Introduction

The Hong Kong Web3 Festival has lately been successfully concluded in April 2023. Mr Keith Choy, Interim Head of Intermediaries of the Securities and Futures Commission (“SFC”), gave a keynote speech on Day One of the Web3 Festival, emphasizing the SFC’s attitude and approaches towards centralised VA trading platforms (“VATPs”) and decentralised finance (“DeFi”). According to the official website of Hong Kong Web3 Association, membership applications are now open, and membership types include senior members, advanced members, and ordinary members. Hong Kong Web3 Association targets to provide members with the latest information on Web 3.0 and regularly hold conferences, research meetings, field observations, and other activities to promote the development and cross-border cooperation of Web 3.0.

Regulatory issues and challenges presented by DeFi

DeFi seeks to decentralise the financial ecosystem and disintermediate traditional financial intermediaries in the provision of products and services using distributed ledger technology (“DLT”), virtual assets (“VA”) and smart contracts. By “democratising” finance, user with internet connection and wallet for storing VA could access DeFi services. Currently, many traditional financial products and services have equivalents in DeFi, including trading, borrowing and lending, asset management, insurance and derivatives.

However, just like other innovative technologies, DeFi presents its own regulatory issues. For example, lack of transparency on the interconnections and linkages due to lack of regulation, market integrity issues due to price oracle manipulation, and investor protection concerns. The SFC acknowledged that regulating DeFi is not a straightforward task. As there is no traditional financial intermediary or smart contract run autonomously, and for some DeFi protocols, the developer or operator has no ability to alter the smart contract’s code after being deployed on the blockchain, it is difficult to identify the responsible person to be held accountable. As the governance of DeFi products and services may be decentralised, involving the use of governance tokens or decentralised autonomous organisations, it begs the question of whether a DeFi service is controlled by the smart contract developer, holders of the governance tokens or members of the decentralised autonomous organisations. Together with the pseudonymous and cross-border nature, these features of DeFi products and services further increase the difficulty to identify the accountable person with respect to the financial transactions and products.

SFC’s approach on DeFi: same business, same risk, same rule

The SFC was of the view that such difficulty is not insurmountable. The SFC will assess each DeFi service or activity on a case-by-case basis after understanding the inner workings and arrangements of a DeFi protocol. The SFC observed that some DeFi protocols may be decentralised in name only with a small group of developers, operators or their related parties still in de facto control such as by holding the vast majority of the governance tokens or having the power to vet governance proposals put forward by others. Therefore, the SFC opined that it is still possible to identify the accountable person.

With regard to DeFi activities in general, the SFC’s approach is that the same existing regulatory framework that applies to the traditional regulated financial activities shall apply. Therefore, if a DeFi activity falls within the scope of the Securities and Futures Ordinance, Cap 571 (“SFO”), it would be subject to the same regulatory requirements applicable to a traditional finance activity, under the “same business, same risk, same rule” approach. The person operating or performing such DeFi activity would be subject to the licensing requirements and be regulated by the SFC. For instance, since provision of automated trading services is a regulated activity under the SFO, decentralised platform which allowed trading in VAs that constitute securities or futures as defined under the SFO would be required to be licensed for the Type 7 regulated activity of providing automated trading services, so as the platform operators. Furthermore, as offer of collective investment schemes (“CIS”) to the public in Hong Kong is subject to authorisation requirements under the SFO, marketing of a DeFi liquidity pooling protocol to Hong Kong which falls within the definition of a CIS may be subject to the same authorisation requirements.

SFC’s approach on Centralised VATPs: proposed new VATP regime

To date, the SFC has focused more on centralised VATPs as majority of VA trading activities takes place on centralised VATPs. In 2019, the SFC has introduced an opt-in regime for the regulation of VATPs which provided trading services in at least one security token. Such regime covered requirements which were applicable to traditional brokers and automated trading venues with adaptions to cater for specific risks of VAs, in line with the SFC’s general “same business, same risk, same rule” approach. The SFC intends to regulate VATPs from both anti-money laundering perspective and investor protection standpoint.

The SFC intended to implement a new licensing regime covering centralised VATPs which enable trading in non-securities tokens. The SFC expected all centralised VATPs operating in Hong Kong, regardless of whether they offer trading in securities tokens or non-securities tokens, must be licensed by the SFC when the new regime comes into effect on 1 June 2023 for virtual asset service providers under the amended Anti-Money Laundering and Counter-Terrorist Financing Ordinance, Cap 615.

On the other hand, the SFC proposed to relax the current investor restriction in trading VAs to include professional investors and retail investors, subject to additional guardrails such as requiring a VATP to understand the risk profile of a client during the onboarding process to assess whether the provision of its services to that client is suitable, as well as setting appropriate limits by reference to the client’s financial situations and personal circumstances to ensure that the client’s VA exposure is reasonable. The SFC proposed a further condition of requiring additional admission criteria which would qualify it as an “eligible large-cap virtual asset”.

The SFC stressed that although size of the VA market is not yet large enough to cause systemic risk concerns, given the actual damage caused already (e.g. losses caused by implosion of the Terra/ Luna algo stablecoin and the collapses of Celsius Network and centralised exchange FTX), it is necessary to set rigorous standards for the regulation of VATPs with appropriate guardrails to protect investors, market integrity and market stability.

Conclusion

Despite recognising the opportunities presented and acknowledging the enormous economic benefits and the potential to change the way the public conduct their activities, the SFC stressed that one must also be aware of the potential risks that entails and manage such risks properly. The SFC’s attitude is clear – to harness the benefits of the innovative technologies in a responsible way. Whilst adopting the general approach of “same business, same risk, same rule”, the SFC opined that salient features of the particular technology will be looked into on a case-by-case basis with necessary adaptations to be made.

 

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Published by ONC Lawyers © 2023