Hong Kong to be digital asset regulatory sandbox for China – Crypto News

New rules for ‘Virtual Asset Trading Platform Operators’, aka crypto exchanges, kick in on June 1, 2023 in Hong Kong. The guidelines will allow licensed exchanges to sell highly liquid cryptocurrencies to retail investors.

This development continues a tradition of Hong Kong, a Special Administrative Region of China, being a sandbox of sorts and a gateway to the mainland and its markets. However, Beijing has banned cryptocurrency trading as well as mining of bitcoin, while also being an enthusiastic adopter of blockchain technology and its potential to streamline and cut costs in a wide collection of industries.

With Hong Kong’s Securities and Futures Commission (SFC) laying out the rules that define what cryptocurrency exchanges need to do to be licensed in the city and operate legally, this could be a sign of China softening its position on digital currencies?

Forkast’s Megha Chaddah spoke with Angelina Kwan, chief executive officer of Hong Kong-based regulation consultant Stratford Finance, about the new rules, what they get right and the gaps that still need to be filled. As a director of the SFC’s Supervision of Markets division from 1999 to 2006, Kwan helped shape early Hong Kong regulations on automated and internet trading services.

The following Q&A has been edited for clarity and length.

Meghan Chaddah: In contrast to regional neighbors, Hong Kong seems to be setting in place virtual asset business guidelines to ensure that these businesses can operate in an orderly fashion. Broadly speaking, would you say the government appears to be putting in place guardrails for customer safety while giving virtual asset businesses room to innovate?

Angelina Kwan: I wouldn’t say there’s specific guardrails. I would say that we are moving forward in a very coordinated fashion in terms of full licensing. This is a 380-page consultation conclusion that reflects the market actually writing into the first set of consultation rules that the SFC put up.

They put up a very good set of rules. The market commented and now they’ve come back with tempered and very good decisions in terms of what the next phase of digital assets is going to be. And it’s going to be very coordinated.

It’s very clear you’re going to get a license if you comply with all the rules and regulations, and retail investors will be able to buy digital assets as long as they pass certain requirements in terms of understanding what they’re getting into, understanding and opening accounts with licensed, virtual asset service providers.

I would say this is a regime that’s very clear who does what, what protections investors get and how do we innovate and move forward for digital assets. I made a forecast in 2018 where I said that the market at the time is not regulated, but in 3-5 years, the market is definitely going to be more and more regulated. And people just have to be on board and understand this.

As virtual assets become more and more like a real asset, you’re going to get institutional and retail adoption of such assets.

Chadda: You talked about retail customers being allowed to trade cryptocurrencies, which are large and highly liquid. But the burden to ensure that these customers understand the risks involved rests on the exchanges themselves. How practical is this requirement and how does it compare to the burden that’s placed on exchanges that deal in traditional financial products?

Quan: I used to work for HKEX (Hong Kong Exchange) and HKEX has this amazing website where it discusses each of its products.

Rules and regulations are published and brokers are the people that sell the products on Hong Kong exchanges. These are the registered people that have licenses, who take ownership of the client relationship and are the ones talking to and advising clients.

They may have investor education training, and the regulator also shares investor education training. So if you go to a number of brokers, they’ll have few seminars. They will have your account executive talk to you about different products. But if you are really not the type of person that would trade, you may not get your account opened by a broker because you may not be the right risk profile. For example, if you’re an 80-year-old retiree with a small pension, you’re not going to be buying derivatives, especially derivatives on very risky assets.

On the flip side, if the same retiree is buying an annuity or putting it into a savings account, that may be something that an 80-year-old [could access] and that’s the part called suitability. That is handled by the broker and the exchange. The broker puts the trade on the exchange that provides the interface.

And that’s where we are now with these licensed exchanges. They have to offer account opening, ensure that their clients know what they’re getting into and what the products are. Some virtual asset exchanges are very good at explaining each product. They may not tell you the risk, but they definitely tell you about the product. They probably have to do more about talking about risk.

Chadda: Approved tokens for investment have to undergo a stringent due diligence process, which includes having a year-long track record and inclusion into acceptable indices. So that minimizes the chances of fly-by-night operators or coins taking advantage of gullible investors. We have seen instances in South Korea where one of the managers of a crypto exchange who was in charge of token listing was accused of taking bribes for listings. Do you think that Hong Kong regulators are keeping up with all that’s happening around the region and closing potential loopholes?

Quan: They are, definitely. But this consultation paper was drafted way before this [South Korea] The bribery case came out. In the consultation draft, it said that if you’re an exchange that wants to offer tokens, your management has to know exactly what they’re offering. So if you’re offering Bitcoin, management will need to know and do due diligence on Bitcoin. You need to know where it came from, where it’s traded, be listed on at least two indices. You need to know that it’s not a scam that you’re going to be offering to your clients. So that’s the requirement that was written almost six months ago.

In the South Korea bribery case, if it was a firm with a management team that was very serious about following the rules, that one guy would not be able to get this token listed unless he was able to convince the entire management team. so that [bribery] would not have occurred if Korea had that type of rule. Management teams now need to be convinced that companies and exchanges need to be convinced that these are the right tokens before they offer them to their clients. So due diligence is required.

On the New York Stock Exchange, it’s FINRa that approves a listing. In Hong Kong, It’s SFC and HKEX that approve the listing. But when you look at virtual asset tokens, you’ve got Satoshi Nakamoto and a group of people that came up with this [Bitcoin] products. That’s it. But there were no guardrails when they listed the token and the token just sort of developed. And many of these tokens were just developed and there’s no background nor documentation, there’s nothing on them. So that’s why firms that are going to be regulated in Hong Kong need to do the due diligence before unleashing these tokens.

Chadda: The rules for virtual trading platforms also talk about safe custody of assets, segregation of client funds. How much of it is due to the collapse of the FTX exchange and the alleged co-mingling of funds? And do you think there’s enough that’s put down in terms of licensing requirements there?

Quan: The current SFC rules do not have legislation to have outsourced custodians at this time. So that’s something I think they’re going to definitely work on. They’re going to require that the exchange getting a license has to have a custodial function, either as an associated entity or within that exchange.

So if you’re getting the license, you’re responsible for the trading, the safekeeping of your hot wallets, your cold wallets, your exchange mechanisms, your people. On the other hand, you have people that don’t have a licensed exchange background. And it’s a free-for-all because you don’t know what’s behind all of this, because it’s not licensed.

We didn’t know [Sam Bankman-Fried, the founder of FTX] didn’t check certain things or we didn’t know some exchanges didn’t have proper custody. But once you get a license, you have to have certain systems in place. You’ve been checked, signed off on and probably have an auditor. Such good housekeeping for a developing asset is going to bring forward the next phase to develop virtual assets.

Chadda: The SFC is saying stablecoins are a no-go for retail trading until we have regulations for this specific type of crypto asset. Do you think Hong Kong’s development of the state CBDC aka the e-HKD has anything to do with this decision?

Quan: The HKMA (Hong Kong Monetary Authority) drafting regulations for stablecoins is one of the reasons the SFC has said what it has said. The HKMA is going to draft an entire regime of how stablecoins should work and how they should be backed. And there have been stablecoin issuers very interested in it. The easy ones are US$1 to one USDT.

The ones that are not easy are the ones that you saw with Terra and Luna, who called themselves [an algorithmic] stablecoin. And that is what the SFC is most worried about.

If it’s a one-for-one like USDC and USDT, it’s very easy to understand. As this starts moving along, I think the SFC and the market will have discussions over coins like that. But for the next iteration of Terra and Luna, that’s definitely not on the table.

My team in the Hong Kong Securities Institute has to establish the questions for this. It will be one of the most transparent. I think it’s very clear and a pretty good way of getting your license. It may take you a while but it’s definitely going to come, whereas [the processes] in other countries have slowed down because they’re overwhelmed or rethinking what they’re going to do next in terms of licensing.

Everything that I said is now codified and in writing so there’s no more excuse of not putting in proper internal controls, security measures and having staff that are trained and have the right background for virtual assets. So it’s a good step forward for Hong Kong to be the regulatory sandbox for China, for digital assets. With that, I think we’ll see a lot of interest in the license because it’s going to be very clear.

Chadda: We’re already hearing so many firms talking about applying for the licenses, such as Okex and ZA Bank. How soon do you think we could see the first of these licenses and where might we be by the end of this year?

Quan: The first two [firms] – Hashkey and OSL – just have to reapply. So you’ll see two [licenses] out the door maybe within 6 to 8 months. But they’re already licensed and fall under the ‘opt in’. Then you’ve got the companies that are being ‘grandfathered’, those already operating in Hong Kong.

Companies are now putting in licensing applications and it will take them some time to figure out the application, so this could take six months to a year because of the processing time, with just four people on the SFC team doing [processing at present],

There are about 10 exchanges in the first batch that have indicated interest in obtaining licenses, which will take about eight months to a year or a year and a half. It took Hashkey almost two years. [together approved], It takes time because there’s so much information and you’ve got to work on different licenses at the same time.

By this time next year, we’ll definitely have a couple of licensed firms. In the letter that went out with the consultation paper, it asked firms to leave Hong Kong if they do not comply with the license application. We’re hoping that people do get the license and we get a very active digital asset industry here, just like securities.