SFC Regulates Crypto-exchanges — Party Over in Hong Kong?
To the surprise of the Hong Kong Cryptocurrency community, the 2018 Fintech Week has been loaded with Bitcoin and Blockchain announcements. While few of the sponsors and speakers deal with these topics directly and almost no specific Blockchain-talks and panels were on the agenda, the event is filled with surprises.
On Tuesday, October 30, the Chairman of the Hong Kong Exchange & Clearing, Charles Li announced a new “blockchain-based” trade finance platform. The announcement comes just days after HKEX’ chief economist calls such platforms “inadequate.”
The platform was also the topic of Norman Chan’s talk the day after as he officially launched the platform on the 10th anniversary of the release of the Bitcoin Whitepaper.
On Thursday morning, the Chief Executive Officer of the city’s security regulator SFC, Ashley Alder, announced in his keynote the strict enforcement and clarification of existing rules, as well as a sandboxing arrangement for cryptocurrency exchanges.
The talk was followed by two Appendices for funds and exchanges respectively that surprised many in the industry in their detail and restrictions.
New vocabulary
Alder acknowledges that the SFC’s scope to regulate this industry is limited. Hong Kong has previously consistently defined cryptocurrencies like Bitcoin as “virtual commodities” that are neither money nor securites.
The SFC has previously acknowledged that while many ICO tokens qualify as securities, they ultimately may not be. In his speech, Alder coins the new term “Virtual Asset” and makes all distinctions meaningless to “bring these activities into our regulatory net for the first time” through “a creative framework.”
I believe this verbally oversteps the jurisdiction of the SFC, much to the harm of Hong Kong’s reputable and reliable legal regime and has no precedence in either the commodities or currencies markets.
Funds
In Appendix 1 the SFC spells out its expectations for licensed corporations managing virtual asset portfolios. This regulation mainly affects those funds and intermediaries that already hold a license from the SFC (mainly Type 1 or 9), but acts as a reminder that generally such activities are regulated already.
The statement will be a harsh dissuasion to the plenty of unlicensed cryptocurrency funds in Hong Kong that they need to obtain a license, regardless of whether they hold only Bitcoin and Ethereum, or also invest in futures contracts or security tokens.
Implications for funds that have more than 10% of their assets in cryptocurrencies and tokens (or state their objective to invest in crypto):
- SFC License necessary
- Fund needs to subscribe to ‘Terms and Conditions” imposed by the SFC, which can vary from fund to fund
- Custody arrangements are expected
- Deal mainly with regulated exchanges
- Only interact with institutional investors
Additional Implications of funds that hold less than 10% of their value in crypto:
- Funds have to divest from their holdings if their assets appreciate beyond the 10% mark
In general, these are not surprises. It is noteworthy however that regulated funds will not be allowed to hold any cryptocurrencies whatsoever if they sell these products to the public, and the exposure of funds only available to qualified investors will be highly limited.
It does for the first time open the possibility that cryptocurrency funds are able to obtain Type 1 and Type 9 licenses, but these will come with extra Terms and Conditions and scrutiny.
To individuals, none of this is relevant. Funds are only attractive to institutional money that for some reason isn’t able or allowed to flow into cryptocurrencies directly, exactly the kind of potential snowball effect the new regulation is designed to prevent.
To Bitcoin and Ethereum, this is not necessarily bad. For the same reason that an ETF is bad for Bitcoin, institutional money eventually just skews power of Blockchains in favor of these institutions and the state. For Bitcoin to succeed it must be decentralized, and its ownership as much spread across the world as possible.
Exchanges
In Appendix II, the SFC lays out a proposed sandbox regime for cryptocurrency exchanges “marketed to Hong Kong investors or conducted in Hong Kong.” It is far more counter-intuitive than the proposed regime for funds and attempts to overreach the SFC’s boundaries.
Existing licensed exchanges are not allowed to conduct any cryptocurrency activities, including OTC brokerages and peer-to-peer trading.
However, while the SFC attempts to regulate crypto-exchanges as a whole, it does recognize that it only has this power if exchanges deal with securities, futures or margin products. The only exception are exchanges that do not hold any funds of their users.
While the SFC will not give exchanges licenses, it does expect all exchanges to behave as if they had these licenses, and subscribe additionally to terms and conditions which will be intransparent and negotiated on a case-by-case basis.
What is referred to as a ‘sandbox’ is instead a cage that places unreasonable burdens on exchanges. To understand why, we look at some of the requirements in detail.
No exchanges can currently fulfill the SFC’s requirements
- All activities need to be under one entity. This disqualifies almost all international exchanges from participating. Specifically to comply with local laws (eg in the United States), exchanges frequently deal with users through a complicated network of entities and representatives.
- The sandbox requires exchanges to only deal with institutional investors. Only a few OTC houses fulfill this requirement. As the SFC in Appendix II makes it cryptocurrencies far less attractive for institutional investors, it’s not clear if there will even be a significant market. Furthermore, an OTC exchange does not fall under the jurisdiction of the SFC unless it offers margin or futures. The sandbox arrangement does not change that.
- Exchanges cannot offer leverage, margin or borrowing at all. This defeats the purpose to join the sandbox for the OTC exchanges that would fall under the SFC’s jurisdiction, too.
- Exchanges are required to hold insurance on all funds they keep. There is nobody, especially not in Hong Kong, who would offer such a product.
- Exchanges are required to maintain bank accounts in Hong Kong. In a city notorious for its lack of banking even to hedge funds and other licensed intermediaries, exchanges will have trouble complying with this requirement.
Some requirements are noteworthy, but eventually possible to comply with.
- Tokens can only be traded 12 months after the ICO, or when the entity emitting the tokens makes a profit, whichever is earlier. While most exchanges that also list tokens would not qualify for this immediately, it is imaginable they would be able to comply after delisting the relevant tokens.
- Exchanges need to conduct knowledge tests of their clients, providing a whole new dimension to the term Know Your Customer.
- An exchange needs to keep 12 months of its operating expenses in reserve to cover potential losses from hacks or errors. Depending on the exchange, this might be entirely realistic given the thick profit margins in the past months, though it’s unclear whether this would be sufficient to cover losses (see Coincheck 2018)
Bad news only for those who need not apply
In summary, the new rules are bad news for cryptocurrency funds and those holding Bitcoin, coins or tokens. This is not unexpected but irrelevant to retail investors. Be your own bank, and if you really must, be your own fund, too.
The exchanges hit the most by the regulations are those that already have little reason to proclaim they are in Hong Kong. Futures platforms, crypto-to-crypto exchanges and ICO platforms are attractive business models because they don’t require a jurisdiction. While Hong Kong was a better place when it didn’t bother such platforms, it was inevitable this day would come. Exchanges will likely maintain parts of their teams in Hong Kong, but work harder to convince the public of a new narrative that places them outside of the SAR.
Exchanges, brokers and ATM operators will be wise to not voluntarily place themselves in the wolf’s cottage. We are to resist the urge of the SFC to redefine virtual commodities, contradictory to repeated and recent statements from the HKMA and Customs & Excise Department (C&ED) of the Hong Kong Police.
Given the SFC’s surge ahead on the regulation of cryptocurrency exchanges, it is becoming more unclear whether the C&ED, which currently oversees Bitcoin, commodities and forex trading, is preparing its own guidelines similar to those of the Money Service Operators License (MSO).
But it is highly unlikely that we will see exchanges submitting to the SFC’s “licensing without a license” regime.
