This article was written by Urszula McCormack and Peter Bullock.
On 18 September 2017, we gathered senior regulators, digital innovators, insurance and banking professionals and experienced professional advisors for a roundtable discussion in Hong Kong about the future of cryptocurrency, under the Chatham House Rule. There was consensus that digital assets offered a remarkable platform for achieving genuinely transformative outcomes. However, views differed about how best to differentiate between the good, the bad and the ugly.
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The state of play
The market capitalisation of cryptocurrency, comprising digital coins and tokens of varying kinds, is approximately USD100 billion. This number is rapidly increasing. It is also volatile, with swings of 25% or more not uncommon. Token sales have surpassed venture capital investment as a source of funding.
In the meantime, work on central bank digital currencies is also gaining momentum, with proof of concept projects in Mainland China, the United Kingdom, Singapore, Hong Kong, Uruguay and others reportedly underway.
In Hong Kong, digital assets are not new, but the use of public token sales to raise funds only officially entered the market in around mid-2017. Increasingly, Hong Kong is seen as a favourable “hub” for token sales for several reasons, including its legal, regulatory, corporate and taxation framework.
Digital assets are important
Digital assets have an important role to play in the digital economy. They create new pathways for encapsulating, moving and using value. They can facilitate cheap, fast and secure transfers. They help users navigate challenging traditional
infrastructure limitations, overcome financial exclusion and even deal with fraud. They are also essential for many blockchain-based platforms.
In tandem with this growth, the crypto ecosystem is flourishing, with new exchanges, crypto mining operations, fund managers, advisers, marketers, smart contract builders, application developers and others rapidly expanding to plug gaps
and capitalise on the bull run of this new technology boom.
A diverse regulatory response
Against this backdrop, regulators across the globe have taken steps to rein in the galloping trend for token sales, or at least ensure that market participants remember that the law is not oblivious to innovation. Regulatory actions have included:
- reminders, in the form of regulatory statements setting out the laws and regulations that are likely to apply;
- listing suspensions, for certain listed companies seeking to participate in cryptocurrency;
- warnings to banks, in relation to the financial crime risks associated with anonymous or pseudonymous digital assets;
- criminal actions, for Ponzi schemes and fraud; and
- outright bans, including a call for refunds.
Certain markets are also now focussing on exchanges.
Does the law really protect participants?
Most jurisdictions already have a vast body of law and regulation to support these regulatory actions. These include securities, remittance, stored value and derivatives regulation, anti-Ponzi scheme laws, listing rules and anti-money
laundering and counter-terrorist financing (“AML/CTF”) requirements.
In addition, a range of civil and criminal laws protect purchasers from breach of contract, fraud, data protection breaches and, to an extent, unfair conduct and terms.
It is still early days. We expect to see these laws engaged more fully in the coming months.
So what is the risk?
Despite the legal protections available, there remains a perceived gap in protecting the public and the integrity of the digital asset market.
Many were of the view that the transnational nature of blockchain-based digital assets, coupled with the complexity and cost of enforcing legal rights make it difficult (if not impossible) to mitigate fully the risks of wrongdoing in the ecosystem.
Some of the key risks identified included:
- cybersecurity, including denial of service and phishing attacks;
- mining manipulation, including frontrunning;
- exchange governance and security;
- secondary trading manipulation, including insider dealing;
- conflicts of interest;
- lack of transparency in pre-sales and founder allocations;
- threats to net neutrality;
- network limitations, including the ability of major networks to deal with spikes; and
- user risk.
Even with the best of intentions, project risk carries its own independent challenge. For example, many platforms for which digital “utility” tokens are issued have not yet been fully developed, there is a risk of failure for many reasons, some of which are outside of the reasonable control of the founders.
How do we address the gaps without stifling innovation?
Regulation must always balance the need for innovation with appropriate protections for the public. There was debate as to whether or not cryptocurrencies and other digital assets had sufficient market penetration to the “average person on the street” (…or one’s grandmother) at this time to warrant any additional measures. Many argued that it had not.
Critically, legislation takes time. In Hong Kong, financial services regulation has required as long as 10 years to implement, although sometimes as low as two years. There are certain legislative designation mechanisms that could
make this a lot faster, but the appetite to use those mechanisms is not clear. For example, certain tokens could be designated as a “collective investment scheme”, but is this really necessary?
"Hong Kong is swiftly becoming a global hub for blockchain innovation. Digital assets have an important role in that story, but smart risk controls are key."
Hong Kong is unlikely to drive significant legal change, unless there were cogent reasons to do so. Actions by much larger markets, or at the international level, would be much more likely to result in additional regulation.
There was no suggestion to regulate blockchain technology or digital assets generally. However, three key channels were identified to address at least some of the risks, alongside the opportunity for aggrieved individuals to take private actions.
…but what about bank accounts?
In tandem, more work needs to be done to ensure that poorly governed token sales and scams do not paint all digital assets with the same broad brush from a practical perspective.
|Industry groups in a number of key markets have implemented standards for digital token sales. A project is now underway to provide this for the Hong Kong market. Such standards are not enforceable, but can assist in raising standards amongst those seeking to do the right thing. They can also help purchasers to know what to look for.
Peer pressure can also occur through advisors sharing best practice with their clients and advising the risks of non-compliance, including fraud, cybersecurity breach of AML/CTF rules.
Industry collaboration and standards would also benefit other areas, such as conflicts of interest, market manipulation and exchange governance in due course. However, these present very significant challenges when they occur beyond the public realm and on a transnational basis.
|Education is a priority. “Caveat emptor” must be made clear. Many regulators, including the Securities and Futures Commission, have issued warnings to help ensure purchasers understand what they are looking for. Additional initiatives are underway.
||Critical to the success of any existing regime is actual enforcement of existing laws. This sends a clear message about the effectiveness of that regime. It also helps legitimate and well-advised market participants to retain an appropriate competitive advantage.
Bank account opening was identified as an ongoing challenge for legitimate businesses. There was recognition that AML/CTF prevention mechanisms were useful, but also a concern that certain banks were not taking into account the
facts and circumstances of each applicant – merely “de-risking” all cryptocurrencies and other digital asset market participants, by refusing them banking facilities or closing existing accounts.
This ties into broader considerations, such as how far privacy should be respected, and by whom. Anonymity and pseudonymity remain favoured by many users, but create risk that tends to result in insurmountable compliance and cost
concerns for banks from an AML/CTF standpoint. Of course, cash is anonymous, but the context is different.
Many issuers and exchanges are already adopting robust know-your-customer (KYC) controls, but are still having accounts rejected or closed.
The way forward
Hong Kong has an enormous opportunity to create a market-leading digital economy. That economy must be innovative and it must be safe. The advent of digital assets should be embraced, with ongoing dialogue between regulators and
key market participants to identify risks as they evolve.
Peer pressure, education and enforcement should be the priorities for Hong Kong, given its robust legal and regulatory environment. More fundamental changes may follow international action in due course and early engagement on mitigating risk is useful.
To which we refer inclusive of “coin offerings”, “ICOs”, “token generating events” and similar.
Under section 393 of the Securities and Futures Ordinance (Cap. 571). See definition of “collective investment scheme”, paragraph (x) in Part 1 of Schedule 1 to the SFO.
To be announced shortly.