## 1. Initial Issuance of 24 Million SOV, and Distribution of RMI’s 12 Million SOV

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---

### Background
- RMI uses the U.S. dollar as legal tender and currently does not have a monetary authority.
- The U.S. committed to providing annual grants averaging US$36 million over 2004-23 (approximately 20% of annual GDP) under the 2003 Compact Agreement.
- Correspondent banking relationships (CBRs) and local banks are needed for aid flows and salary remittances; remittances are primarily coursed through Western Union and Moneygram.
- Banking landscape:
  - Bank of the Marshall Islands (BOMI): domestic bank, five branches including Kwajalein Atoll.
  - First Hawaiian Bank (FHB), a subsidiary of BNP Paribas: BOMI’s only remaining U.S. CBR; in 2014 issued notice of CBR termination contingent on BOMI securing alternatives.
  - Bank of Guam (BoG): foreign-owned, one branch in Majuro; has American Bankers Association routing numbers and U.S. Federal Deposit Insurance Corporation deposit insurance.
- Trust Company of the Marshall Islands (TCMI):
  - more than 4,405 maritime vessels (161 million in gross tons) registered with TCMI as of June 2018.
  - TCMI has twenty-seven offices worldwide.
  - Under the 2017 appropriations act, $7.5 million (3.3% of GDP) from the ship registry was expected to be provided to the government budget in Fiscal Year 2018.
- Non-resident entity registrations have significantly increased since 2010 (previously reported as many as 30,000 non-resident entities).

### Trends and drivers of CBR pressures
- BNP Paribas sanctions context:
  - In June 2014, BNP Paribas was sanctioned with a record US$8.9 billion fine; settlement included a twenty-four month prohibition on U.S. dollar clearing services as a correspondent bank, covering subsidiaries including FHB.
  - BNP Paribas directed FHB to sever CBR ties with foreign banks, including BOMI; FHB notified BOMI of intent to terminate its CBR by end-2014 but was granted a temporary exemption conditioned on BOMI securing alternatives and submitting quarterly progress reports.
- AML/CFT weaknesses contributing to CBR pressures:
  - 2011 APG report found shortcomings in RMI’s AML/CFT framework and implementation, including inadequate offsite compliance monitoring and lack of onsite examinations.
  - Banking Commission cited unsatisfactory bank reporting, human resource constraints, and insufficient training.
  - Some private bank officials reported onsite examinations were not regularly performed (previous inspections were more than several years ago).
- Offshore registry vulnerabilities affecting reputation:
  - 2011 APG found non-resident company registry lacks accurate and current beneficial and legal ownership information; no mandatory requirement to provide such information during registration or to inform TCMI of ownership changes.
  - Non-resident companies permitted to issue bearer shares (resident domestic corporations prohibited).
  - RMI was included in the EU’s list of non-cooperative jurisdictions in taxation matters but removed in March 2018 after high level commitments.
  - Tax Justice Network identified RMI as one of the top secrecy jurisdictions and gave poor ratings on legal entity transparency criteria.
  - TCMI asserts timely responses to RMI authorities’ information requests, but quality/accuracy may be limited by absence of mandatory ownership information requirements.
  - Offshore registries contribute to reputation risk even if they have little to no relationship or transactions with domestic banks.

### Impact of CBR pressures
- Potential consequences if BOMI loses FHB CBR:
  - Severe diminishment of BOMI’s ability to serve clients due to lack of access to U.S. dollar clearing services.
  - Expected disruptions to payment flows related to grants under the 2003 Compact Agreement and other external aid.
  - Marshallese citizens working for the U.S. military and U.S.-based companies (especially in Kwajalein Atoll) would be particularly hard hit.
  - U.S.-based banks providing services to American personnel in Kwajalein Atoll are not permitted to bank Marshallese citizens owing to policy restrictions.
- Role of Bank of Guam (BoG):
  - BoG’s continuing access to the U.S. financial system could mitigate impact but not resolve all challenges.
  - Concentration of U.S. dollar cross-border payments into BoG poses challenges due to foreign ownership, headquarters business decisions, and lack of branches in other islands.
  - BoG has AML/CFT controls and electronic systems for detecting and filing suspicious transaction reports.
  - The potential issuance of the decentralized digital currency could increase the ML/TF risk profile and impact BoG’s headquarters’ risk assessment.
- Remittances:
  - BOMI provides Moneygram services without need for bank accounts; Western Union operates two branches in Majuro and Kwajalein Atoll.
  - Western Union applies company-wide AML/CFT controls.
  - Limited information prevents authorities from providing clear insights on CBR pressures’ impact on remittance flows.
  - Banking Commission is developing CBR forms to collect monthly volumes and values of funds sent and received.
  - Money transfer operators have not noticed significant changes in remittance volumes or values in recent months; remittance costs appear steady.
  - Except for Kwajalein Atoll salary recipients, projected impact of BOMI CBR termination on overall remittances remains unclear.

### Actions taken and recommended to address CBR pressures
- BOMI measures:
  - Consulting legal experts to establish a clearing house facility in Hawaii to obtain direct access to U.S. financial system for check-clearing and wire transfers; process expected to be lengthy given required approvals from U.S. authorities (e.g., U.S. Federal Reserve) and compliance needs.
  - Approached other U.S. banks for new CBRs; efforts unsuccessful so far due to concerns about risk management in RMI, costs, and profitability.
  - With technical support from FHB, BOMI is strengthening AML/CFT compliance: upgrading AML/CFT software, conducting independent audit of AML/CFT system, designating compliance officers, and providing staff training.
- RMI authorities’ measures:
  - With assistance from Financial Services Volunteer Corps, amended the Banking Act to strengthen AML/CFT supervision.
  - Developing manuals and procedures to enhance AML/CFT supervisory effectiveness.
  - Banking Commission conducting on-site AML/CFT examinations and providing support to BOMI for quarterly reporting to FHB and BNP Paribas; supervisory personnel have been added.
  - Exploring establishment of a Monetary Authority, though authorities recognize it may have limited impact on alleviating CBR pressures.
  - Amendments to the Associations Law require corporations issuing bearer shares to use all reasonable efforts to obtain and maintain beneficial owner information and to cancel bearer shares not complying within a prescribed 360-day phase-in period.
  - Engaged the World Bank to assist in conducting RMI’s first assessment of its money laundering and terrorist financing risks.
- Additional recommended steps (staff):
  - Once the national risk assessment is completed, develop an action plan to address identified risks.
  - Continue upgrading authorities’ capacity to conduct risk-based AML/CFT supervision, leveraging international technical assistance.
  - Impose AML/CFT obligations on offshore corporate and maritime registries.
  - Ensure implementation of requirements to increase transparency of beneficial ownership of legal persons, including existing legal persons and bearer shares issued prior to November 2017.
  - Ensure competent authorities have timely access to up-to-date beneficial ownership information of non-resident companies.

### The SOV — RMI’s decentralized digital currency: introduction and staff view
- Legislative action and issuance approach:
  - In February 2018, RMI Parliament passed the “Declaration and Issuance of the Sovereign Currency Act 2018” (the “SOV Act”).
  - The law lays the legal foundation for issuance of a digital decentralized currency, the Sovereign (SOV), based on blockchain technology and declared as legal tender in addition to the U.S. dollar.
  - The SOV will be issued by the Ministry of Finance and will be non-redeemable.
  - The SOV will be introduced via an initial coin offering (ICO) organized by an appointed foreign start-up with limited financial sector experience.
  - The law requires transparency over the identity of SOV users (encryption of identification information on the blockchain), but scope and practicalities remain to be established.
- Staff assessment:
  - At the time of drafting, a number of practical and legal questions about the SOV remained unanswered.
  - Staff concluded that, in the absence of clear mitigating measures, the macroeconomic and financial integrity risks associated with the SOV exceed the potential benefits.
  - Staff recommended that the authorities seriously reconsider issuance of the SOV.

### SOV design, issuance, institutional arrangements, and operational features
- Intended characteristics and legal status:
  - The SOV is intended to be a “digital decentralized currency” based on blockchain technology; the SOV Act does not define “digital decentralized currency.”
  - The SOV is intended to be denominated in its own units of account and transferred peer-to-peer, without intermediary.
  - The SOV is intended to be the RMI’s second legal tender alongside the U.S. dollar; the law declares the SOV legal tender for all debts, public charges, taxes and dues, and amends the General Fiscal Matters Act to reference the SOV alongside the U.S. dollar.
  - Section 251 of the Compact provides that instituting another currency requires terms of an appropriate currency transitional period as agreed with the U.S. Government; at drafting time, the U.S. Government had not taken a formal position on the SOV Act under the Compact.
  - The SOV is explicitly not equivalent to a central bank digital currency (CBDC).
- Initial issuance and distribution:
  - Fixed issuance at 24 million SOV units total.
  - Distribution: 12 million SOV units to RMI and 12 million SOV units to the appointed organizer.
  - During the ICO, the RMI will sell 6 million of their 12 million units.
  - RMI’s ICO proceeds (sale of 6 million SOV units) and RMI’s remaining SOV units (6 million SOV units) allocated to various RMI trust funds.
  - Each SOV unit divided by 100 sub-units.
- Supply growth rule and reserves:
  - Supply growth rule: 4 percent a year relative to the amount of SOV units in existence during the past year.
  - New SOV units may be distributed either pro-rata to all SOV owners on RMI Constitution Day at noon every year, or as mining fees to miners on the SOV blockchain.
  - The law allows for 2.4 million SOV units to be vested annually in the Resident-Citizen Allocation Fund, at a rate of 20 percent per year over 5 years.
- Oversight and governance:
  - RMI Cabinet approved the establishment of the Oversight Committee on March 5, 2018.
  - Oversight Committee composition: Chief Secretary (Chairperson), Secretary of Finance, Banking and Postal Services (Vice Chairperson), Attorney General or designee, Banking Commission (or designee) and a private sector representative.
  - Committee mandate includes oversight of issuance and trading, monitoring pre-ICO and ICO processes, acting as conduit between the appointed organizer and RMI Government, approving currency exchanges where the SOV will be traded, reporting suspicious transactions, and approving appointment of attorneys, “KYC firms,” audit firms, and other experts.
- Technology and privacy features:
  - Underlying technology being developed by the appointed organizer; work on the SOV protocol is ongoing with intention to develop a hybrid blockchain based on a permissioned protocol requiring users to authenticate a non-anonymous blockchain system.
  - All users of the SOV will be required to undergo standard know-your-customer (KYC) procedures and requirements as may be promulgated by the Banking Commissioner, and their identities encrypted on the blockchain.
  - Details of the mining process and technical design are still to be finalized; organizers are seeking financial support and legal advice on U.S. AML/CFT requirements.

### Potential benefits
- Primary stated purpose:
  - SOV issuance may enable the RMI to generate revenue gains to assist with fiscal adjustment in response to reduced Compact grants.
  - Authorities intend that SOV’s legal tender status will bolster confidence and demand for the SOV, increasing its value and providing a revenue source to finance expenditures including social expenditures and RMI’s response to climate change.
- Other theoretical benefits:
  - Greater speed and efficiency in making payments and transfers, particularly across borders (e.g., remittance flows).

### Potential risks and challenges
- AML/CFT and financial integrity risks:
  - Virtual currencies/crypto assets raise risks of misuse for money laundering (ML), terrorist financing (TF), and other illegal activities.
  - The SOV Act was adopted without prior assessment of potential financial integrity risks; under the AML/CFT standard, countries should identify, assess and mitigate ML/TF risks.
  - Unless strong AML/CFT measures are implemented, issuance of the SOV will expose RMI’s financial system and economy to potentially significant ML and TF risks and elevate the already high risks of losing the last U.S. dollar CBR.
- Regulatory and oversight gaps:
  - Absence of a common global regulatory approach leaves SOV exposed to significant regulatory arbitrage.
  - Authorities intend the SOV to be traded on pre-approved exchange platforms only; it is unclear what conditions for authorization will be and how RMI authorities will ensure approved foreign exchange platforms are duly regulated and supervised for AML/CFT purposes.
  - It is unclear who will perform customer due diligence, how beneficial owners will be identified, whether miners will be included, and how encryption and access to identity information will be controlled.
  - Monitoring and enforcement modalities of the Oversight Committee are still to be established and unclear how they would apply outside exchange platforms (e.g., mining).
- Macroeconomic, monetary, and fiscal risks:
  - SOV may not fulfill all functions of money; limited telecommunication infrastructure will likely hinder SOV becoming a widely-used medium of exchange.
  - SOV could pose significant monetary and financial stability risks given legal tender status and potential for large exchange rate volatility.
  - No current exchange rate policy or policy mechanism to ensure convertibility of SOV to other currencies.
  - Currency mismatch and liquidity risks could affect government, banks, households and firms with SOV exposure.
  - Fiscal and monetary implications of vesting to Resident-Citizen Allocation Fund:
    - Example calculation from staff: 20 percent of 2.4 million SOV is 0.48 million SOV units, which at $50 each would amount to $24 million, or roughly 11 percent of 2018 GDP.
    - A high SOV price would boost potential revenue gains but imply greater monetary instability risk; transfers of purchasing power could require sizable reductions in other government spending to prevent unsustainable aggregate demand increases.
- Operational, governance, cybersecurity, and legal risks:
  - Issuance and initial management delegated to a third party which will receive half of the initial SOV issuance, creating potential conflict of interest and outsourcing risks.
  - Cybersecurity and protocol control risks exist; development and maintenance of the SOV protocol have been entirely delegated to the appointed organizer; authorities have no control over the protocol or its development.
  - Little consideration given to legal consequences of a potential breach of the protocol or rights of recourse if SOVs are stolen prior to distribution.
  - Reputational risk to the RMI and potential adverse effects on the ease with which financial intermediaries operate in the RMI.

### Key numerical and date-specific items (preserved exactly)
- Fixed issuance at 24 million SOV units total.
- Distribution: 12 million SOV units to RMI and 12 million SOV units to the appointed organizer.
- During the ICO, the RMI will sell 6 million of their 12 million units.
- RMI’s ICO proceeds (sale of 6 million SOV units) and RMI’s remaining SOV units (6 million SOV units) allocated to various RMI trust funds.
- Each SOV unit divided by 100 sub-units.
- Supply growth rule: 4 percent a year relative to the amount of SOV units in existence during the past year.
- RMI Cabinet approved the establishment of the Oversight Committee on March 5, 2018.
- Compact entry year: 1986; renewal year: 2003; anticipated reduction of U.S. Compact grants after 2023.

### Conclusion and staff recommendation
- Staff recommends the authorities seriously reconsider issuance of the SOV as legal tender.
- Key summary points motivating the recommendation:
  - Absence of a common global regulatory approach leaves SOV exposed to significant regulatory arbitrage.
  - Unless strong AML/CFT measures are implemented, issuance of the SOV will expose RMI’s financial system and economy to potentially significant ML and TF risks and elevate the already high risks of losing the last U.S. dollar CBR.
  - Issuance in the absence of a monetary policy framework could pose significant macroeconomic management challenges.
  - Limited capacity and infrastructure within the RMI could be a practical obstacle to SOV success.
  - Potential benefits from revenue gains appear considerably smaller than potential costs from economic, AML/CFT, reputational, governance and legal risks.

*International Monetary Fund staff report (August 10, 2018).*

### 1. Initial Issuance of 24 Million SOV, and Distribution of RMI’s 12 Million SOV _______ 11

### 1. Initial Issuance of 24 Million SOV, and Distribution of RMI’s 12 Million SOV _______ 11

### A. Background
- RMI uses the U.S. dollar as legal tender and currently does not have a monetary authority.
- The U.S. committed to providing annual grants averaging US$36 million over 2004-23 (approximately 20% of annual GDP) under the 2003 Compact Agreement.
- Correspondent banking relationships (CBRs) and local banks are needed for aid flows and salary remittances from U.S. employers; remittances are primarily coursed through Western Union and Moneygram.
- Banking landscape:
  - Bank of the Marshall Islands (BOMI): domestic bank, five branches including Kwajalein Atoll; provides banking services to a substantial portion of the population.
  - First Hawaiian Bank (FHB), a subsidiary of BNP Paribas: BOMI’s only remaining U.S. CBR; in 2014 issued notice of CBR termination contingent on BOMI securing alternatives.
  - Bank of Guam (BoG): foreign-owned, one branch in Majuro; has American Bankers Association routing numbers and U.S. Federal Deposit Insurance Corporation deposit insurance.
- Trust Company of the Marshall Islands (TCMI) administers offshore corporate and maritime registries under a 1990 joint venture; as of June 2018:
  - more than 4,405 maritime vessels (161 million in gross tons) are registered with TCMI.
  - TCMI has twenty-seven offices worldwide.
  - Under the 2017 appropriations act, $7.5 million (3.3% of GDP) from the ship registry was expected to be provided to the government budget in Fiscal Year 2018.
- Non-resident entity registrations: previously reported as many as 30,000 non-resident entities registered with TCMI in 2010; registrations have significantly increased since then.

### B. Trends and Drivers of CBR Pressures
- FHB/BNP Paribas sanctions context:
  - In June 2014, BNP Paribas was sanctioned with a record US$8.9 billion fine; settlement included a twenty-four month prohibition on U.S. dollar clearing services as a correspondent bank, covering subsidiaries including FHB.
  - BNP Paribas directed FHB to sever CBR ties with foreign banks, including BOMI; FHB notified BOMI of intent to terminate its CBR by end-2014 but was granted a temporary exemption conditioned on BOMI securing alternatives and submitting quarterly progress reports.
- AML/CFT weaknesses contributing to CBR pressures:
  - 2011 APG report found shortcomings in RMI’s AML/CFT framework and implementation, including inadequate offsite compliance monitoring and lack of onsite examinations.
  - Banking Commission cited unsatisfactory bank reporting, human resource constraints, and insufficient training as contributors to ineffective AML/CFT supervision.
  - Some private bank officials reported onsite examinations were not regularly performed (previous inspections were more than several years ago).
- Offshore registry vulnerabilities affecting reputation:
  - 2011 APG found non-resident company registry lacks accurate and current beneficial and legal ownership information; no mandatory requirement to provide such information during registration or to inform TCMI of ownership changes.
  - Non-resident companies permitted to issue bearer shares (resident domestic corporations prohibited).
  - RMI was included in the EU’s list of non-cooperative jurisdictions in taxation matters but removed in March 2018 after high level commitments.
  - Tax Justice Network identified RMI as one of the top secrecy jurisdictions and gave poor ratings on legal entity transparency criteria.
  - TCMI asserts timely responses to RMI authorities’ information requests, but quality/accuracy may be limited by absence of mandatory ownership information requirements.
  - Offshore registries contribute to reputation risk even if they have little to no relationship or transactions with domestic banks.

### C. Impact of CBR Pressures
- Potential consequences if BOMI loses FHB CBR:
  - Severe diminishment of BOMI’s ability to serve clients due to lack of access to U.S. dollar clearing services.
  - Expected disruptions to payment flows related to grants under the 2003 Compact Agreement and other external aid.
  - Marshallese citizens working for the U.S. military and U.S.-based companies (especially in Kwajalein Atoll) would be particularly hard hit; their salaries are ordinarily encashed or deposited with the BOMI branch in Kwajalein Atoll.
  - U.S.-based banks providing services to American personnel in Kwajalein Atoll are not permitted to bank Marshallese citizens owing to policy restrictions.
- Role of Bank of Guam (BoG):
  - BoG’s continuing access to the U.S. financial system could mitigate impact but not resolve all challenges.
  - BoG is monitored and regulated by several U.S. agencies; its direct U.S. system access is less at risk.
  - Concentration of U.S. dollar cross-border payments into BoG poses challenges due to foreign ownership, headquarters business decisions, and lack of branches in other islands (e.g., Kwajalein Atoll).
  - BoG has AML/CFT controls and electronic systems for detecting and filing suspicious transaction reports.
  - The potential issuance of the decentralized digital currency could increase the ML/TF risk profile and impact BoG’s headquarters’ risk assessment.
- Remittances:
  - BOMI provides Moneygram services without need for bank accounts; Western Union operates two branches in Majuro and Kwajalein Atoll.
  - Western Union applies company-wide AML/CFT controls.
  - Limited information prevents authorities from providing clear insights on CBR pressures’ impact on remittance flows.
  - The Banking Commission is developing CBR forms for banks and money transfer operators to collect monthly volumes and values of funds sent and received.
  - Money transfer operators have not noticed significant changes in remittance volumes or values in recent months; remittance costs appear steady.
  - Except for Kwajalein Atoll salary recipients, projected impact of BOMI CBR termination on overall remittances remains unclear.

### D. Actions to Address CBR Pressures
- BOMI measures and efforts:
  - Consulting legal experts to establish a clearing house facility in Hawaii to obtain direct access to U.S. financial system for check-clearing and wire transfers; process expected to be lengthy given required approvals from U.S. authorities (e.g., U.S. Federal Reserve) and compliance needs.
  - Approached other U.S. banks for new CBRs; efforts unsuccessful so far due to concerns about risk management in RMI, costs, and profitability.
  - With technical support from FHB, BOMI is strengthening AML/CFT compliance: upgrading AML/CFT software, conducting independent audit of AML/CFT system, designating compliance officers, and providing staff training.
- RMI authorities’ measures:
  - With assistance from Financial Services Volunteer Corps, amended the Banking Act to strengthen AML/CFT supervision (e.g., supervisory coverage of other financial institutions and designated non-financial businesses and professions).
  - Developing manuals and procedures to enhance AML/CFT supervisory effectiveness.
  - Banking Commission conducting on-site AML/CFT examinations and providing support to BOMI for quarterly reporting to FHB and BNP Paribas; supervisory personnel have been added.
  - Exploring establishment of a Monetary Authority, though authorities recognize it may have limited impact on alleviating CBR pressures given potential legal/operational constraints and risk exposure of a monetary account abroad (e.g., Federal Reserve Bank of New York).
  - Amendments to the Associations Law require corporations issuing bearer shares to use all reasonable efforts to obtain and maintain beneficial owner information and to cancel bearer shares not complying within a prescribed 360-day phase-in period.
  - Engaged the World Bank to assist in conducting RMI’s first assessment of its money laundering and terrorist financing risks, involving relevant public agencies and private stakeholders.
- Additional recommended steps (staff):
  - Once the national risk assessment is completed, develop an action plan to address identified risks.
  - Continue upgrading authorities’ capacity to conduct risk-based AML/CFT supervision, leveraging international technical assistance.
  - Impose AML/CFT obligations on offshore corporate and maritime registries.
  - Ensure implementation of requirements to increase transparency of beneficial ownership of legal persons, including existing legal persons and bearer shares issued prior to November 2017.
  - Ensure competent authorities have timely access to up-to-date beneficial ownership information of non-resident companies.

### The SOV—RMI’s Decentralized Digital Currency: Introduction and Staff View
- Legislative action:
  - In February 2018, RMI Parliament passed the “Declaration and Issuance of the Sovereign Currency Act 2018” (the “SOV Act”).
  - The law lays the legal foundation for issuance of a digital decentralized currency, the Sovereign (SOV), based on blockchain technology and declared as legal tender in addition to the U.S. dollar.
  - The SOV will be issued by the Ministry of Finance and will be non-redeemable.
  - The SOV will be introduced via an initial coin offering (ICO) organized by an appointed foreign start-up with limited financial sector experience.
  - The law requires transparency over the identity of SOV users (encryption of identification information on the blockchain), but scope and practicalities remain to be established.
- Staff assessment:
  - At the time of drafting, a number of practical and legal questions about the SOV remained unanswered.
  - Staff concluded that, in the absence of clear mitigating measures, the macroeconomic and financial integrity risks associated with the SOV exceed the potential benefits.
  - Staff recommended that the authorities seriously reconsider issuance of the SOV.

*Source: International Monetary Fund staff report (August 10, 2018).*

### 2.      The main purpose of the SOV’s introduction is to generate revenue gains for the

### cr18271 - 2.      The main purpose of the SOV’s introduction is to generate revenue gains for the

### Background and context
- The RMI is a small island country, heavily reliant on external aid, mainly from the U.S., facing risks from natural disasters and climate change, and does not have a central bank to set monetary policy.
- The authorities envisaged that revenue gains from the issuance of the SOV will assist with the anticipated reduction of U.S. Compact grants after 2023.
- The concept of legal tender can vary across jurisdictions; the SOV’s legal tender designation within the RMI is central to the expected revenue generation.
- RMI entered its “Compact of Free Association” with the US in 1986; the Compact was renewed in 2003, and Compact financial provisions are expected to expire in 2023 with the Compact Trust Fund (CTF) created to contribute to long-term budgetary self-reliance.

### SOV design, issuance, and institutional arrangements
- The SOV is intended to be a “digital decentralized currency” based on blockchain technology; the SOV Act does not define “digital decentralized currency.”
- The SOV is intended to be denominated in its own units of account and transferred peer-to-peer, without intermediary.
- The SOV is intended to be the RMI’s second legal tender alongside the U.S. dollar; the law declares the SOV legal tender for all debts, public charges, taxes and dues, and amends the General Fiscal Matters Act to reference the SOV alongside the U.S. dollar.
- Section 251 of the Compact provides that instituting another currency requires terms of an appropriate currency transitional period as agreed with the U.S. Government; at drafting time, the U.S. Government had not taken a formal position on the SOV Act under the Compact.
- The SOV is explicitly not equivalent to a central bank digital currency (CBDC) because:
  - it may not fulfill the functions of money,
  - it will not be a central bank liability, and
  - there is no policy to ensure that the SOV is convertible at par for USD by the RMI authorities.
- Initial issuance and distribution:
  - Total units at issuance fixed at 24 million units, to be distributed equally between the RMI and the appointed organizer (12 million units each).
  - The SOV is to be issued by the Ministry of Finance and introduced via an initial coin offering (ICO), performed by the appointed organizer.
  - Prior to the ICO, the RMI will maintain 12 million SOV units, and 12 million SOV units will be for benefit of the appointed organizer.
  - During the ICO, the RMI will sell 6 million of their 12 million units.
  - RMI’s ICO proceeds (sale of 6 million SOV units) and RMI’s remaining SOV units (6 million SOV units) will be allocated to various RMI trust funds.
  - Each SOV unit will be divided by 100 sub-units.
- Supply growth rule:
  - According to the law, the supply of SOV units will grow at 4 percent a year relative to the amount of SOV units in existence during the past year.
  - New SOV units may be distributed either pro-rata to all SOV owners on RMI Constitution Day at noon every year, or as mining fees to miners on the SOV blockchain.
- Operational and oversight arrangements:
  - An Oversight Committee was established (RMI Cabinet approved on March 5, 2018) comprising the Chief Secretary (Chairperson), Secretary of Finance, Banking and Postal Services (Vice Chairperson), Attorney General or designee, Banking Commission (or designee) and a private sector representative.
  - The Committee’s mandate includes overall oversight of issuance and trading of the SOV; monitoring pre-initial ICO and ICO processes; acting as conduit between the appointed organizer and RMI Government; approving currency exchanges where the SOV will be traded; reporting suspicious transactions; and approving appointment of attorneys, “KYC firms,” audit firms, and other experts.
- Technology and privacy features:
  - The underlying technology is being developed by the appointed organizer; work on the SOV protocol is ongoing with an intention to develop a hybrid blockchain based on a permissioned protocol requiring users to authenticate a non-anonymous blockchain system.
  - All users of the SOV will be required to undergo standard know-your-customer (KYC) procedures and requirements as may be promulgated by the Banking Commissioner, and their identities encrypted on the blockchain, with the stated purpose of ensuring greater transparency than other virtual currencies/crypto assets.
  - Details of the mining process and technical design are still to be finalized; organizers are seeking financial support and legal advice on U.S. AML/CFT requirements.

### Potential benefits
- Primary stated purpose:
  - SOV issuance may enable the RMI to generate revenue gains to assist with fiscal adjustment in response to reduced Compact grants.
  - Authorities intend that SOV’s legal tender status will bolster confidence and demand for the SOV, increasing its value and providing a revenue source to finance expenditures including social expenditures and RMI’s response to climate change.
- Other theoretical benefits (depending on final configuration):
  - Greater speed and efficiency in making payments and transfers, particularly across borders (e.g., remittance flows).

### Potential risks and challenges
- Novel regulatory and monetary territory:
  - The SOV Act was passed at a time when there is little certainty regarding the best regulatory approach to virtual currencies/crypto assets; regulatory challenges are heightened by the novelty and rapid evolution of virtual currencies/crypto assets and the lack of global consensus.
  - The SOV places the RMI at the frontier of crypto assets as legal tender; monetary issues under a dual currency system are likely to be challenging in the medium term.
- Preconditions noted by authorities:
  - The authorities stated the SOV would only be issued once the planned issuance and use are deemed to comply with the FATF standard and U.S. regulations and once its use in transactions in the U.S. financial system has been approved by the U.S. government; they expected it would take few years to issue the SOV.
- Financial integrity risks:
  - Virtual currencies/crypto assets raise risks of misuse for money laundering (ML), terrorist financing (TF), and other illegal activities, due in part to varying degrees of anonymity, decentralization, global reach, speed, segmentation of services, and potential absence of regulated intermediaries.
  - The SOV Act was adopted without prior assessment of potential financial integrity risks; under the AML/CFT standard, countries should identify, assess and mitigate ML/TF risks, including those from new products, business practices, delivery mechanisms, and technologies.
  - Without effective AML/CFT measures, virtual currencies/crypto assets pose a threat to the integrity of domestic and international financial systems.
  - The range and level of risks vary greatly depending on intrinsic characteristics of the crypto asset, operating model, and country context.
- Lack of common regulatory approach:
  - There is currently no common approach to AML/CFT regulation and risk mitigation for virtual currencies/crypto assets; FATF guidance and work have sought consistent safeguards, but country responses vary widely, including prohibitions, application of existing AML/CFT laws, reporting requirements, and ongoing law/regulation development.
- Operational readiness and oversight limits:
  - Details of key operational elements (mining process, protocol features, interface with traditional financial system) remain under development and dependent on external financing and expertise.
  - The SOV’s effectiveness in fulfilling the functions of money, convertibility relative to USD, and implications under the Compact remain unresolved.

### Key numerical and date-specific items (preserved exactly)
- Fixed issuance at 24 million SOV units total.
- Distribution: 12 million SOV units to RMI and 12 million SOV units to the appointed organizer.
- During the ICO, the RMI will sell 6 million of their 12 million units.
- RMI’s ICO proceeds (sale of 6 million SOV units) and RMI’s remaining SOV units (6 million SOV units) allocated to various RMI trust funds.
- Each SOV unit divided by 100 sub-units.
- Supply growth rule: 4 percent a year relative to the amount of SOV units in existence during the past year.
- RMI Cabinet approved the establishment of the Oversight Committee on March 5, 2018.
- Compact entry year: 1986; renewal year: 2003; anticipated reduction of U.S. Compact grants after 2023.

*Source: cr18271.*

### 22.      This entails that the use of the SOV is likely to be exposed to very different regulatory

### 22.      This entails that the use of the SOV is likely to be exposed to very different regulatory

### AML/CFT risks and planned transparency
- Absence of a common approach to AML/CFT regulation of virtual currencies/crypto assets creates two main concerns for the RMI:
  - No defined standard or best practices to guide mitigation of potential AML/CFT risks of the SOV.
  - Ensuring appropriate AML/CFT measures are applied to trading of the SOV abroad will likely be challenging regardless of domestic regulatory approach.
- Authorities intend the SOV to be traded on pre-approved exchange platforms only; the Oversight Committee is tasked with the approval process, but:
  - It is unclear what conditions for authorization will be.
  - It is unclear how RMI authorities will ensure approved foreign exchange platforms are duly regulated and supervised for AML/CFT purposes.
  - It is unclear how mining activities abroad will be addressed.

### Key unanswered questions about transparency and customer due diligence
- Who are the “users” of the SOV subject to identification?
  - The law refers to but does not define “users.”
  - Based on discussions, “user” appears generally understood to capture the persons behind the sender’s private key but this remains to be confirmed.
  - No consideration seems to have been given to beneficial owners of SOVs, and it is unclear whether miners will be included.
- Who is expected to perform the customer due diligence?
  - The SOV Act does not specify who should undertake customer due diligence.
  - The SOV Act provides that “digital currency exchanges in the RMI shall be regulated by the responsible government entity to ensure that they are licensed and regulated consistent with anti-money laundering requirements under the Banking Act.”
  - Discussions indicated a single foreign private sector firm may be tasked with identification of users; it is unclear whether this applies to all purchasers or only those using RMI domestic exchange platforms.
  - It is unclear how trading of SOVs abroad will be subject to adequate AML/CFT measures, including effective supervision or monitoring, and how unauthorized platforms will be prevented.
  - It is unclear how customer due diligence requirements will apply in the context of SOV mining, and who will encrypt information on the blockchain (e.g., the third party “identifier” or digital currency exchangers or individual users).
- What will be the exact scope and modalities of the customer due diligence requirements?
  - The SOV protocol is said to provide transparency regarding the name of the users and the source of their funds, but only the first element appears to be considered at drafting.
  - Pursuant to the SOV Act, the AML provisions in the Banking Act will apply to the ICO process and to the trading, conversion or transfer of the SOV in the RMI. These include customer due diligence requirements for financial institutions and cash dealers, and reporting and record keeping requirements that are only broadly in line with the FATF standard.
  - Representatives of the appointed organizer indicated identification by governmental ID documents, proof of residency and possibly a fingerprint biometric marker (which is not currently envisaged in the Banking Act).
  - Once information is encrypted, it is not clear whether and how changes in the identified person’s risk profile will be taken into account.
- What level of transparency will the blockchain provide?
  - The SOV Act provides that the users’ “identities will be encrypted on the blockchain.”
  - Discussions indicate this is still under consideration: some say the receiver will see identity information of the last two senders; others say broader information will be visible to all.
  - Intention seems to be that all identification information will be accessible to authorities including law enforcement under certain conditions that are still to be determined.
- Who will be responsible for encryption on the blockchain?
  - The assumption so far is encryption will be incumbent upon the appointed organizer at issuance, and possibly of the exchangers thereafter, but this remains to be confirmed.
  - It is unclear whether any identification information will need to be encrypted during the mining process.

### Oversight, monitoring, and implementation gaps
- Answers to the above questions and the level of implementation of transparency requirements will determine whether planned transparency deters criminal misuse.
- RMI authorities will have limited controls over implementation abroad; transparency alone may be insufficient.
- Monitoring and enforcement are unclear:
  - The SOV Act indicates the “Legal Tender Committee shall ensure [the] KYC process and requirements are effectively applied at the ICO process.”
  - The recently established Oversight Committee appears to have overtaken that role with a broader mandate to oversee issuance and trading of the SOV and to report suspicious transactions.
  - Modalities of Oversight Committee oversight are still to be established and unclear how they would apply outside exchange platforms (e.g., mining).
- Most SOV trading is anticipated to take place abroad, potentially exposing the SOV to significant regulatory arbitrage.

### Effectiveness of RMI AML/CFT framework and assessments
- RMI’s last AML/CFT assessment was conducted in late 2010; the assessment report was adopted in July 2011.
- The 2011 assessment: RMI had reasonably sound AML/CFT measures but some technical and implementation deficiencies remained.
- The next assessment is tentatively scheduled for October 2020, and will establish the extent to which the RMI is effective in addressing ML/TF risks.
  - High effectiveness ratings require adequate proof that the AML/CFT framework is being applied and achieving eleven predetermined outcomes set in the assessment methodology.
  - Outcomes include elements beyond customer due diligence and suspicious transaction reporting, such as availability of beneficial ownership information and effective investigation and prosecution of ML offenses.
- For the SOV, RMI should be attuned to risks to its domestic financial system from SOV use and trading abroad and be able to show adequate mitigation.

### Risks to U.S. Compact Bilateral Relations (CBR)
- Enactment of the law has increased pressure on the RMI’s remaining U.S. CBR.
- While the CBR currently remains in place, it is not clear this will be the case once the SOV is issued.

### Challenges to macroeconomic management and monetary stability
- The SOV may not fulfill all functions of money (medium of exchange, store of value, unit of account).
- Specific constraints:
  - Limited telecommunication infrastructure will likely hinder SOV becoming a widely-used medium of exchange.
  - Use as a store of value depends on stability; elevated exchange rate volatility reduces attractiveness.
  - There does not appear to be an intention to price goods and services in SOV, or to use SOV as a unit of account in RMI.
- SOV could pose significant monetary and financial stability risks given legal tender status and potential for large exchange rate volatility:
  - Strong SOV appreciation (depreciation) would increase (lower) wealth and purchasing power of SOV holders, affecting demand for goods and assets with potentially large consequences for inflation and asset prices.
  - Instability is most relevant for residents who can easily buy goods or other assets locally.
  - Expenditure of foreign-held SOV within RMI could pose additional inflation and asset price risks depending on convertibility and capital flow regime.
- No current exchange rate policy or policy mechanism to ensure convertibility of SOV to other currencies.
  - If SOV is not easily convertible, foreigners may be encouraged to spend SOV within the RMI.
- Currency mismatch and liquidity risks:
  - SOV volatility would affect balance sheets of government, banks, households and firms with SOV exposure.
  - Example: government tax revenue received in SOV that subsequently depreciates would reduce USD value of government revenue.
  - Example: bank receiving debt servicing payments in SOV that subsequently depreciates would reduce net value of bank assets.
  - Any agent receiving SOV payments against USD denominated liabilities faces currency mismatch risk.
  - Government and local bank could face U.S. dollar liquidity risks under currency convertibility if SOV used to settle debts and taxes.
  - Currency mismatch and liquidity risks could be offset to the extent agents can both receive and make payments in SOV.
  - Practical barriers may exist to making government payments in SOV (infrastructure limitations).
- Uncertainty about monetary policy framework:
  - The SOV Act stipulates a 4 percent annual growth rule of SOV supply intended to stabilize SOV value and achieve monetary stability.
  - Implementing a 4 percent growth rule may increase SOV supply without regard to RMI economic conditions at any time.
  - Authorities noted the appointed organizer will develop a separate stability mechanism to automatically adjust SOV supply to prevent excessive price volatilities.
- Fiscal and monetary implications of vesting to Resident-Citizen Allocation Fund:
  - The law allows for 2.4 million SOV units to be vested annually in the Resident-Citizen Allocation Fund, at a rate of 20 percent per year over 5 years.
  - If vested SOV were distributed immediately upon vesting, this could represent a sizable monetary expansion akin to “helicopter money” depending on the SOV exchange rate.
  - Example calculation from staff: 20 percent of 2.4 million SOV is 0.48 million SOV units, which at $50 each would amount to $24 million, or roughly 11 percent of 2018 GDP.
  - A high SOV price would boost potential revenue gains but imply greater monetary instability risk; transfers of purchasing power could require sizable reductions in other government spending to prevent unsustainable aggregate demand increases.
  - If SOV price is low, or SOV retained in trust funds, impact on monetary conditions could be more limited.
  - Staff’s current understanding is that government taxes, fees and charges would continue to be denominated in U.S. dollars.

### Other risks and operational challenges
- Third-party dependencies and governance:
  - Issuance and initial management of the SOV will be delegated to a third party which will receive half of the initial SOV issuance.
  - Dual role of issuer and private investor may create appearance of conflict of interest that a central bank would not have.
  - Arrangement creates risk of outsourcing core functions such as monetary policy.
- Cybersecurity and protocol control:
  - SOV would face cyber risks that do not appear to be mitigated.
  - Development and future maintenance of the SOV protocol have been entirely delegated to the appointed organizer; authorities have no control over the protocol or its development and no means to ensure it is safe.
  - Ensuring security of the protocol is crucial given legal status and allocation of half of initial issuance to RMI population.
- Legal consequences and clarity:
  - Little consideration given to legal consequences of a potential breach of the protocol.
  - Unclear whether RMI population will have a right of recourse if SOVs are stolen prior to distribution.
  - Little consideration given to other aspects such as whether SOV will be available for loan transactions.
- Reputational risk:
  - Issuance presents reputational risk to the RMI.
  - Intention is to have a first-mover advantage, but no guarantee first-mover advantage would accrue as other virtual currencies develop.
  - Risks could affect RMI’s reputation for a sound regulatory environment and the ease with which financial intermediaries operate in the RMI.

### Conclusion and staff recommendation
- Considering significant risks and challenges, staff recommends the authorities seriously reconsider issuance of the SOV as legal tender.
- Key summary points motivating the recommendation:
  - Absence of a common global regulatory approach leaves SOV exposed to significant regulatory arbitrage.
  - Unless strong AML/CFT measures are implemented, issuance of the SOV will expose RMI’s financial system and economy to potentially significant ML and TF risks and elevate the already high risks of losing the last U.S. dollar CBR.
  - Issuance in the absence of a monetary policy framework could pose significant macroeconomic management challenges.
  - Limited capacity and infrastructure within the RMI could be a practical obstacle to SOV success.
  - Potential benefits from revenue gains appear considerably smaller than potential costs from economic, AML/CFT, reputational, governance and legal risks.

*International Monetary Fund — Republic of the Marshall Islands, Section 22 (excerpts).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2018/cr18271.pdf_