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Five questions about Ashley Alder’s crypto regulation

The Hong Kong SFC chief is regulating all virtual-asset business, raising big questions for the industry’s future.



HK image: Photo by Sean Foley on Unsplash

Ashley Alder, CEO of the Hong Kong Securities and Futures Commission, has just announced a sweeping change to regulation that will bring all “virtual asset” activities under his purview.

This is in keeping with global trends to regulate crypto but goes further. The SFC will issue a consultation paper. Its contents and scope will begin to answer some big questions about what this means for the budding crypto industry – in Hong Kong and beyond.

First, what did Alder say?

Go back to last year’s Hong Kong Fintech Festival, when he announced the SFC would regulate any virtual assets that it could characterize as securities.

This opened the door to regulating crypto exchanges that catered only to professional investors (institutions and wealthy individuals), but left alone firms involved in non-securities cryptocurrencies such as Bitcoin and Ethereum.

It could also make Hong Kong even more attractive for trading digital fiat currencies, such as China’s e-CNY, now in pilot tests.

Since then, the SFC has granted an approval-in-principle license to OSL, a digital-asset platform operated by HKEX-listed BC Technology Group. Arrano Capital also became the first licensed asset manager to offer cryptocurrency investment products.

However, this “opt-in” approach has its limitations. Operators of centralized digital exchanges can remain outside of SFC’s purview if they avoid securities assets.

During that same speech a year ago, Alder made clear his displeasure with some of these unregulated venues, particularly in the derivatives space.

Since that time, some of these platforms have come under a cloud: BitMEX, domiciled in Seychelles but operating out of Hong Kong’s Cheung Kong Center, has been accused of money laundering by the U.S. Mainland Chinese authorities have detained Star Xu, founder of OKEx, domiciled in Malta but also operating in Hong Kong (for reasons that are not clear).

After a year of study, the SFC has hit upon a means to bring these unregulated venues to heel: it interprets its adherence to anti-money laundering precepts under the international Financial Action Task Force as meaning SFC must supervise any provider of virtual-asset financial services that either operates in Hong Kong, or markets to Hong Kong residents.

Hugh Madden, CEO of BC Technology Group, said the announcement will affect the majority of players in Hong Kong’s crypto industry. “There are not many institutionally focused firms like us,” he said.

“Today we will propose a new licensing regime under the Anti Money Laundering Ordinance for platforms trading any type of crypto asset,” Alder said at this year’s Hong Kong Fintech Week. Failure to obtain an SFC license to operate or market to residents in the city will be an offense.

What do licensed firms have to do?

Getting licensed means the SFC can assess businesses, ensure compliance, and enforce its rules. Applicants will have to assure the SFC of their financial resources, business experience, and operational soundness. 

Clara Chiu, director of licensing for intermediaries at SFC, says the SFC will be empowered to license and supervise virtual-asset exchanges trading assets that aren’t securities.

Licensing and conduct requirements will be similar to the existing regime for licensed providers, including restrictions from servicing retail investors, at least for now.

“We expect licensed participants to segregate client assets from their own; to ensure keys to wallets are managed properly; and we will have the power to deal with possible market manipulation,” she said. “If there are serious breaches, there will be intervention and restrictions placed on their business.”

Those firms such as OSL or Arrano that are already licensed under the existing regime will not be required to seek an additional license.

“Both the existing regime and the new regime are benchmarked against well understood regulatory principles for broker-dealers and trading venues,” Alder said. “Same risks, same business—same rules.”

Will this drive crypto business out of Hong Kong?

On the one hand, the SFC is providing a huge amount of clarity to the virtual asset industry, which is sure to benefit those businesses catering to institutions. The SFC is positioning Hong Kong to be a world leader in crypto for these investors.

This will be good news for traditional banks such as DBS and Standard Chartered that are laying the groundwork to provide custody and trading in crypto.

This is, however, a narrow part of today’s industry.

What do retail-focused firms do about it?

There are many operators of crypto trading and services in Hong Kong, or catering to Hong Kong investors, that will now face a stark choice.

They can change their business model. This would mean ditching the lucrative world of retail, which drives the volumes in leading derivatives exchanges such as Binance Futures, Huobi, OKEx, FTX and BitMEX.

They can either lobby the SFC for special permissions. One industry executive said some of these firms can argue that any employees located in Hong Kong are part of a distributed management team that does not cater to local investors, or threaten Hong Kong’s financial stability.

Or they can sell to a licensed operator.

But for many of these operators, they will have to exit the market. This raises the question: if not Hong Kong, then where?

What are credible alternative jurisdictions?

The choices are narrowing. In 2017, fuelled by the ICO boom, many exchanges set up in lightly regulated jurisdictions, from places that don’t ask questions (Seychelles) to those within the European Union but with permissive regulators (Malta, Cyprus), or sophisticated places that aren’t in the EU (Switzerland, Liechtenstein).

The EU is formulating its own FATF-inspired rules around crypto, however. Singapore has also amended its Payments Services Act to license virtual-asset firms, including those catering to retail. But so far it has yet to award any licenses, and local demand for crypto is far less than in risk-loving Hong Kong, notes a lawyer.

Even if a firm relocates to a jurisdiction with a soft touch, it will find it increasingly difficult to cater to investors in any of the 39 markets and two regional organizations that are members of the FATF. IOSCO, a much broader association of global securities regulators, is likely to also get in on the act.

Enforcing rules against cross-border venues will be tough. Playing the regulatory arbitrage game will endure for another year or so. But this looks like a business model with diminishing returns.

So the race will be on to find those venues that offer the best mix of regulation that caters to institutions and possibly gives firms legal access to retail. But these businesses will also require much greater levels of capital and resources, not least to meet the new compliance burdens.

The outcome therefore may be consolidation, with regulated, well-capitalized entities ready to acquire.

What about retail investors?

Although regulating crypto venues is part of an emerging trend, the Hong Kong SFC has a particular fixation on keeping retail investors out of the space.

This could lead many operators with mass-retail businesses to decide it’s not worth trying to meet SFC requirements. What’s the point of getting a license if you’re still not allowed to cater to your core market?

One solution for firms to avoid regulation is to jettison their centralized-exchange models. The SFC’s wording is specific to centralized venues. Over the past year, the DeFi world has undergone lots of innovation, huge assets and turnover, and lots of crises and dramas.

It will be up to the wording of the SFC’s consultation (yet to be produced) that may determine what makes a virtual-asset business “centralized” or not – particularly with regard to ensuring a platform does not hold or manage client keys to assets, or otherwise look like a custodian.

Both the SFC’s final consultation paper and global regulatory trends will give shape over the next year to whether DeFi will evade scrutiny.

At some point, however, the SFC will have to decide whether retail investors can access cryptocurrencies such as Bitcoin and Ethereum.

The SFC currently allows retail investors to buy complex, risky investment products, so long as they pass a suitability test by a distributor such as a bank. Can the SFC adapt its suitability rules to crypto?

Here’s betting this will be Alder’s announcement at next year’s Fintech Week.

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