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The Development and Regulation of Cryptoassets: Hong Kong Experiences and a Comparative Analysis

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Abstract

Cryptoassets have emerged as a new category of financial products in recent years and have attracted a great deal of attention from market participants and regulators. While the characteristics of cryptoassets, such as anonymity and disintermediation in transactions, bring significant benefits, they come with a range of significant risks concerning investor protection and market integrity. Due to the difficulties in regulating cryptoassets under the traditional framework, Hong Kong has set up its first comprehensive regulatory regime on cryptoassets in November 2018, imposing new standards on cryptoasset fund managers, distributors and platform operators. By means of a comparison with four major jurisdictions overseas, including Mainland China, the US, the UK, and Singapore, the strengths and potential concerns of Hong Kong’s new regime are analysed. Overall, the new regulatory regime for cryptoassets in Hong Kong is a significant development, addressing the issues of regulatory gaps and regulatory arbitrage that existed under the previous framework as well as introducing enhanced regulatory standards. This has the effect of improving investor protection, but there are some remaining concerns. Chief amongst them are the problems with regulatory scope, the application of traditional regulatory standards to cryptoassets that do not fall within the definition of securities or futures, problems with the sandbox mechanism, and ultimately as a matter of regulatory philosophy, the need for a better balance between investor protection and market development.

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Notes

  1. Nakamoto (2008).

  2. For a more detailed discussion of the concept of cryptoassets, see below Sect. 2.

  3. Arnold et al. (2018), p 22.

  4. Hughes and Middlebrook (2015), p 512.

  5. Hong Kong Securities and Futures Commission (2018). To provide more guidance, this new regulation contains Appendix 1 (Regulatory Standards for Licensed Corporations Managing Virtual Asset Portfolios) and Appendix 2 (Conceptual Framework for the Potential Regulation of Virtual Asset Trading Platform Operators).

  6. Kakavand et al. (2017), p 7. In the process of synchronisation, new transactions between users are broadcast across the network, verified by cryptographic algorithms, and grouped into blocks. The blocks are then added to the blockchain and can no longer be altered.

  7. Robinson (2018), p 908.

  8. European Securities and Markets Authority (2016), p 8.

  9. HM Treasury (2018), p 11.

  10. Financial Conduct Authority (2017), p 11. A ‘permissionless’ network is one which anyone is allowed to validate and add new records to the existing set of records. This is in contrast to ‘permissioned’ networks, where only users with specific rights can perform the same actions.

  11. Ibid.

  12. UK Parliament (2018), para. 10.

  13. The IOSCO is an association of securities regulators, which acts as the global standard-setter for worldwide securities regulation.

  14. Azgad-Tromer (2018), p 104.

  15. Bitcoin.com (2018).

  16. Sonderegger (2015), p 186.

  17. HM Treasury (2018), p 37.

  18. Hong Kong Securities and Futures Commission (2018), p 2.

  19. HKEX (2018), p 19.

  20. HM Treasury (2018), p 37.

  21. Securities and Futures Commission (2008), pp 2, 16, 35, 37. The Lehman Minibonds were an unlisted investment product which led to significant investor losses in 2008. Investigations by the SFC showed that although disclosure on the marketing leaflet complied with the law, the intermediaries adopted improper selling practices and were given inadequate financial advice, which resulted in investors purchasing unsuitable products that were overly complex and risky. This catastrophe exposed the weaknesses of the disclosure-based regulatory model, particularly for more complex and opaque financial products.

  22. Azgad-Tromer (2018), p 109; Zetzsche et al. (2017), p 15.

  23. Bank for International Settlements (2018), p 107.

  24. Gilson and Kraakman (1984), p 552.

  25. The Clearing House and Independent Community Bankers of America (2014), pp 4–5.

  26. International Monetary Fund (2016), p 28.

  27. Ibid.

  28. Ibid., p 29.

  29. National Cyber Security Centre (2018), p 25.

  30. Brookes (2018), p 84.

  31. Hong Kong Securities and Futures Commission (2018), p 2.

  32. Wieczner (2018), p 70.

  33. Das (2018).

  34. Ponsford (2015), p 30.

  35. Marian (2015), p 56.

  36. HM Treasury (2017), p 40.

  37. Brookes (2018), p 82; Corbet et al. (2019), p 193.

  38. Twomey (2013), p 72.

  39. Tritten (2018).

  40. Financial Stability Board (2018b), p 14. The FSB is an international body which monitors and makes recommendations for the global financial system. It should be noted that this view may change in light of the rapid developments of technology in this field.

  41. Ibid., p 8.

  42. HM Treasury (2018), p 38.

  43. Zetzsche et al. (2017), p 17.

  44. HM Treasury (2018), p 31.

  45. International Monetary Fund (2018), p 26.

  46. Marian (2015), p 55.

  47. Sonderegger (2015), p 183.

  48. Ibid., p 177.

  49. International Monetary Fund (2016), p 5.

  50. Ametrano (2016), p 10.

  51. Anderson (2018), p 9.

  52. HM Treasury (2018), p 13.

  53. Ibid., p 32.

  54. European Securities and Markets Authority (2018), p 9, para. 30.

  55. Demertzis and Wolff (2018), p 2.

  56. European Banking Authority (2019), p 17.

  57. Chan (2018).

  58. Securities and Futures Commission (2017c).

  59. Registration requirements refer to the prospectus regime for securities such as shares under Parts II and XII of the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap 32) (CWUMPO), while the authorisation requirement under Part IV of the SFO means SFC authorization for collective investment scheme products such as funds.

  60. Securities and Futures Commission (2017b).

  61. Securities and Futures Commissions (2018b). Under Section 4 and Schedule 3 to the Securities and Futures (Licensing and Registration) (Information) Rules (Cap 571S), intermediaries are required to notify the SFC of any ‘significant changes’ in the nature of their business and the types of service they provide. Importantly, the notification requirements cover all cryptoassets, regardless of whether they qualify as securities or not.

  62. Adler (2018), p 7.

  63. Hong Kong Securities and Futures Commission (2018), p 4. The de minimis requirement provides that only portfolio managers who intend to invest 10% or more of the gross asset value (GAV) of their portfolios in cryptoassets will be subject to the SFC’s oversight in this way.

  64. Ibid. The Existing Requirements refer to existing requirements under the SFO, the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct), the Fund Manager Code of Conduct, and guidelines, circulars and frequently asked questions issued by the SFC.

  65. Ibid.

  66. In essence, the Terms and Conditions cover:

    1. (i)

      The type of investors and disclosure to investors: portfolio managers should ensure that only ‘professional investors’ are permitted to invest into cryptoasset portfolios (subject to the de minimis requirement), and ensure risk disclosure to investors and distributors;

    2. (ii)

      Safeguarding of assets: portfolio managers should select appropriate custodial arrangements by assessing the accessibility and security of stored assets. A duty of care, skill and diligence is imposed. Additional requirements covering insurance and disclosure apply to cases of self-custody;

    3. (iii)

      Portfolio valuation: with no generally accepted valuation principles for cryptoassets, managers should select reasonably appropriate valuation methodologies in the best interests of investors;

    4. (iv)

      Risk management: managers should set appropriate limits for each product, market and counterparty, conduct periodic stress testing, and assess the reliability and integrity of cryptoasset exchanges;

    5. (v)

      Auditors: managers should appoint an independent auditor with capability in cryptoassets to audit the financial statements of funds; and

    6. (vi)

      Liquid capital: different levels of liquid capital requirement are imposed on managers depending on whether they hold client assets.

    Hong Kong Securities and Futures Commission (2018), Appendix 1 (Regulatory Standards for Licensed Corporations Managing Virtual Asset Portfolios), pp 3–6.

  67. Ibid., p 5.

  68. Ibid.

  69. Ibid.

  70. Securities and Futures Commission (2018a). The statement contains further regulations that cryptoasset fund distributors are subject to.

  71. Ibid., p 1. The suitability obligations for fund distribution refer to the Frequently Asked Questions on Compliance with Suitability Obligations by Licensed or Registered Persons, and the Frequently Asked Questions on Triggering of Suitability Obligations.

  72. Ibid., p 1.

  73. Ibid., p 2.

  74. Hong Kong Securities and Futures Commission (2018), p 6. Automated trading services are Type 7 regulated activities under the SFO.

  75. Securities and Futures Commission (2017a).

  76. Ibid., p 6.

  77. Ibid., p 7. The licensing conditions include five mandatory ‘core principles’, and a list of ‘proposed terms and conditions’ which may be modified based on discussions between the SFC and the platform operator. Hong Kong Securities and Futures Commission (2018), Appendix 2 (Conceptual Framework for the Potential Regulation of Virtual Asset Trading Platform Operators), pp 3–5.

  78. Ibid., p 6.

  79. Hong Kong Securities and Futures Commission (2018), Appendix 2 (Conceptual Framework for the Potential Regulation of Virtual Asset Trading Platform Operators), p 2.

  80. Hong Kong Securities and Futures Commission (2019).

  81. Ibid., pp 6, 7. Cryptoasset platform operators which operate a centralised online trading platform and offer trading of at least one security token on its platform are regulated by the SFC, and require a licence for Type 1 (dealing in securities) and Type 7 (providing ATS) regulated activities.

  82. Ibid., pp 8, 9. In essence, the Terms and Conditions cover:

    1. (i)

      Safe custody of assets: platform operators should hold client assets on trust, predominantly in cold wallets, have in place procedures for handling cryptoasset transfers, procure insurance, and safely manage private keys for digitally signing transactions;

    2. (ii)

      Know-your-client (KYC): platform operators should comply with KYC requirements, ensure clients have sufficient knowledge of cryptoassets and associated risks before providing trading services or otherwise provide training, and assess concentration risks by setting trading or position limits;

    3. (iii)

      AML and CFT: platform operators should implement adequate AML/CFT systems, regularly review and enhance them based on SFC guidance and FATF recommendations, for example by deploying cryptoasset tracking tools;

    4. (iv)

      Prevention of market manipulative and abusive activities: platform operators should implement written policies and controls for the proper surveillance of activities, take immediate steps to restrict or suspend trading upon discovery of manipulative or abusive activities;

    5. (v)

      Accounting and auditing: platform operators should select and appoint auditors with experience and track record in virtual asset related businesses;

    6. (vi)

      Risk management: platform operators should have a risk management framework to identify, measure, monitor and manage risks, and require customers to pre-fund their accounts;

    7. (vii)

      Conflicts of interest: platform operators should not engage in proprietary trading or market-making activities except at arm’s length via an independent external party, and regulate employees’ dealings; and

    8. (viii)

      Virtual assets for trading: platform operators should set up a function to establish, implement and enforce the rules on cryptoasset issuers, the criteria for cryptoasset inclusion, and the criteria for halting, suspending and withdrawing cryptoassets from trading, and perform due diligence.

    Hong Kong Securities and Futures Commission (2019), Appendix 1 (Licensing Conditions and Terms and Conditions for Virtual Asset Trading Platform Operators).

  83. Hong Kong Securities and Futures Commission (2019), p 15.

  84. South Korea also imposes an outright ban. Carlson and Selin (2018), p 23.

  85. Guanyu Fangfan Bitebi Fengxian de Tongzhi (关于防范比特币风险的通知) [Notice on Precautions Against the Risks of Bitcoins] (promulgated on 5 December 2013 by the People’s Bank of China and others). In December 2013, the PBOC issued the Notice on Precautions Against the Risks of Bitcoins, which defines Bitcoin as a ‘specialised virtual commodity’ without legal status as fiat currency. Financial institutions are prohibited from engaging in Bitcoin-related business activities and must observe Bitcoin-related AML obligations.

  86. Guanyu Jinyibu Jiaqiang Dui Shexian Feifa Jizi Zijin Jiaoyi Jiance Yujing Gongzuo de Zhidao Yijian (Yinfa 2016 No. 201) (关于进一步加强对涉嫌非法集资资金交易监测预警工作的指导意见 (银发 2016 201号)) [Further Strengthening the Monitoring and Early Warning of Suspected Illegal Raising Fund Transactions] (promulgated on 9 September 2016 by the People’s Bank of China).

  87. Chuzhi Feifa Jizi Tiaoli (Zhengqiu Yijiangao) (处置非法集资条例(征求意见稿)) [Exposure Draft of a Regulation to Handle Illegal Fundraising Released] (promulgated on 24 August 2017 by the China Banking Regulatory Commission).

  88. Guanyu Dui Daibi Faxing Rongzi Kaizhan Qingli Zhengdun Gongzuo de Tongzhi (关于对代币发行融资开展清理整顿工作的通知) [Notification Concerning the Undertaking of Cleaning-up and Rectification Work on ICOs (Notification No. 99)] (promulgated on 2 September 2017 by the Office of the Leading Group for the Special Campaign against Internet Financial Risks).

  89. Guanyu Fangfan Daibi Faxing Rongzi Fengxian de Gonggao (关于防范代币发行融资风险的公告) [Announcement on Preventing the Financing Risks of Initial Coin Offerings] (promulgated on 4 September 2017 by the People’s Bank of China and other departments).

  90. Guanyu Kaizhan Wei Feifa Xuni Huobi Jiaoyi Tigong Zhifu Fuwu Zicha Zhenggai Gongzuo de Tongzhi (Yinguan Zhifu 2018 No. 11) (关于开展为非法虚拟货币交易提供支付服务自查整改工作的通知 (银管支付 (2018) 11号) [Notification on Self-inspection and Rectification Work on the Provision of Payment Services for Illegal Virtual Currency Transactions] (promulgated on 17 January 2018 by the People’s Bank of China).

  91. Deng et al. (2018), pp 466, 493.

  92. Liu (2018).

  93. Singapore Business Review (2018), p 1.

  94. Yiu and Lee (2018).

  95. Securities and Futures Commission (2018c).

  96. Securities and Futures Commission (2018d).

  97. Adler (2018), p 5.

  98. Hong Kong Securities and Futures Commission (2018), p 1.

  99. Girasa (2018), p 217.

  100. Barsan (2017), p 54.

  101. Financial Stability Board (2018a), p 5.

  102. Securities and Futures Ordinance, Sch. 1, Pt. 1, Sec. 1.

  103. SEC v. W. J. Howey Co., 328 US 293 (1946), p 293.

  104. In the UK, cryptoasset-related activities are only subject to regulation if they are considered to be ‘regulated activities’ under the Financial Services and Markets Act 2000 (Regulated Activities) Order (RAO) and the Payment Services Regulations 2017. Bailey (2018), p 1.

  105. Securities and Exchange Commission (2018).

  106. Bank for International Settlements (2018), p 107.

  107. Financial Action Task Force (2018), p 15. The FATF is an intergovernmental organisation and the global standard setter for AML and CFT regulations.

  108. Ong (2019).

  109. Hong Kong Securities and Futures Commission (2018), Appendix 2, p 6.

  110. Michael (2015), p 21.

  111. Adler (2018), pp 5–6.

  112. Hong Kong Securities and Futures Commission (2018), p 6.

  113. Ibid.

  114. Huang and Schoenmaker (2015), p 251.

  115. Ibid., p 225.

  116. Bank for International Settlements (2018), p 107.

  117. Ibid.

  118. Hong Kong Securities and Futures Commission (2018), Appendix 1, pp 3–5.

  119. HKEX (2018), p 21.

  120. Hong Kong Securities and Futures Commission (2018), p 2.

  121. Hong Kong Securities and Futures Commission (2018), Appendix 1, pp 3–4.

  122. Hong Kong Securities and Futures Commission (2018), Appendix 1, p 6.

  123. Hong Kong Securities and Futures Commission (2018), Appendix 1, p 6. Portfolio managers are generally required to maintain increased liquid capital where they hold ‘client assets’. Under the new regime, the holding of non-SF cryptoassets will also trigger this requirement.

  124. In the UK sandbox, multiple participants have emphasised the importance of having dedicated case officers to maintain a close dialogue, facilitate engagement with FCA subject-matter experts, and obtain feedback. This is particularly the case for less regulatory savvy start-ups. Deloitte (2018), p 4.

  125. Ibid., p 9.

  126. Monetary Authority of Singapore (2016), p 3.

  127. Payment Services Act 2019 (No. 2 of 2019). The new S-PSA was passed by the Singaporean Parliament on 14 January 2019, and will come into force when supporting subsidiary legislation is ready. As of the end of 2019, the S-PSA was not yet operational.

  128. Monetary Authority of Singapore (2017), p 3.

  129. Official website of the Money Authority of Singapore for the sandbox, http://www.mas.gov.sg/Singapore-Financial-Centre/Smart-Financial-Centre/FinTech-Regulatory-Sandbox.aspx.

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Authors and Affiliations

  1. Faculty of Law, Chinese University of Hong Kong, Sha Tin, NT, Hong Kong, SAR

    Robin Hui Huang & Ferdinand Fai Yang Loo

  2. Faculty of Law, University of New South Wales, Sydney, Australia

    Robin Hui Huang

  3. Faculty of Law, McGill University, Montreal, Canada

    Robin Hui Huang

  4. East China University of Political Science and Law, Shanghai, China

    Robin Hui Huang

  5. School of Law, Jiangxi University of Finance and Economics, Jiangxi, China

    Demin Yang

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  1. Robin Hui Huang
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Correspondence to Demin Yang.

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This research received support from Direct Research Grant at Chinese University of Hong Kong; also from Hong Kong Research Grants Council’s General Research Fund project ‘The Regulation of Fintech in China’. Thanks to Menglu Wang for her excellent research assistance.

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Huang, R.H., Yang, D. & Loo, F.F.Y. The Development and Regulation of Cryptoassets: Hong Kong Experiences and a Comparative Analysis. Eur Bus Org Law Rev 21, 319–347 (2020). https://doi.org/10.1007/s40804-020-00174-z

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