Over the past week, regulators in both the United Kingdom and Hong Kong have voiced words of caution regarding varying virtual assets. Both regulators were concerned in particular about the integrity of the cash markets for virtual assets and products giving retail investors both direct and indirect exposure to virtual assets.
On October 29, 2018, the United Kingdom’s Cryptoasset Task Force (“Task Force”), a working group composed of representatives of Her Majesty’s Treasury (“HM Treasury”), the Financial Conduct Authority (“FCA”) and the Bank of England, issued its final report (“Report”). The Report recognizes numerous potential benefits of the use of distributed ledger technology in the financial services industry. Among others, the Report cites enhanced resilience, more efficient end-to-end settlement processes, more efficient reporting auditing and oversight, efficiency gains from automated contract controls, and the tokenization of existing assets. Interestingly, the Report distinguishes between three different types of virtual assets: exchange tokens such as Bitcoin, security tokens and utility tokens. While noting that these three different types of tokens are not necessarily mutually exclusive, it describes the use case for both security and utility tokens as capital raising and direct or indirect investment.
The Report also lists several challenges. For instance, it notes that there may be legal issues with the enforceability of smart contracts, and the General Data Protection Regulation’s “right to erasure” which could be fundamentally incompatible with the immutable nature of data recorded on many distributed ledger systems. The Report highlights four high level sets of risks posed by virtual assets: the risk of financial crime, risk that consumers will purchase unsuitable products, risk to market integrity, and implications for financial stability if virtual assets were more widely used.
With respect to risks to the consumer, the Report noted two risks in particular. First, the Report notes that many initial coin offerings are being sold where the only information provided to buyers of the tokens are white papers “which often feature exaggerated or misleading information.” Second, the Task Force observed that even though financial instruments that reference exchange tokens may be regulated, they pose “specific risks to consumers. Leveraged derivatives, such as CFDs and futures, can cause losses that go beyond the initial investment.” Such risks, the Report continued, “can be exacerbated by product fees such as financing costs and spreads, as well as by a lack of transparency in the price formation of the underlying [the exchange token].” This concern about price formation in the underlying cash market is reminiscent of the Securities and Exchange Commission’s basis for denying of an application to list a Bitcoin exchange traded product.
As a result, the Report’s next steps direct both the FCA and HM Treasury to conduct consultations seeking public comment on where the regulatory perimeter should be set for the regulation of virtual assets so that there is greater clarity when a virtual asset is a regulated product and if so, what kind of regulated product. In addition, the Report calls on the FCA to conduct a consultation seeking comment on whether the sale of derivatives referencing exchange tokens such as Bitcoin to retail consumers should be banned. Banning the sale of such derivatives would be in stark contrast to the approach taken by the U.S. Commodity Futures Trading Commission which allowed two futures exchanges to launch trading in Bitcoin futures in December 2017.
Meanwhile, half a world away, on November 1, 2018, the Hong Kong Securities and Futures Commission (“SFC”) issued a Statement on Regulatory Framework for Virtual Asset Portfolios Managers, Fund Distributors and Trading Platforms (“Statement”). In the Statement, the SFC said that it “notes with concern the growing investor interest in gaining exposure to virtual assets via funds and unlicensed trading platform operators in Hong Kong. The SFC has identified significant risks associated with investing in virtual assets.” To address these risks, the Statement articulated guidance and regulatory standards for portfolio managers and fund distributors and announced that the SFC was “exploring a conceptual framework for the potential regulation of virtual asset trading platform operators.”
The Statement declared that funds which invest solely in virtual assets that are not securities or futures (“non-SF virtual assets”) will need to be licensed as dealing in securities if they distribute these funds in Hong Kong. In addition, the management of portfolios of non-SF virtual assets by asset managers who are licensed to manage portfolios of securities and futures will be subject SFC regulation. Critically, under the SFC’s framework, only “professional investors” may buy into funds investing more than a de minimis (ten percent of gross asset value) amount in non-SF virtual assets. Under the Hong Kong Securities and Futures Ordinance’s Professional Investor Rules, only corporations and partnerships with total assets of HK $ 40 million (USD $ 5.1 million) or managing portfolios of HK $ 8 million (USD $ 1 million) and individuals with a portfolio of HK $ 8 million qualify as “professional investors.”
The Statement’s release of a conceptual framework for trading platform operators seems to reflect even more unease. The SFC said that it was not prepared at this stage to grant any trading platform a license, and rather it would observe the live operations of virtual asset platforms in the SFC Regulatory Sandbox. It recognized that
[i]t may be a possibility that due to the inherent characteristics of the underlying technology or business models of platform operators, the SFC will conclude that risks involved cannot be properly dealt with under the standards it would expect, and that investor protection still cannot be ensured.
The SFC questioned whether “platform operators would satisfy the expected anti-money laundering standards, given that anonymity is the core feature of blockchain, which is the underlying technology for virtual assets.” On the other hand, the SFC held out the possibility that a successful platform operator could emerge after a minimum twelve-month period of close supervision by the SFC of the platform’s operation in the Regulatory Sandbox which could then apply for removal from the Sandbox and licensing.
It is interesting that in the span of a week, two regulators, half a world apart, articulated similar concerns regarding the integrity of the cash markets for exchange tokens such as Bitcoin and the sale of products to retail investors giving them exposure to virtual assets. Perhaps, great minds think alike.