Late last year, the SFC (Hong Kong’s securities regulator) announced a new regulatory framework allowing digital asset exchanges to be regulated by the SFC. This move was met with interest from around the world as various jurisdictions propose new regulatory regimes for the space, and exchanges serving Hong Kong customers face new scrutiny and decisions about how to proceed. The newly drafted regulatory framework would allow the SFC to issue licenses to these exchange venues, though they appear to be having a difficult time finding insurance coverage for funds held on exchange, a requirement of the proposed regulatory framework.
On closer inspection of the proposed changes, it’s evident that further analysis is warranted. Aside from the insurance requirements, two other directives are important: first, the regulations apply only to exchanges dealing with legally-defined securities. The SFC outlines that operating an exchange venue that offers securities trading (even a single trading pair) is the qualifying criterion for these regulations — otherwise, the scheme is opt-in. Second, the regulations would also require exchange venues to restrict access to the exchange to those individuals who qualify as “professional investors”, similar to accredited investors in the US.
This combines two hot debates in the cryptocurrency sphere and might force Hong Kong exchange venues to pick a side: what is and isn’t a security, and who should have access to this new asset class?
Exchange Insurance Requirements are Expected
In requiring insurance for custodied digital assets, the SFC is acting largely as we have expected from regulatory bodies. The guidance recognizes the underlying digital assets as bearer instruments, whereby there is no delineation between possessing the asset and owning it. Adequate insurance coverage ensures that there is effectively a separation between ownership and custody: if the custodian or exchange realizes a risk event that is covered by insurance, their client might in effect still have claim to their lost assets.
Furthermore, the regulations require that a maximum of 2% of funds may be held in hot (online) wallets with full insurance coverage, while the rest must be held in cold (offline) storage with a minimum 95% of the value of those assets insured. This can sound like a strong step in the right direction with regard to investor safety, however, we encourage further discussion and guidance on how to interpret this requirement. In particular, policies can and do exist that would meet this requirement by the letter of the law, while still falling short in terms of their scope of coverage.
Classifying a Security
A security is popularly defined as a tradable financial asset. A classic test of whether or not something is an investment contract, which is always a security, is called the Howey Test. This test asks whether “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
Bitcoin by design has no entity for issuing such a security; nor can the issuance of Bitcoin be captured and leveraged to raise capital. As such, Bitcoin can not pass the Howey Test and in 2019 the SEC Chairman clarified that Bitcoin is not a security. This clarity places Bitcoin in opposition to many other cryptocurrencies, but even so, there remains substantial regulatory ambiguity. For example, while the initial offering of Ethereum tokens at ICO passes the Howey Test and was almost certainly a securities offering, the SEC has indicated that the Ethereum token ceased to be a security once the network reached a critical size, at which point the token was better treated like a commodity.
This definition illuminates the pending SFC regulations in a new light: if an HKD/BTC trading pair is not in the purview of the SFC, which cryptocurrencies might be?
A Bifurcation in the Exchange Market
The proposed framework is an opt-in licensing scheme, meaning that qualifying exchanges can choose whether or not to become licensed. This is presumably because some non-security assets like Bitcoin don’t fall within the SFC’s remit, while others would be expected to classify as securities. This means an exchange can choose not to become licensed without risking an enforcement action by ensuring it does not expose trading pairs containing security assets. The head of the SFC, Ashley Alder, recently stated that Bitcoin and other cryptocurrencies “are not securities” and the SFC “only has the power to regulate a platform that trades virtual assets or tokens which are legal securities or futures contracts.”
Rather than an attempt to regulate all digital asset exchanges, these regulations instead appear to be the SFC positioning itself for a future environment in which tokenized securities, such as equities, are being actively traded. This helps explain why the regulations also outline that exchanges seeking a license must restrict access to “professional investors” who have an HK$8M (approx. US$1M) portfolio — a standard requirement for Hong Kong securities investors. In the cryptocurrency exchange business, most users are retail, meaning that choosing to abide by these regulations could kill a substantial amount of trade volume, such that many exchanges may choose to continue existing outside of the SFC’s remit.
So how might an exchange continue to serve its retail customer base and avoid falling under the purview of the SFC? It likely requires restricting the trading pairs on offer to ensure there’s no grey area as to whether or not a customer is trading a security. It follows that this new scheme in Hong Kong might force a bifurcation in the local cryptocurrency exchange market. Exchange venues appear set to choose which side of the market they want to be on.
Already we see that Hong Kong-based exchange OSL has applied for the regulatory sandbox, and Huobi, by virtue of already being listed on the Hong Kong Exchanges and Clearing Market (HKex), might also be an early beneficiary of the scheme. Given how substantial the Hong Kong market is, it will be interesting to observe where other venues fall.
Until Next Time
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