Dear ,

Seasons Greetings

Money is life. For nearly every human being on the planet, it’s more important than children, mom, art, whatever. Technically, it’s a record of payment. It can be a currency, but it doesn’t need to be. For an abstract idea, both real and unreal, money is quite tangible.

You may not know what money is, but you know what is money.

But now money’s changing, perhaps forever.

Crypto is life. You just don’t know it yet.

Big Risk of Digital Currency is Ignorance

What are digital assets? How do they work? How are they worth anything? If you’re familiar with the space, you likely settled these questions to your own satisfaction so long ago that you don’t remember what it’s like to not know the answer. But imagine explaining them to the most intelligent person you know who doesn’t already know the answer, and you’ll see how difficult it can be to assuage the sense of unease that larger investors may feel when approaching an asset class whose entire basis is obscure to them.

Where retail investors typically make investment decisions themselves, for themselves, the picture is obviously different for institutional investors. Rather than a process of educating individuals, it’s a more complex dynamic involving businesses hiring and adapting for digital asset comprehension and expertise. With more governance and oversight, considerably higher stakes and many more stakeholders, institutional investors have moved more slowly than their retail counterparts to enter the digital assets space.

Risk of being defrauded

The risk of fraud grew sharply in 2017 with an explosion in a new fundraising method for businesses, the Initial Coin Offering. Associated tools like Initial Token Offerings allowed small companies to raise money quickly to support their ventures, seeming to usher in a new world of rapid access to finance and business ideas with massive potential, without intermediaries, delays or barriers to entry.

Unfortunately, the ICO space really did lack barriers to entry; coupled with the sometimes-abstruse nature of the technology involved, this led to a proliferation of openly fraudulent ICOs in a space filled with projects that weren’t always well-thought-out. Vaporware, exit frauds and wishful thinking abounded, and the mostly-retail investors who entered the space were defrauded of millions.

Look a little closer, and the picture changes, though. In 2017, just three major fraudulent ICOs accounted for the majority of dollars lost to digital assets fraud — not just in the ICO space. While three quarters of 2017’s ICOs were scams, most were ineffective, generating little profit for their perpetrators. The biggest effect scam ICOs had was to discredit ICOs, and digital assets more generally, and to foreground the fear of being defrauded amongst institutional investors.

Risk of market volatility

Digital assets markets move fast. They appear to be volatile from the point of view of investors in traditional assets, and while that’s partly because they’re much more fast-moving, it’s also because they are volatile.

Just a few days ago, on September 24, 2019, the value of nearly every widely-traded digital asset that’s widely traded fell by around 10% in a single day. For experienced digital asset investors, that’s not necessarily anything to worry about; for investors accustomed to the smaller, slower changes that are normal in the world of traditional assets investment, it’s a major shock.

Institutional investors are accustomed to moving large sums, protected by law, regulation and professional standards and ethics. The extent to which the digital assets space can provide these is the measure of likely institutional involvement in this asset class.

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Increasingly, finance professionals and institutions are entering the digital assets space, offering solutions that the earlier, retail-focused infrastructure of the space could not: from investment advice and management to pensions, trust and custody services, as well as additional technological solutions to the persistent security problems that plagued the digital asset space.

New company types grew up, featuring mixed specialities — neither banks seeking access to lucrative new markets, nor tech companies seeking access to financial markets, but hybrid firms with a foot in each camp and able to instruct their individual and institutional clients on how to get the best from an exciting new asset class.

At the same time, regulation became stronger and more nuanced. Again, this took place simultaneously from two directions. Existing agencies have assessed their remits and absorbed those aspects of the digital assets space that they or the courts have concluded are in their wheelhouse. In the USA, for instance, a series of court decisions established that the SEC has the right to oversee some types of ICO as securities sales, creating clearer guidelines for both investors and sellers and establishing the likely future boundaries of legislation. The SEC issued new guidance on the subject in July this year, and has spent the time since in consultation with other agencies including those in Switzerland and elsewhere, seeking to ensure an appropriate level of understanding of digital assets to regulate effectively. (SEC staff will be speaking to Congress to help legislators do the same.)

Other countries’ regulators are moving in similar directions — Hong Kong’s SFC announced new rules on digital assets in November of 2018 — and at the same time, international regulators are looking to establish regional and global frameworks of regulation. While their focus tends to be on money-laundering (AML) and use of the proceeds of financial crimes to fund terrorism (CFT), the effect is to create safer, better-regulated spaces for digital assets transactions globally.

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Why were the new rules introduced?

As things stood before, funds that fell outside the legal definition of "securities" and "futures' contracts" were not subject to SFC regulation. This meant that crypto funds managed by unregulated portfolio managers also didn’t enjoy the protection of the Securities and Futures Ordinance (SFO).

While crypto funds operated under the SFC radar, investors had little guidance on portfolio management selection either.

When the SFC decided to reach out and cover crypto funds, therefore, it did so to provide regulatory clarity to both portfolio managers and institutional investors considering entering the crypto space.

The result is wide-ranging regulatory coverage that focuses on digital assets as a new area of regulation, rather than tweaking older rules on securities to fit.

Who is subject to the new regulations?

The new regulations address three types of firms. First, those managing funds which invest solely in digital assets, but which aren’t already covered by existing securities law. These will now require a license for Type 1 regulated activity, or securities trading. In other words, firms dealing solely with digital assets will be securities traders for regulatory purposes even if the assets they trade in aren’t technically securities.

Firms that manage securities or futures contracts for clients, and are already licensed for Type 9 regulated activities (asset management), for managing securities and/or futures portfolios, will also be affected. These firms will face additional licensing requirements if 10% or more of their investment is in non-securities and futures virtual assets.

Finally, persons distributing funds that invest in virtual assets in Hong Kong, to whatever degree, will also be covered.

Changes to custody of digital assets

Until now, most crypto-funds have held their assets in their own custody. Under the new rules, this is less likely to happen, as special requirements will apply where virtual assets have to be held in self-custody and the working assumption is that a custodian will be used.

The new SFC regulations require that the most appropriate custodial arrangement should be selected, but the SFC itself acknowledges that "virtual asset funds face a unique challenge due to the limited availability of qualified custodian solutions," and that "available solutions may not be totally effective."

Typically, the best solution will likely involve the selection of a trustee like Legacy Trust Company — one qualified the Trustee Ordinance to offer custody of assets, including digital assets. This offers the optimal custodian arrangement for the majority of situations.

Regulatory standards

The regulatory standards that will be applied are laid out in an appendix to the SFC's statement, "regulatory standards for licensed corporations managing virtual asset portfolios." In summary, they will require licensees to:

• Only permit professional investors, as defined in the Securities and Futures Ordinance, to invest in any portfolio intending to invest in virtual assets, or an intention to invest 10% or more of the GAV of the portfolio in virtual assets; there’s an exception if the fund is authorised by the SFC under section 104 of the SFO
• Clearly disclose all associated risks to potential investors and distributors, and exercise due skill, care and diligence in their selection, appointment and ongoing monitoring of custodians
• Exercise due care in selecting valuation principles, methodologies, models and policies, and disclose these to investors
• Perform risk management by assessing the reliability and integrity of virtual asset exchanges, set appropriate caps to limit exposure to individual virtual asset exchanges, and set appropriate limits for each product, market and counterparty — for instance, setting a cap on investments in non-liquid virtual assets or newly-launched ICO tokens
• Appoint an independent auditor to audit the funds
• Where they hold virtual assets that aren’t securities or futures contracts, maintain a required liquid capital of not less than HK$3m, or its variable required liquid capital, whichever is the higher.

Conclusion

Until now, investment in digital assets has largely been unregulated, despite clear risks. As regulators worldwide move to enact frameworks to manage or mitigate that risk, Hong Kong's SFC has redefined its own role, extending its reach beyond the limitations of its previous statutory authority to regulate even those digital assets that aren’t securities and futures.

For Hong Kong’s crypto-funds, this is likely to be a mixed blessing; many in the industry will benefit from added credibility and legitimacy through more effective and transparent regulation. Some crypto-funds will baulk at the likely six-to-12 month long licensing process, and instead either withdraw from Hong Kong, or seek to move their operations under the umbrella of a licensed entity. However, many licensed entities are unwilling to engage with the digital assets market, meaning the likely effect will be a reduction in the number of crypto funds as well as a pivot to higher commitment to quality.

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