Guest Speaker  | Keith Choy,  the interim supervisor of the Intermediaries Division of the Hong Kong Securities and Futures Commission (SFC)(the chairman of the Fintech Advisory Group)

Compiler  | Ehan Wushuo Blockchain

Good morning. It is an honor to be invited to speak at this wonderful festival. The past few years have seen many amazing developments and breakthroughs in various technologies. For example, we have seen enterprises integrating artificial intelligence into their businesses, and central banks, financial institutions are exploring the benefits of using the Distributed Ledger Technology (DLT). Just a few weeks ago, I got to experience the wonders of Chatgpt firsthand. The potential applications of the relevant technology and the impact of its concretization are huge. We've seen news reports that financial companies are testing the tool and using it to write research reports. I must admit that the idea of using Chatgpt to write this presentation also came to my mind. But I gave up, and that was because such technology has its own limitations and errors, including the fact that it sometimes generates the wrong answers to questions. As an example. An asset manager asks Chatgpt to give him ten stocks that could benefit from virtual reality. Chatgpt provides seven names, and the manager discovers from the remaining three that Chatgpt has made up three fake names. This example highlights the importance of taking advantage of innovative technologies in a responsible manner. As with the advent of DLT-based web3, it promises huge economic benefits and has the potential to change the way the Internet and we interact. We must also be aware of the potential risks and manage them appropriately.

To be clear, the SFC (Hong Kong Securities and Futures Commission) recognizes the opportunities that web3 presents. In fact, our CEO, Ms. Julia Leung, already stated in her speech at last year's Hong Kong Fintech Week that the SFC has taken note of the potential impact of web3, virtual assets, NFT, metaverse and GameFi in our daily lives and that we support the underlying DLT technology development and innovation, so let me take this opportunity to share with you today: SFC policy initiatives and two very important topics related to that - centralized Virtual Asset Trading Platforms (VATPs) and Decentralized Finance (DeFi).

So let's start with DeFi, just like the evolution from Web 2.0 to Web 3.0, to enable a decentralized Internet that delivers the power of fintech to users and puts it into practice. DeFi advocates for a decentralized financial ecosystem that uses Distributed Ledger Technology (DLT), Virtual Asset (VA) and Smart Contract to deliver financial services without traditional financial intermediaries. The original idea behind DLT was to democratize finance and make DeFi services accessible to anyone with an Internet connection and a wallet capable of storing virtual assets. Proponents believe that by embracing the ideas behind DeFi, the financial services industry will see a paradigm shift of sorts. In the DeFi space, we are already seeing many products and services similar to traditional finance, including trading, lending, asset management, insurance, and derivatives. However, DeFi also faces some unique challenges.

First, financial stability issues arise from the interconnectedness within the DeFi and Virtual Asset (VA) ecosystem, as well as between DeFi and traditional financial products. Financial stability risks also arise from leverage, for example, users in a VA lending agreement can use the VA as collateral to obtain more loans. Second, the transparency of such interrelationships and linkages is low due to a lack of data and the fact that many of the companies and activities involved are currently unregulated. Third, the DeFi ecosystem faces market integrity issues, such as price manipulation, pre-emption and other types of abusive behavior. Finally, it is of concern that the increasing scale of cyber attacks raises investor protection concerns. For example, in March 2022, the NFT gaming platform "Axie Infinity" suffered a massive hack that resulted in the theft of $625 million worth of assets.

You may ask whether regulation is feasible in the face of DeFi's uniqueness. In fact, regulating DeFi can be difficult for a number of reasons. First, who should be responsible when problems arise? Traditional financial intermediaries cannot operate independently, and in some DeFi protocols, once a developer or operator deploys a smart contract to the blockchain, it can no longer be modified. In addition, the governance of a DeFi product or service may be decentralized to varying degrees and may involve the use of governance tokens or decentralized autonomous organizations. Governance token holders (which may include the original developers of the smart contract) may vote on product changes such as new product features. In this decentralized governance scenario, identifying the individual responsible for defining the product or service can become very difficult. This issue sidesteps the question of whether the DeFi service is controlled by the smart contract developers, some or all of the governance token holders. Second, regulation becomes more difficult due to the autonomous nature of DeFi and the challenge of identifying DeFi protocol developers and operators, a challenge further heightened by the cross-border nature of DeFi products and services, whose developers and operators may be located in multiple jurisdictions.

I will now share with you the SFC's view on DeFi, which aims to ensure that financial activities subject to its regulation are defined by applying the same existing regulatory framework as long as DeFi activities fall within the scope of the Securities and Futures Ordinance (SFO). DeFi will be subject to the same regulatory requirements as traditional financial entities, following the principle of "same risk, same rules" promoted by the SFC. Persons engaging in or performing such activities should comply with the licensing requirements and be regulated by SFC to clarify that the provisions of automated trading services are SFO-regulated activities. If a decentralized platform allows trading in securities or futures that constitute securities or futures under the SFO, then the platform and its operator will need to be licensed under the Regulations on Local Financial Supervision and Administration.

In Hong Kong, Collective Investment Schemes (CIS) offered to the public must comply with authorization requirements under the Securities and Futures Ordinance (SFO), as DeFi liquidity pool agreements that meet the definition of CIS may be subject to these legal requirements. Arrangements that offer Virtual Asset (VA) deposits, savings, income and services to investors in Hong Kong, some of which may constitute CIS under SFC regulation, may even in effect be an Illegal Collective Investment Scheme (ICIS). The challenge of determining who should be held accountable for DeFi may not be entirely insurmountable in practice, and the SFC will evaluate each DeFi service or activity on a case-by-case basis as it learns the inner workings and arrangements of the DeFi agreement. However, in the context of some of the challenges mentioned earlier, it is worth noting that some DeFi protocols may be decentralized in name only. In reality, a small group of developers, operators or interested parties may still have control, for example, they may hold the majority of governance tokens or have the right to make decisions on governance recommendations from audits. Therefore, when analyzing this issue, it is important to focus on the actual solutions of these arrangements and not just on how they advertise their projects.

Next, I will discuss centralized Virtual Asset Trading Platforms (VATPs). Today, the SFC is more focused on centralized VATPs because the majority of Virtual Asset (VA) transactions occur on these platforms. This point of contact with investors raises investor protection issues, which explains why SFC introduced in 2019 comprehensive regulatory measures for VATPs, specifically for VATPs that offer at least one security token trading service. The regulatory regime covers the requirements applicable to traditional broker-dealers and automated trading platforms, with certain adjustments for VA specific risks.

This now means that we are not only regulating VATPs from an AML perspective, but also from an investor protection perspective. Regulatory requirements cover areas such as the safekeeping of liquid assets, conflicts of interest, cybersecurity, prevention of market manipulation activities, and the development of access procedures for distressed transactions. As you may be aware, following the passage of the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO) in 2022 by the Legislative Council, SFC is looking to implement a new licensing regime covering centralized VATPs. When that regime comes into effect on June 1 of this year, centralized VATPs that do not trade in security tokens, and all centralized VATPs operating in Hong Kong, regardless of whether they offer transactions in security tokens or non-security tokens, will have to be licensed by us. The turmoil in the cryptocurrency market itself reinforces the belief in the need to set higher regulatory standards and develop appropriate guardrails for VATPs in order to protect investors, market integrity and market stability. While this incident demonstrates that the Virtual Asset market is not yet large enough to raise systemic risk concerns, we cannot forget the cases that have caused harm to consumers.

For example, retail investors suffered losses from the implosion and collapse of the virtual asset lending platform Celsius Network and the centralized exchange FTX. The news reports following the FTX failure revealed a range of issues, including a lack of basic governance and risk management controls, conflicts of interest, and, more importantly, misuse of such assets, which would not be tolerated in any regulated entity. These failures demonstrate that it is critical for VATPs to have a robust risk management mindset, which is precisely the area covered by our existing VATPs regulatory regime. That is why when SFC issued the consultation paper, we effectively translated the comments under the existing regulatory requirements into proposals for a new regime, with certain revisions based on market developments and experience of operating the current regimes. Under the current regimes, SFC imposes conditions on operators that restrict them to providing services only to professional investors. This requirement will be relaxed, but subject to additional GAAP accounting rules established to protect investors. This includes a requirement for VATPs to understand the risk profile of their clients during the account opening process to assess the appropriateness of providing such services and to set appropriate limits. Ensure that the type of exposure is reasonable by referring to the customer's financial situation and personal circumstances. In addition to requiring VATPs to establish standards for due diligence and access to VA for trading, SFC recommends that VA offered to retail investors should meet additional access criteria that would qualify them as eligible large cap virtual assets. Now, given the turmoil and scandals in the virtual asset ecosystem, I believe everyone would agree that SFC-licensed VATPs must put in place appropriate controls and risk management measures to prevent similar incidents from occurring in Hong Kong. the SFC's consultation on the proposed regulatory requirements under this new regime concluded on 31 March.

I would like to take this opportunity to thank those market participants and interested parties who reviewed the consultation paper and provided feedback on the proposals. It cannot be stressed enough that this engagement and constructive dialogue with the industry is critical to the development of SFC's policies. We will carefully review all comments received to ensure that the regulatory regime for centralized VATPs in Hong Kong is robust, effective and strikes the right balance between investor protection and support for innovation. In summary, the SFC fully supports the use of new technologies to deliver financial services and products in Hong Kong. We need to embrace technological innovation, be alert to potential risks and accelerate the delivery of our commitment to protect investors in our markets. I firmly believe that with the joint efforts of the government, regulators and the industry, Hong Kong will eventually become not only an international financial center, but also a premier hub for web3 and virtual assets. I hope you enjoy the event. Thank you very much.

Reprinted from Wushuo Blockchain