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A highly regulated financial services centre

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In July, The Tokenizer published The Security Token RegRadar Report produced in collaboration with the government of Liechtenstein. As part of the report, we did a series of qualitative interviews with leading legal experts from the selected countries.

This interview with Padraig Walsh, Partner, Tanner De Witt, provides insight into Hong Kong’s regulatory development history with regard to security tokens. Also, the interview explores to what extent Hong Kong has an accommodating and friendly attitude towards the new industry of security tokens. 

Could you please start by telling about the development within the token economy and the security token industry in Hong Kong?

Padraig Walsh (PW): It started for me probably around six years ago, give or take, which would have been relatively early days in Hong Kong.

And anywhere, I guess…

PW: Yes, anywhere, but I think Hong Kong was at the vanguard, largely because of the dynamics here. That was at a time where we had an inquiry about a particular business involved in cryptocurrency trading that wanted to make trading available to retail. There wasn’t any framework under which they could be licensed at the time. So the advice we gave was that there was no license in Hong Kong that was necessary for them. But they were quite ambitious, and they said, “Whether we need it or not, is there a license we could apply for?”. So that was a general indication of the Hong Kong market at the time. This was a business that wanted to be regulated and wanted to try to do the right thing. However, over the next two to three years, the vast preponderance of inquiries that we fielded were very much on the other side of that extreme, with businesses focussing on how to avoid being regulated. That probably gives you an insight into where Hong Kong was.

Hong Kong is a highly regulated financial services centre, and cryptocurrency businesses have faith in the stability of the system here. For a start, it’s got a very strong culture of dealing and trading, and there has always been a significant amount of capital here in Hong Kong. At the same time, within mainland China, from the very early days, you had a clampdown and prohibition in respect of ICOs and other cryptocurrency transactions, which meant that Hong Kong became the centre of activity in this part of the world. 

There was a time lag before regulation caught up. Things happened that shouldn’t have happened under our securities law and regulation. The Securities and Futures Commission and other regulators identified the issues and immediately started to engage. Firstly, the SFC clamped down on bad actors and bad activities, particularly where the retail investing public was at risk. Then secondly, the SFC put together a framework based on existing laws that were suitable for Hong Kong as a financial services centre and to allow financial institutions to begin to engage in this new asset class.

So that’s probably a potted history of that period in Hong Kong, where it started from a wild west frontier land, to now where there is a well-developed regulatory framework in place that is probably the best in this part of the world.

But there’s no specific regulatory framework for security tokens in Hong Kong, right?

PW: Well, there’s no specific law. The Securities and Futures Ordinance was not specifically amended to account for virtual assets. Instead, the Securities and Futures Commission issued regulatory frameworks, guidelines,  codes of conduct and these kinds of regulatory guidance. This was all conducted under the existing legislation. For instance, there is a regulatory framework that has been published in respect of ATSs, automated trading systems, which is basically what the token exchanges are. The framework also deals with dealer brokers in respect to virtual assets. Then there’s another regulatory framework put together with supporting codes that have been published in respect of fund managers that have exposure to cryptocurrency assets.

Recently, there’s a consultation paper that’s been published, which will bring other forms of token exchanges and other forms of virtual asset trading under the framework of the Securities and Futures Commission, primarily for AML and KYC compliance purposes, even if it does not involve virtual assets that are securities under the Securities and Futures Ordinance. So in time, what you will have is an almost level playing field for almost all aspects of the cryptocurrency domain. 

I guess you are familiar with the new European regulation called MiCA – Market in Crypto Assets – and of course MiFID ll. And in Europe, the MiCA regulates almost all types of crypto, except for the financial instruments like security tokens that are already covered by MiFID II. So it includes the majority, but it leaves out the security tokens, and it sounds as if it’s perhaps a little bit the same here? 

PW: Yes, it’s similar in terms of having one framework for tokens that are security tokens and another framework for other forms of virtual assets. However, in Hong Kong, soon, both systems of regulation will be under the same regulator.

Could you elaborate a little bit on Hong Kong’s relation to mainland China regarding this area? I suppose there might have been some pushback from the big Chinese neighbour since they do not seem too happy about the crypto space. Could you say a bit about that?

PW: Hong Kong operates as one country, two systems policy. Hong Kong is part of China but has a different legal system from mainland China. So, there are two legal systems. This is relevant in respect of cryptocurrency. In mainland China, there was a clampdown on cryptocurrency – almost an absolute prohibition. However, I never got the sense that there was any overt or even indirect pressure on regulatory bodies in Hong Kong to follow the same policy. 

On a practical level, if you prohibit something in one location, then there’s a spillover from that location. We saw a number of people who had previously been operating in mainland China, looking to operate elsewhere. Some of those came to Hong Kong for a spell of time until regulation caught up. 

Hong Kong didn’t take the approach of the absolute prohibition. It just took the approach of saying: “We have flexible laws that already deal with most of the evils around this, so we can continue to enforce those laws”. This allowed the regulator to, at the same time, identify the potential benefits of the underlying technology and its future direction. So it was a carrot-and-stick approach.

Do you expect any pushback or any attempt to influence Hong Kong from China going forward? Or do you think that the way you are doing these things in Hong Kong might instead affect mainland China? 

PW: In the past, you could see how mainland China looked to Hong Kong as a jurisdiction for particular trial initiatives and eventually linked that back into mainland China. The trend in mainland China now seems to be to focus on creating breathing space for state-controlled initiatives essentially to foster and gain traction development. The digitized RMB is an example of that. 

So I think there will be different approaches, but there will be crossovers. Hong Kong wouldn’t necessarily adopt the same policies as mainland China in the financial services domain. This will happen, though, in areas where it makes sense to collaborate.

Would you say that the government and the Hong Kong authorities have a vision for the further development of the token economy?

PW: You should look at this at a couple of levels. 

Firstly, at a macro level, the Hong Kong vision for the future, in general, is based around technology, technology development, and being part of the digital world and the digital environment. So if you look at that, and then you acknowledge that financial services is a core area of strength for Hong Kong, then you will see that promoting Hong Kong as a tech hub or as a tech centre also involves promoting Hong Kong as a fintech hub and a fintech centre. This is where cryptocurrency and the token economy fits into government policy.

Then, more specifically, is the role of Hong Kong in respect of cryptocurrency and the token economy. The policy I see materializing is to pursue this on a regulated playing field. If you are an underfunded and disruptive new project, Hong Kong may not necessarily be the right place for you. However, if you are well-funded with experienced people, both in terms of the financial aspects and technology aspects, and you are bringing forward a project that is well thought out and well-planned, then Hong Kong is very close to the top of the list in respect of where you might bring that project forward and develop it.

In terms of paving the way for the security token industry in the future, could you say something about the strengths and challenges for Hong Kong?

PW: One key strength, looking at it as a lawyer, is that there’s a higher degree of regulatory certainty in Hong Kong compared to many other jurisdictions. That taps into a few other things, particularly for securities token offerings. For instance, you already have an experienced group of professionals, advisors, consultants, custodians, and participants in financial markets generally. This expertise is already all here in Hong Kong. The different pieces of the jigsaw are in one place. That’s a key advantage.

And in terms of challenges?

PW: The challenges are similar to those in many places. You need more quality projects coming through to provide the right kind of liquidity and the right kind of profile and success. The ripple effect of that will attract more projects. So that needs to happen.