Speaker: Choi Chung-fai, Interim Head of Intermediaries Department, Hong Kong Securities and Futures Inspection Commission (Chairman of Fintech Advisory Group)
Original compilation: Ehan Wu said blockchain
Good morning. It is an honor to be invited to speak at this wonderful festival. Over the past few years, there have been many amazing developments and breakthroughs in various technologies. For example, we are already seeing businesses integrate AI into their operations, and central banks, financial institutions are exploring the benefits of using distributed ledger technology (DLT). Just a few weeks ago, I experienced the wonders of Chatgpt firsthand. The potential applications of related technologies and their concrete implications are enormous. We see news reports that financial firms are testing the tool and using it to write research reports. I must admit that the idea of using Chatgpt to write this speech also crossed my mind. But I gave up, and that's because such techniques have their own limitations and bugs, including that it can sometimes generate wrong answers to questions. for example. An asset manager asked Chatgpt for ten stocks that could benefit from virtual reality. Chatgpt provided 7 names and the manager found out from the remaining 3 that Chatgpt made up 3 false names. This example highlights the importance of taking advantage of innovative technological advantages in a responsible manner. As DLT-based web3 emerges, it promises huge economic benefits and the potential to change the way the internet interacts with us. We must also be aware of potential risks and manage them properly.
To be clear, the SFC (Hong Kong Securities and Futures Commission) recognizes the opportunities presented by web3. In fact, our CEO, Ms. Julia Leung, said in her speech at Hong Kong Fintech Week last year that SFC has noticed the potential impact of web3, virtual assets, NFT, Metaverse and GameFi in our daily lives, and we support the underlying DLT technology development and innovation, so let me take this opportunity to share with you today: two very important themes related to SFC policy initiatives - centralized virtual asset trading platform (VATP) and decentralized finance (DeFi).
So let's start with DeFi, just like the evolution from Web 2.0 to Web 3.0, realize the decentralized Internet, pass the power of fintech to users and put it into practice. DeFi advocates the construction of a decentralized financial ecosystem, using distributed ledger technology (DLT), virtual assets (VA) and smart contracts to provide financial services, and abandoning traditional financial intermediaries. The original idea of DLT was to democratize finance, making DeFi services accessible to any user with an internet connection and a wallet capable of storing virtual assets. Supporters believe that as long as the philosophy behind DeFi is upheld, the financial services industry will usher in a seismic paradigm shift. In the DeFi field, we have seen 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 stem from within the DeFi and virtual asset (VA) ecosystem, as well as the interconnectedness between DeFi and traditional financial products. Financial stability risks also come from leverage, for example, in a VA lending agreement, users can use VA as collateral to obtain more loans. Second, there is less transparency about such interrelationships and linkages due to data scarcity 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, front-running, and other types of abuse. Finally, it is worth noting that the growing scale of cyber attacks has raised 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 might ask whether regulation is feasible in the face of the uniqueness of DeFi. In fact, due to a variety of reasons, it is indeed difficult to regulate DeFi. First, who is responsible when something goes wrong? Traditional financial intermediaries cannot operate independently, and in some DeFi protocols, once a developer or operator deploys a smart contract on the blockchain, it cannot be modified. Additionally, the governance of DeFi products or services may be decentralized to varying degrees, possibly involving the use of governance tokens or decentralized autonomous organizations. Governance token holders (which may include the original developer of the smart contract) can vote on product changes such as new product features. With such decentralized governance, identifying the individual responsible for defining a product or service can become very difficult. This question begs the question of whether DeFi services are controlled by smart contract developers, some or all governance token holders. Second, regulation becomes more difficult due to the autonomous nature of DeFi and the identification challenges for DeFi protocol developers and operators. The cross-border nature of DeFi products and services further exacerbates this challenge, as their developers and operators may be located in multiple jurisdictions.
Now, I will share with you the views of the Hong Kong Securities Regulatory Commission (SFC) on DeFi. The SFC aims to ensure that for financial activities regulated by it, these activities 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). Under the principle of "same risk, same method" advocated by SFC, DeFi will be subject to the same regulatory requirements as traditional financial entities. Persons engaging in or performing such activities are subject to licensing requirements and are regulated by the SFC to clarify that the regulation of automated trading services is an activity regulated by the SFO.If a decentralized platform allows transactions that constitute securities or futures regulated by the SFO, that platform and its operators will need to obtain a license for Type 7 regulated activity.
In Hong Kong, offering collective investment schemes (CIS) to the public must comply with authorization requirements under the Securities and Futures Ordinance (SFO), as DeFi liquidity pool agreements that comply with the CIS definition may need to comply with these legal requirements. Arrangements to provide virtual asset (VA) deposits, savings, benefits and services to Hong Kong investors, some of which may constitute a CIS within the SFC's regulatory purview, may even actually be an illegal collective investment scheme (ICIS). The challenge of determining who should be held accountable for DeFi may actually not be entirely insoluble. The SFC will evaluate each DeFi service or activity on a case-by-case basis after understanding the inner workings and arrangements of the DeFi protocols. However, in terms of some of the aforementioned challenges, it is worth noting that some DeFi protocols may only be decentralized in name. In practice, a small group of developers, operators, or interested parties may still have control, for example, they may hold the vast majority of governance tokens or have the power to make decisions on governance recommendations from audits. Therefore, when analyzing this problem, 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 (VATP). Today, SFC is paying more attention to centralized VATPs, as most virtual asset (VA) transactions happen on these platforms. This touchpoint with investors raises investor protection concerns, which explains why the SFC in 2019 introduced sweeping regulatory measures for VATPs, particularly those offering at least one security token trading service. The regulatory regime covers requirements applicable to traditional brokers and automated trading platforms, with some adjustments for VA-specific risks.
Now, this means that we not only regulate VATP from an anti-money laundering perspective, but also from an investor protection perspective. Regulatory requirements cover areas such as the safekeeping of liquid assets, conflicts of interest, cybersecurity, protection against market manipulation activities, and the development of entry procedures for distressed transactions. As you may know, following the passage of the Anti-Money Laundering and Counter-Terrorist Financing Amendment Act 2022 by the Legislative Council, the SFC is looking to implement a new licensing regime covering centralized VATPs.When the regime comes into effect on June 1 this year, centralized VATPs that allow non-security token transactions, all centralized VATPs operating in Hong Kong, regardless of whether they offer security tokens or non-security token transactions, must obtain our permission.The turmoil in the cryptocurrency market itself has reinforced belief in the need to set record-breaking regulatory standards and put in place appropriate guardrails for VATPs 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 must not forget the cases where consumers were harmed.
For example, retail investors suffered losses due to the implosion and collapse of virtual asset lending platform Celsius Network and centralized exchange FTX. News coverage following FTX’s failure revealed a host of issues, including a lack of fundamental governance and risk management controls, conflicts of interest, and, more importantly, misuse of this type of asset, which would not be tolerated in any regulated entity of. These failures show that it is critical for VATPs to have a sound risk management mindset, which is exactly the area covered by our existing VATP regulatory regime. This is why, when the SFC issued a consultation paper, we effectively translated comments under existing regulatory requirements into proposals for a new regime, with certain amendments based on market developments and experience with the operation of the existing regime. Under the current system, SFCs impose conditions on operators restricting their services to professional investors only. This requirement will be relaxed, subject to additional GAAP accounting rules put in place to protect investors. This includes requiring VATPs to understand a client's risk profile during the account opening process to assess whether it is appropriate to provide such services, and to set appropriate limits. Ensure that the type of exposure is reasonable by reference to the client's financial situation and personal circumstances. In addition to requiring VATPs to develop due diligence and criteria for admitting VAs to trade, the SFC also proposes that VAs offered to retail investors should meet additional criteria for admission that would qualify them as eligible large-cap virtual assets. Now, given the turbulence and scandals in the virtual asset ecosystem, I believe everyone will agree that a VATP licensed by the SFC must have proper controls and risk management measures in place to prevent similar incidents from happening in Hong Kong. The SFC's consultations on the proposed regulatory requirements under this new regime concluded on 31 March.
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