The risks…

The SFC describes these risks in various terms but, in the main, three issues appear to create the major concerns.

First, virtual Assets represent a risk in terms of valuation, volatility and liquidity to the extent that – in contrast with usual currencies and financial assets – they are not backed by governments and are not supported by physical assets. In fact, their value tends to fluctuate with offer and demand, which makes them very volatile assets lacking agreed valuation standards, while market integrity tends to be threatened by possible manipulations.

Second, virtual assets present a risk to the extent that no accounting and auditing standards exist. KYC opportunities remain very limited, valuation remains approximate while money laundering risks increase. The demand for those assets rises, nonetheless, which suggests that there are numerous opportunities to abuse investors.

Third, security obviously is another challenge. As the SFC notes, custody of the virtual assets remains a source of risk, particularly for funds managing important quantities of assets. Conflicts of interest may also appear as far as exchanges are concerned, especially when operators can be both agents and principal. But the SFC has decided to move on.

The next step.

As a result, the SFC is putting into place a framework designed to “bring a significant portion of Virtual Asset portfolio activities into its regulatory net”.

On the one hand, the regulator has issued a ‘guidance’ detailing the standards of conduct expected from Virtual Asset professionals, i.e. portfolio managers and fund distributors. On the other hand, it has announced that it now explores ‘a conceptual framework’ for the possible regulation of crypto exchanges.

Portfolio managers.

The guidance will first affect portfolio managers investing (or planning on investing) more than ten percent of the fund’s gross value in Virtual Assets, whether or not these assets fall under the definition of Securities and Future Contracts.

To put things simply, only professional investors will be allowed to invest in such assets, and specific licenses will need to be obtained in order to manage portfolios. Type 1 or Type 9, depending on the activities involved.

Portfolio managers, furthermore, will now be ‘required to inform the SFC if they are presently managing (or planning to manage) one or more portfolios that invest in Virtual Assets”. The regulator will then consider whether the standard Terms & Conditions can be adapted into “reasonable and appropriate” licensing conditions, while refusing to abide by such conditions will lead to rejection and to an obligation to unwind any existing portfolio.

Fund distributors.

Licencing requirements will also apply to firms which distribute funds that invest in Virtual assets.

A Circular to Intermediaries requires that financial products only be made available to professional investors. The said intermediaries will have an obligation to make sure that investors know the risks undertaken, but they will also have to conduct due diligence proceedings, inquire on fund management, custodial services, fund valuation policy etc.

Crypto exchange regulation?

Last but not least, the SFC is also considering a possible ‘conceptual framework’ for the regulation of crypto exchanges.

The topic is interesting because it is somehow controversial. One will remember the banning of crypto exchanges in Mainland China last year, and the way exchanges and capital simply moved abroad.

Overall, the ambition of the Hong Kong SFC is therefore to start with a basic (twofold) question, i.e. can exchanges be regulated at all, and how?

The SFC has drafted a very complete proposal here, with a view to determining whether the rules applicable to traditional exchanges could be applied to Virtual Asset platforms.

Exchange operators would be allowed to work only with professional investors, post-ICO limitations would be applied, and only pre-funded transactions would be allowed (while leveraged operations would be prohibited).

The Exchange operators would also be expected to abide by significant disclosure obligations, they would have to respect financial resource, insurance, and AML/KYC requirements, etc.

Interestingly, however, the SFC visibly knows that regulating exchanges is a difficult task, and it mentions upfront that a possible conclusion of the inquiry could be that Virtual Asset exchanges cannot be regulated.

Key Takes.

The move by the SFC is overall significant and most welcomed, especially considering that 2017 and 2018 have been agitated years for the crypto industry.

We see three major takeaways here.

One relates to the general message behind the initiative. Another relates to what the move means in terms of developing a Blockchain industry in Hong Kong. The third relates the what the initiative means in terms of crypto exchange regulation in the future.

General message.

First, the SFC definition of “virtual assets” has a broad scope of application which covers all digital tokens and therefore includes digital currencies like Bitcoin, platform tokens like ETH, utility tokens from a variety of projects, asset-backed tokens like stable coins, or any other “virtual commodities, crypto assets and other assets of essentially the same nature”.

The statement makes no distinction between security tokens and utility tokens, that is, which suggests that the framework would apply to both, thus solving a problem which currently monopolizes a lot of attention.

Second, the SFC places the focus on investor protection. The purpose is openly announced: preserving investors from risks deemed difficult to foresee, and the investors’ interests would be protected at least from the fund management level, distribution level or both. Making products available to professional investors through a professionalization of the Virtual assets industry, in sum.

Third, with this regulatory initiative, Hong Kong is placing itself at the forefront of global Virtual Asset regulation.

In mid-October 2018, the FAFT called countries to ensure that virtual asset service providers are subject to AML/CFT regulations and invited regulators to increase licensing procedures to increase security on crypto markets. Standards are also being developed progressively in the United States where the characterization of cryptos as Securities is provided a relative framework to the industries, whilst efforts are also being made in Japan. In Singapore the MAS might preserve a distinction between Securities and utility tokens (see here and there), but more clarity could be needed.

In other words, the Hong Kong SFC is taking measures to be considered as one among the first movers on the matter, which is interesting considering that a month ago a tech publication wrote that ‘Singapore is the crypto sandbox that Asia needs‘.

Impact in terms of Blockchain & Fintech industry development.

The above suggests that the FSC’s Virtual Assets initiative could be seen as a positive step toward increasing confidence in the market.

By providing a clearer and safer investment environment, the regulator would overall encourage the growth of Hong Kong’s crypto, Blockchain and Fintech industry. In fact, this initiative could well attract more investors in the future, especially considering the recent efforts made by the HKMA in relation to virtual banking and Open API.

>> Related Reading: Hong Kong HKMA’s releases Open API Framework: What it means for banks.

>> Read also: Virtual Banking Regulation in Hong Kong?

Impact on Crypto?

Last but not least, the SFC’s decision to integrate crypto exchanges in its sandbox program could pave the way towards regulating exchanges, which – as the primary contact point between retail investors to the world of cryptocurrencies – are a big part of the ecosystem.

This, in other words, could be seen as a first step to licensing the exchanges as per what happened in Japan. At the same time, and as already noted, the SFC knows that there might only be very limited room to do so.

To qualify for the sandbox would not be easy, however, as the move would force the interested exchanges to come clean and review their practices. Which many might not want to do.

Applying for the Sandbox would also mean that the exchanges will have to face significant compliance costs, a difficult decision to make in a market where trading (and the generated trading fees) is low. The cost factor might also act as a deterrent to the extent that, as Registered Market Operators (RMO), the exchanges would be subjected to intensive reporting and processes, segregation of fiduciary duties, internal controls and audits much like the traditional stock exchanges.

The most ambitious part, overall, will however relate to the necessity to prevent market manipulation, which in reality might simply make a major share of the reported trading volume vanish.

Ashley Adler, the SFC’s CEO, overall concluded with the following quote: “We hope to encourage the responsible use of new technologies and also provide investors with more choices and better outcomes.” This idea is at the heart of the initiative and it constitutes a step in the right direction. Let us hope that the industry follows and contributes to creating a safer and more sustainable ecology in the blockchain industry.