New financial technology regulation to bolster Bahrain's capital markets against cybersecurity breaches

In keeping with its aim to transform the kingdom into a regional hub for financial technology (fintech), the Central Bank of Bahrain (CBB) has undertaken several important regulatory reforms aimed at attracting new cryptocurrency and blockchain companies. Cryptocurrency development is expected to keep Bahrain at the forefront of regional fintech development; Bahrain was the first country in the Middle East to establish a central bank-licensed cryptocurrency exchange. However, concerns regarding consumer protection and safeguards – particularly in the wake of dozens of high-profile initial coin offering (ICO) scams reported between 2017 and 2019 – have somewhat dampened the outlook.

Competitive Advantage

According to Bloomberg, Bahrain’s bid to attract companies focused on blockchain technology and cryptocurrency trading “comes as the sector remains largely unlicensed and unregulated in major global financial hubs. This is forcing adopters to seek clarity from smaller jurisdictions that have been more open to regulating the market, such as Malta, Liechtenstein and Gibraltar”. In other words, the kingdom could gain a competitive advantage by becoming an early adopter of well-regulated cryptocurrency technology and exchanges. Opening a cryptocurrency exchange in Bahrain, particularly one offering over-the-counter settlement services enabling fiat withdrawals from cryptocurrency accounts, is expected to support the more widespread adoption of fintech and boost investment in fintech solutions.

Regulatory Sandbox

The CBB, which shares regulatory responsibilities for Bahrain’s capital markets with Bahrain Bourse (BHB), seeks to transform the kingdom into a regional conventional and sharia-compliant fintech hub. In October 2016 the central bank created the FinTech & Innovation Unit, which was tasked with establishing a fintech-supportive regulatory environment. This included the establishment of a regulatory sandbox programme, under which new and existing Bahraini companies are given up to two years to trial and test fintech solutions ranging from online payments to open banking systems (see Banking chapter). As of November 2019, 36 companies were approved by the CBB to participate in the regulatory sandbox, with Tarabut Gateway, a subsidiary of local digital infrastructure provider Almoayed Technologies, and Rain, a local sharia-compliant cryptocurrency exchange, having graduated beyond the testing phase.

Cryptocurrency Regulations

Formal regulations for cryptocurrency and blockchain companies were unveiled in February 2019. According to the Bahrain Economic Development Board (EDB), the central bank previously issued a consultation paper examining draft regulations for cryptocurrency platform operators. Days later the CBB issued the final rules on a range of activities relevant to cryptocurrency, with the creation of the crypto-assets module, under Volume 6 of the CBB Rulebook permitting cryptocurrency usage in the kingdom. The crypto-asset rules cover areas including licensing, governance, minimum capital requirements, control environment, risk management, anti-money-laundering/countering the financing of terrorism requirements, standards for conducting business, conflict of interest regulations, reporting rules and cybersecurity requirements.

However, most banks have not yet been convinced of the benefits of digital currencies and thus do not plan to issue their own digital currency any time soon, despite cryptocurrency and its supporting technology, blockchain, becoming increasingly popular in the Gulf region. Blockchain holds significant potential to make an impact on industries beyond the financial sector; its distributed ledger technology could be deployed in areas such as land registration and securities issuances. The International Data Corporation, a market intelligence company, forecast the total amount spent on blockchain technology by businesses globally will rise by 88.7% in 2019 to $2.9bn.

SprinkleXChange & Rain

One of the most important fintech developments in Bahrain is the initial public offering (IPO) platform SprinkleXchange, which offers companies the chance to list and trade using smart contracts transacted using blockchain technology. The platform, which uses the Ethereum blockchain for settlement and clearing, is expected to list up to 1000 IPOs by 2023, targeting companies with a market capitalisation of between $20m and $200m, as well as those with a global customer base and a blockchain-savvy investor base. According to Alexander Wallin, CEO of SprinkleXchange, companies from sectors including real estate, forestry and biotechnology have expressed interest in listing. As of late October 2019, however, no SprinkleXchange listings had yet been announced.

The new exchange has been marketed as a quicker and more efficient traditional stock market, offering automated central clearing systems, repositories, stock certificates, dividends and voting. Prices are set through a Dutch auction method, and the company charges a one-time flat fee of $19,000 for each listing, in addition to a monthly fee starting at $1000. A fee of 1% will be charged to on raised capital. As of mid-2019 the company was reportedly considering the establishment of exchange-traded funds to further boost growth and activity.

The other key fintech development in Bahrain, Rain, was the first project and graduate of the CBB’s regulatory sandbox programme. At the end of July 2019 Rain successfully closed a $2.5m round of venture capital funding backed by BitMEX, a major global cryptocurrency exchange incorporated in Seychelles. Speaking at the exchange’s launch that same month, Arthur Hayes, CEO and co-founder of BitMEX, said that Rain will bring greater diversification to markets in the Middle East. However, concerns regarding investor and consumer protection mechanisms are expected to impinge on the platform’s potential.

Stronger Regulation

Offered via ICOs, oftentimes without a corresponding product or service, new cryptocurrencies were extremely popular with digital investors in 2017 and 2018. According to a report published jointly by PwC and Switzerland’s Crypto Valley Association, the total volume of ICOs between January and May 2018 more than doubled the entire volume of ICOs in 2017, accounting for $13.7bn of investment over the five-month period.

In the early years the industry was almost completely unregulated, however, and scam ICOs became extremely prevalent. According to a July 2018 study prepared by ICO advisory firm Statis Group, up to 80% of the ICOs conducted in 2017 worth $1.3bn were later identified as scams. The vast majority of the $1.3bn was funnelled into three ICOs: Pincoin ($660m), Arisebank ($660m) and Savedroid ($50m).

Cryptocurrency theft also remains a significant risk, with US-based cybersecurity company Carbon Black reporting that $1.1bn of cryptocurrency was stolen during the first half of 2018 alone. Meanwhile, cryptocurrency intelligence firm CipherTrace estimates that cryptocurrency investors could lose as $4.3bn to theft and fraud over the course of 2019.

While SprinkleXchange and Rain are not specifically targeting ICOs and new currency issuance, Rain backer BitMEX has faced multiple accusations of financial misconduct from traders and investors. In July 2019 the US Commodity Futures Trading Commission launched a probe into BitMEX to determine whether it broke US law by allowing US traders onto its exchange platform. That month BitMEX recorded over $500m of capital outflows.

US regulators have increasingly cracked down on ICOs and cryptocurrency companies and exchanges, targeting those that sold what amounted to unregulated securities to investors without holding the broker-dealer licence required by the US Securities and Exchange Commission. This is one of the most significant challenges facing widespread cryptocurrency adoption, as US investors are essentially prohibited from participating in most ICOs.

Proceed with Caution

The CBB’s regulatory approach is expected to help keep Bahrain’s nascent crypto industry secure, with the bank’s crypto-asset rules addressing order matching, pre- and post-trade transparency, market manipulation and abuse, and conflicts of interest. The bank’s regulations also include requirements that ensure enhanced due diligence when onboarding clients, only encrypted safe custody accounts or wallets that can be retrieved are maintained, key-person risks are adequately managed and investors understand how to use safe custody wallets. These stringent rules offer a more positive outlook for cryptocurrency development and, if effective, could see the kingdom outpace regional competition to become a major global cryptocurrency centre and leader in fintech regulation.