Review of the Month: November 2018

Review of the Month: November 2018

November 20, 2018

SFC’s New Regulatory Approach For Digital Assets

The Securities and Futures Commission (SFC) in Hong Kong recently set out a new approach to the regulation of virtual assets.

To clearly understand how the statement will affect the industry, we created this Q&A below with our legal team.

What is the main message that the SFC has circulated?

The regulatory approach announced last week allows the SFC to regulate the management and distribution of virtual assets regardless of their classification (widely debated to date) as to whether a token constitutes a security, utility, a futures contract or neither of them.

Separately, the SFC is setting out a conceptual framework for the potential regulation of virtual asset trading platforms (cryptocurrency exchanges).

How does the circular affect the role of custodians for virtual assets?

The role of custody will become more critical in the virtual assets market. However, we need to make a distinction between the impact of this message on virtual assets funds distributors, fund managers and platform operators.

Fund managers

Licensed fund managers will have to select the most appropriate custodial arrangement. Assets could be held in self-custody or with a third-party custodian or exchange. Fund managers should assess custodial arrangements, or combinations of arrangements, based on ease of access and security of the custodian.

Fund managers should also exercise diligence in the selection and ongoing monitoring of custodians, paying attention, among other things, to experience, track record, regulatory status, corporate governance, senior management background, financial resources, insurance cover and operational capabilities.

For assets kept in self-custody fund managers should document the reasons for self-custody, segregate these assets from the licensed corporations’ own assets and implement appropriate measure to safeguard them.

Fund distributors

Intermediaries distributing virtual assets funds should conduct proper due diligence on funds not authorized by the SFC.

With respect to custodial arrangements, the due diligence should include segregation of clients’ assets, internal controls on authorization schemes to transfer assets from custodians, allocation of assets to be kept at different host locations (e.g. custodians, exchanges) and types of storage (e.g. hot storage, cold storage), regulatory status of the custodian, robustness of IT systems, contingency plans, financial soundness and insurance coverage.

Platform operators

The SFC has also disclosed a number of terms and conditions that may be imposed on licensed platform operators.

Specifically, with respect to custody, platform operators are expected to disclose their custodial arrangements, segregate clients’ virtual assets from the corporations’, safely store a sizable amount of virtual assets (e.g. 98%) in cold storage to minimize the probability of hacking and taking out an insurance policy against for theft and hacking. In addition, the insurance policy should cover a substantial portion of virtual assets (e.g. full coverage for virtual assets in hot storage and 95% for those held in cold storage).

What are the main implications for the virtual assets market?

The most straightforward implication is that the SFC will impose licensing conditions on funds, exchanges, and more generally on operators within the virtual assets industry. These operators are those which deal with, or manage portfolios investing in virtual assets, irrespective of whether the virtual assets meet the definition of “securities” or “futures contracts”.

Moreover, the SFC aims to set out a conceptual framework to explore a pathway for compliance for virtual asset trading platform operators who are willing to be supervised by the SFC. Under this framework, the SFC will, in a sandbox environment, explore whether virtual asset trading platforms are suitable for regulation and observe the operations of interested trading platform operators and their compliance with proposed regulatory requirements.

In terms of timeline, we believe that the SFC will move fast with the implementation of licensing rules and sandbox environment, which will be positive for the Hong Kong virtual currency ecosystem in the long term.

Doubts remain in terms of how smoothly the SFC’s framework can be adopted considering some inherent characteristics of virtual assets. In fact, the SFC itself highlights that in some cases certain regulatory standards might not be satisfied and SFC might decide not to regulate certain operators. This is the case for anti-money laundering standards given that “anonymity is a core feature of blockchain, which is the underlying technology for virtual assets”.

Hex Trust in the Media

Hex Trust was recently featured in Forbes, sharing our views on the introduction of blockchain-based governance models.

Our Managing Partner, Alessio Quaglini, commented in the Forbes feature:

“Blockchain and other decentralized technologies give users a final say, stabilize the system, reduce structural asymmetries and provide economic incentives to users. From proof-of-work (Bitcoin) to proof of stake (Ethereum) to third generation protocols like EOS using delegated proof of stake, the industry is constantly testing, improving and iterating to find the most effective governance methods for each type of decentralized organization.”

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Hex Trust in the Community

Thanks to FINNOVASIA and InvestHK for organising a fantastic Hong Kong FinTech Week and continuing to push Hong Kong as a global FinTech Hub.

There was a fascinating mix of panel discussions covering the latest trends and regulations in Blockchain, FinTech, and Banking. It was a pleasure for Hex Trust to be part of the weeklong set of events and contribute to building this ecosystem.

Members of the Hex Trust team will be in Macau this week for the Sora Summit.

If you’ll be there, please reach out if you’d like to meet us.

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