SFC’s regulatory stance on DeFi and VATPs: Embracing innovative technologies in a responsible way
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 |