Hong Kong Securities Regulatory Commission official original text: If DeFi involves securities and futures trading, it also needs to be licensed

Apr 14, 2023

Speecher：Keith Choy, Interim Head of Intermedlaries Division, Hong Kong Securities and Futures Commison(Chairman of Fintech Advisory Group)

Editor：@null_aez, WuBlockchain

Link: https://www.web3festival.org/hongkong2023/live?lang=zh-CN

Good morning. It’s an honor to be invited to speak at this wonderful festival. Over the past few years, there have been many amazing developments and breakthroughs across various technologies. For example, we’ve seen enterprises incorporating artificial intelligence within their bussinesses, central banks, financial insititions are exploring the benefits of using distributed ledger technology (DLT). Just a few weeks ago, I experienced firsthand the wonders of Chatgpt. The potential applications of this technology and the like, and their reifications are huge. We’ve seen news report that financial firms are testing the tool and using it to write research reports. I must confess the thought of using Chatgpt to write this speech has also come across my mind. But I have forbidden it, that’s beacause the knowful technology has its own limitations and false including the fact that it sometimes produces possible something but incorrect responses to questions. Give you one example. An asset manager asked Chatgpt to give him ten stocks that would benefit from virtual reality. Chatgpt provided 7 names, so, the asset manager prompted from the three remaining ones and Chatgpt made up 3 fake names. Now this story highlights the importance of harnessing the benefits of innovative technologies in a responsible way. And just as the emergence of web3, which is built on DLT, promises to bring with the enormous economic benefits and the potential to change the internet and the way we interact. We must also be aware of the potential risk and manage them properly. To be clear, the SFC (the Securities and Futures Commission) recognize the opportunity presented by web3 . Indeed, our ceo Ms Julia Leung, though, has already stated in her statements on last year’s hong kong fintech week that the sfc is attuned to the potential impact of web3, virtual assets, NFTs, metaverse and GameFi in our daliy life and that we are supportive of the underlying DLT technology and responsible or innovation, so let me take the opportunity today to share with you: the SFC and policy initiatives in relation to two very important topics — Centralized VA trading platform and decentralized finance.

So let’s start with DeFi, just as the evolutions of web2 to web3, to decentralize the internet and we distribute the power from fintech and performs act to users. DeFi sticks to decentrilized financial ecosystem and intermediate traditional financial intermediaries in the provision of financial services using DLT, VA and smart contracts. The original idea behind DLT was to democratize finance, so that any user with an internet connection and the wallet for storing VA could access DeFi services. Proponents believed that if the ethos behind the DeFi is implemented, then this will cause a seismic paradigm shift in the financial services industry. We already see that many traditional financial products and services have equivalence in DeFi including trading, borrowing and lending, asset management, insurance and derivatives. However, DeFi presents its own issues.

Firstly, financial stability indication arising from the interconnectedness within DeFi and VA ecosystems as well as between DeFi and these traditional financial works. Financial Stability concerns also arise from the leverage obtained, for example, VA borrowed from one VA borrowing and lending protocol as collateral to obtain further borrowers. Second, there is limited transparency on this interconnectedness and linkages, due to a lack of data and partly because many of these firms and activities are currently unregulated. Third, the DeFi ecosystem is exposed to market integrity issues such as price Oracle manipulation, front running transactions and other types of abusive behaviors. Last but not least, there are Investor Protection concerns arising from the increasing number of a scale of successful cyber attacks. For example, one of the largest hacks resulted in 625 million US dollar being stolen from the NFT game platform ‘Axie Infinity’ in March 2022. Now you may ask given the unique features of DeFi, whether regulations is possible. Regulating DeFi is not straightforward task due to various factors. And first, who should be held accountable when things goes wrong? There is no chance of traditional financial intermediary and smart contracts run autonomously. In some DeFi protocols, the developer or operator has no ability to order this smart contract field once it has been deployed on the blockchain. Additionally, the governance of DeFi products or services may be decentralized to varying degree and may involve the use of governance tokens or a decentralized autonomous organizations. Governance tokens holders, which may include the original developer of the smart contract, as well as the useless of DeFi products or services may be able to vote on product changes such as new product features. With such Decentralized Governance, it may be difficult to identify the persons responsible for the defined products or services. This issue begs the question of whether these DeFi services is controlled by the smart contract developer some or all holders of the governance tokens or the members of dials. Second, Second, as the autonomous nature of the DeFi and the identification of the developer and operators of the DeFi protocol challenge. This challenge is further compounded by the cross border nature of DeFi products and services whose developers and operators may be based in multiple jurisdictions.

Now, let me share with you this SFC current thinking on defi which is not the top common problem and ensure that SFC will define activities through the same existing regulatory firm that applies to financial activities regulated by the SFC as such, as long as the defi activity falls within the scope of the Securities and future ordinance, SFO（Securities and Futures Ordinance）. It would be subject to the same regulatory requirements applicable to a traditional financial entity under the surfaces of the same risk and same approach as SFC alluded earlier. The person operating or performing such activity should be subjected to a licensing requirements and be regulated by the SFC by way of illustration to provisions of automated trading services is a regulated activity under this. If a decentralized platform allowed trading in which constitute securities or futures as defined under the SFO, then the platform and the operators will be required to be licensed for type seven regulated activity. The offer of collective investment scheme to public in Hong Kong is subject to authorization requirements under the SFO as such over defi liquidity pooling protocol to Hong Kong which fall under the definitions of CIS may be subject to such legal requirements. Would you want market participants of the risks associated with VA platforms offering VA deposits, savings, earnings and seeking services to investors in Hong Kong, among other things, really minded market participants that some of these arrangements may constitute CIS under the SFO and may in fact be an offer ICIS. The challenge associated with identifying persons who should be held accountable in defi may not actually be insurmountable. To understand how to hold an accounta, the SFC will assess each defi services or activity on a case by case basis after understanding the inner workings and arrangements of a defi protocol. But with regards to some of the challenges outlined earlier, I would like to point out some defi protocols may be decentralized in name only, in reality, a small group of developers, operators or the related parties, maybe individual control, as they may, for example, hold the vast majority of the governance tokens or have the power to form governance proposals put forward by audits. Now, as such, when analyzing this issue, it is important to look through to the actual settlements of their arrangements rather than how they are labeled.

Next, I would talk about centralized VATPs. Today, the SFC has focused more on centralized VATP as this is where the majority of the VA trading take place. And this touch point with the investor cupcake poses Investor Protection concerns. This explains why when the SFC introduced in 2019, a comprehensive of inner achievement for the regulation of VATPs, which provided trading services in at least one securities token. This regime covered requirements which were applicable to traditional brokers and automated trading surfaces venues with certain adaptations to cater for the specific risks of VA.

Now, this means that we regulated the VATP from not just an AML perspective, but also from an investor protection standpoint, with requirements encompassing areas such as safe custody of current assets, conflicts of interests, cybersecurity, prevention of the market manipulative activities, as well as admissions process for listing the evil trading, as you may be aware of following from the passage of the anti money laundering and counter terrorist financing Amendment Bill 2022 by the Legislative Council, the SFC is looking to implement a new licensing regime covering centralized VATPs, which enable trading in non securities token when this regime comes into effect on 1st June this year, all centralized VATP operating in Hong Kong, regardless of whether they offer trading in securities tokens or non securities token must be licensed by us. Now the events of crypto winter have only in its own reinforce and resolved and conviction that it is necessary to set record standards for the regulation of VATPs with appropriate guardrails in place to protect investors, market integrity and market stability. Although this event demonstrates the size of the VA market is not yet large enough to cause systemic risk concerns, we must not forget that where consumer harm was caused.

For example, retail investors lost money from the implosion and the collapse of the VA lending platform Celsius network and centralized exchange FTX. News reports of the post mortem of FTX failures highlighted a whole host of issues including the lack of basic governance and risk management controls, conflicts of interest, and more importantly, the misuse of this kind of assets, which simply cannot be tolerated in any entity that is subject to regulation. Such failures showed how critical it is for VATP to have a robust risk management mindset, a comprehensive public effective control spending the areas already covered under our existing VATP regime. Now that’s why when the SFC released the consultation paper, we effectively transpose the existing regulatory requirements under our current opinion into the proposal for the new regime, with certain amendments to account for the market developments and lessons from the operating the existing regime. Under the current regime, the SFC impose conditions on operators to restrict them to only provide services to professional investors. This requirement will be relaxed, subject to additional GAAP rules being put in place to protect investors. This include requiring a VATP to understand the risk profile of client during the onboarding process to assess whether the provision of services to that kind is suitable, as well as set appropriate limits. By reference to the client’s financial situations and personal circumstances to ensure that the kinds of VA exposures is reasonable. Aside from requiring the VATP to establish criteria on the due diligence and admission of VA for trading, the SFC also proposed that VA made available to retail investors should satisfy additional admission criteria, which would qualify it as an eligible large cap virtual assets. Now, as I’m sure you will all agree in light of the reason turmoil and scandals since in the VA ecosystem, it is critical that the SFC license VATPs have appropriate controls and risk management measures in place to prevent the occurrence of similar events in Hong Kong. The SFC consultations on the proposed regulatory requirements under this new regime close on 31st of March.

I would like to take this opportunity to thank those market participants and interested parties who reviewed the consultation paper and provide feedback on the proposals. I cannot emphasize enough that how important such engagement and constructive dialogue with the industry is for truly SFC’s policy formulation. We will of course diligently review all comments received to ensure that Hong Kong implement a robust ranking for the centralized VATP, which is fit for purpose and strikes the appropriate balance between investable protections and support for innovation. In conclusion, the SFC fully support the use of novel technology to deliver financial services and products in Hong Kong. We should be bold in embracing technology innovation, alert to potential risks and step fast in commitment to protecting investors in the market. I sincerely believe that the collective efforts of the government, the regulators and the industry will ultimately culminate in the establishment of Hong Kong as not just an international financial center, but the premier hub for web3 and virtual assets. I hope you enjoyed the festival. Thanks very much.

Wu Blockchain

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