International Financial Centres (IFCs) have spent decades adapting to constantly evolving regulatory standards. These efforts to appease regulators in order to maintain access to international capital markets have come at a significant cost, often reflected in higher compliance fees and enhanced due diligence requirements for the clients that continue to use certain IFCs.
In an era of ever-shifting goalposts, the wisdom and sustainability of a ‘comply at all costs’ culture is often questioned. Any argument, however, that a leading IFC can survive, let alone thrive, without abiding to internationally agreed standards and implementing any legislation necessary to allow law-abiding clients to continue using their structures, is deeply flawed.
Adapt and survive is now the new hymn sheet for leading Caribbean IFCs such as the Cayman Islands, Bermuda, the British Virgin Islands and The Bahamas. Since the OECD first coined the term ‘harmful tax competition’ in the late 1990s, these IFCs have been able to provide a measured response, continuously innovating and growing, while bearing the brunt of international criticism. It has proven a long game and one that we are still playing some 30 years later. The rules might not have changed but the stakes are higher. The pandemic has deeply impacted the tourist economies of Caribbean IFCs, leaving the financial sector to pick up the slack.
Cayman: Continued Growth
The fact that IFCs such as the Cayman Islands have continued to grow in the last three years despite the global pandemic is an impressive achievement. To do this while international politicians and regulatory authorities have ratcheted up the rhetoric and intensified the pressure on IFCs to such an extent is remarkable. The Cayman Islands Monetary Authority’s (CIMA) recent 2021 Year in Review outlined the healthy state of the jurisdiction’s investment funds sector, with 27,398 regulated funds on the books at the end of last year, compared with 24,591 the previous year[i].
Private equity funds have driven a considerable amount of this growth and as that asset class eclipses hedge funds by assets under management (AUM), powered by a post-pandemic surge in fundraising, Cayman remains the overwhelming domicile of choice for the world’s biggest private equity companies. The number of active Exempted Limited Partnerships (ELPs) - the favoured vehicle for a private equity fund - on the Cayman Islands General Registry in 2021 was a record 34,343. That was up 10 per cent on the previous year and is a number that has trebled over the last ten years as the private equity industry has exploded. Global private equity dry powder is at a record US$1.32 trillion[ii] and as the funds engage in more downstream M&A activity, local service providers support those activities as well.
It is sometimes argued that increased regulation will drive away clients, but the overall experience across the Caribbean has been largely positive, both with regard to updating legislation to meet international practice, or specific actions to correct deficiencies. In 2020 the Cayman Islands brought closed-ended private funds, including real estate, venture capital and infrastructure funds under the same regulatory scope as hedge funds had always been under, following major pressure from the European Union.
In addition to satisfying certain requirements, these funds now have to submit annual audited accounts that must be signed off by a local auditor. Although that change caused some initial concern from the industry regarding the increased regulatory requirements and compliance costs, the industry has continued to thrive. Having now been regulated for more than a year, private fund managers have by all accounts had a generally positive experience, with the compliance requirements not especially onerous in the context of their major international operations. The legislation was introduced to facilitate the removal of the Cayman Islands from the EU’s list of non-cooperative jurisdictions in February 2020. Technical issues relating to the timing of its legislation meant the Cayman Islands was not removed from the EU blacklist until November 2020, a development which was lauded by the government and the financial sector at the time. That joy has proven to be short lived, however, as European policymakers voted in new criteria by which to determine the listing and de-listing process, which leaves the Cayman Islands back on the EU AML list from March 2022 and a new round of uncertainty for the IFCs.
Meanwhile, the Cayman Islands remains on the FATF’s grey list of jurisdictions under increased monitoring and is in the progress of working to address the deficiencies in its AML/CTF regime. The focus of the FATF’s concern relating to the Cayman Islands is centered around enforcement, in particular effective sanctions where there is inadequate information on beneficial ownership and to demonstrate prosecutions and effective sanctions for all types of money laundering offences.
The jurisdiction remains confident that its policy of cooperation with the industry and negotiations with international officials will result in positive engagement with the FATF. It has been highlighted that in terms of the FATF’s Technical Compliance Standard, Cayman’s legislative amendments mean that it is compliant or largely compliant with all 40 of the FATF’s recommendations and that is something that only four G20 nations and two fellow IFCs can claim.
The Bermuda Experience
Bermuda’s interactions with EU authorities have gone a bit smoother, as the jurisdiction was recently rewarded for its legislative reforms and elevated to the EU’s whitelist. Further updates are in store as the jurisdiction looks to remain ahead of the regulatory curve. The changes enacted primarily related to how investment funds would sit within Bermuda’s economic substance legislation, with the government having also introduced measures to regulate private funds under its Investment Funds Act. Additionally, the territory has made further strides with its beneficial ownership (BO) register. Having been previously available to government authorities for several decades, the BO information will be publicly accessible from 2023. Further changes to investment funds regulation in Bermuda in 2022 are expected to focus on greater enforcement powers for the monetary authority, with a robust toolkit to respond to any matters of non-compliance. For the insurance sector, which has traditionally been Bermuda’s strongest suit, the regulator is gearing up to issue guidance for the integration of Environmental, Social, and Governance (ESG) considerations such as climate change risks, in terms of expectations for boards and risk management practices.
The Bermuda Monetary Authority (BMA) frames its supervisory activities as forward-looking regulation to seize on opportunities in the market, in line with its vision as an agile financial centre capable of capitalising on dislocation to create non-traditional solutions. As one of the first IFCs to develop a specific framework for initial coin offerings (ICOs) in 2018, Bermuda has since sharpened its focus on digital assets, along the lines of FinTech, Decentralised finance (Defi) and InsurTech. The BMA has said it will continue to adjust regulations to support prudent development in this sector.
The BVI, which also ascended to the EU whitelist in 2020, has since significantly enhanced its compliance framework from a Combatting the Financing of Terrorism (CFT) perspective with the Proliferation Financing (Prohibition) Act 2021. This updated previous legislation to meet global standards on proliferation and financing of weapons of mass destruction. Alongside additional updates on the Anti-Money Laundering (AML) side, the BVI Financial Services Commission has in the past year stepped up its evaluations of how licensees are implementing client and institutional risk assessments as well as training, with onsite and desk-based supervision. Just as Bermuda has made its name in insurance, the BVI has built up a strong reputation as a key domicile for start up managers, with its now well-established framework for Incubator Funds which can run for two years to allow managers to build a track record with less onerous regulatory requirements.
Stability In The Bahamas
In addition to updating regulations for corporate services providers and implementing the Digital Assets and Regulated Exchanges Act, the Bahamas introduced a more modern framework for its banking regulation, bringing resolution methods in line with international best practice for financial institutions going through stress with the potential to fail. This important development, which includes a prescribed recovery plan for troubled banks, has helped to increase confidence in the stability of the nation’s banking system.
With the growing competitive threat of midshore financial centres, particularly in Asia, new initiatives to further the development of Hong Kong and Singapore as financial centres aim to challenge the Caribbean’s IFCs historical dominance as a domicile for investment funds. Already major hubs for fund management, these alternative centres have introduced new laws that mimic successful fund vehicles, taking advantage of the regulatory tension and perceived weakness in the Caribbean. Hong Kong has introduced the limited partnership fund (LPF) regime in an attempt to attract private equity and venture capital funds to its shores.
Singapore’s Variable Capital Company (VCC) framework, meanwhile, is designed to provide a domestic alternative for the establishment of investment funds. The regulatory authority in Singapore is also giving managers a rebate on the fund set up costs for the first three years in a concerted effort to increase the attractiveness of the new regime. Traditionally, the inflexible domestic Singapore company had been far less efficient for funds. Now, over 300 VCCs have been set up in the first two years of the project, primarily from smaller regional managers consolidating operations in their own time zone.
Adapting To The Pressures
Rival financial centres are sharpening up their act as the regulatory pressure increases in the Caribbean. The impact of the EU’s latest move, which blocks European institutions and investors from Cayman Islands SPVs in securitisation transactions is one recent example. European deals that would otherwise be using Cayman vehicles are now being re-routed through other IFCs as a result. The European structured finance market is much smaller than the US, but the situation still serves to highlight the need for governments across the Caribbean’s IFCs to take all steps necessary to retain institutional business.
The goal posts have shifted again with more politically motivated action against IFCs, but we can continue to respond and address issues, with the focus also on beneficial ownership and economic substance, while embracing new opportunities in that area, along with FinTech and the digital currency space. Continued agility and regulatory integrity remain key to survival.
[ii] 2022 Preqin Global Private Equity Report
Paul Byles is Director of FTS, a Cayman Islands compliance and management consulting firm and founder of the Cayman Islands Financial Services Institute. He also serves as an independent director and consultant to financial services firms. He is an economist and former regulator who has worked in the offshore sector for over 25 years. He is author of the books ‘Inside Offshore’ and 'Introduction to Offshore Financial Services: A BVI text'.