blockchain. Criminal enterprises could not create the next “Silk Road” using our new digital currency because, on a showing of need, law enforcement officials could trace a transaction, but only by going through authorities in the trusted jurisdiction. This feature could overcome the reputational problem that has hounded bitcoin. The payment data would not, like beneficial ownership data in the Cayman registry, be accessible to the public. Perhaps just as importantly for those motivated by financial privacy concerns, the payment data in the central clearing house would not be accessible to banks, payment card networks, or others with private interests in analyzing or monetizing the data.

The reputational problems of virtual currencies are variants of the problems faced by business finance vehicles that the Cayman Islands has been successfully overcoming by its firm but nimble approach to regulation. Creativity in the regulatory and governance sphere is precisely the missing ingredient that can enable virtual currency to live up to its disruptive but beneficial potential. Offshore financial centers like the Cayman Islands are well familiar with the concept of disruption, having been disruption agents themselves in the course of facilitating global finance solutions. Will some offshore jurisdiction seize the opportunity to empower needed law enforcement while simultaneously protecting financial privacy by adopting the Cayman Islands’ regulatory model in the virtual currency space? The time is ripe for a virtual currency tied to a private centralized clearing house of virtual currency transactions, where both the currency and its digital payments ledger are governed by a trusted global financial hub. No jurisdiction is better positioned to adopt a Cayman approach to virtual currency than Cayman itself. But if not the Cayman Islands, it seems only a matter of time before another creative jurisdiction steps into a leadership role in this space. Until then, let us, for convenience sake, call our imagined virtual currency Caymancoin.