This week, Hong Kong’s Securities and Futures Commission (SFC) issued an opt-in virtual asset trading protocol. The new regulations cover all digital asset trading platforms operating in Hong Kong. Surprisingly, due to the legal structure of the city’s financial regulatory bodies, the new regulations are purely voluntary.
As such, the SFC hopes that the new regulations will help investors to better determine a platform’s licensing status. The new regulatory regime covers any exchange that offers security tokens. In other words, any token that falls under the definition of “securities” under the Securities and Futures Ordinance (SFO).
Interestingly, the decision to make the regulations opt-in was out of necessity. Basically, the SFC is bound by the Securities and Futures Ordinance (SFO). As such, the SFC can only provide enforcement up to the actions specified in the SFO. Basically, the SFC must wait until the SFO is amended to include digital assets prior to creating a mandatory stature on digital securities.
Opt-in Virtual Asset Trading
The new regulatory regime was first announced by the SFC CEO Mr. Ashley Alder at this year’s Hong Kong Fintech Week 2019. During the announcement, Alder explained the details set out in the SFC’s position paper. Importantly, the Position Paper is an extension of the SFC’s statement made on 1 November 2018 in regards to online virtual assets exchanges.
As it stands today, you can think of these regulations as a conceptual framework for the potential regulation of exchanges. Basically, virtual asset trading platform operators can base their company’s operations on these regulations to ensure they remain compliant, even during the development of further regulations in the sector.
The Position Paper detailed terms and conditions applicable to the licensed platforms. It also states the reason for the opt-in licensing mechanism and the overall goal of the concept which is to help investors better distinguish regulated platforms from unregulated ones.
Opt-in Virtual Asset Trading
Any virtual asset trading platform that operates within the city limits of Hong Kong should evaluate the Position Paper carefully. The document can help a company to determine whether it would benefit from a regulated status. Additionally, the paper helps new exchanges determine what changes they need to make in order to receive licensing in the sector.
As it stands today, the SFO only has jurisdiction of virtual assets that fall within the definition of securities. In other words, trading of virtual assets that are not securities tokens will not be subject to these regulations, market misconduct, or other provisions listed in the paper.
What’s in the Regulations – Opt-in Virtual Asset Trading
According to the Position Paper, any centralized virtual asset trading platform that offers the trading of at least one security token in Hong Kong can apply for a license. There are two types of licenses available. These licenses include Type 1 (Dealing in Securities) and Type 7 (Providing Automated Trading Services) licenses. Once a firm receives a license, it automatically qualifies for the SFC’s regulatory sandbox.
Any exchanges that wish to apply for an SFC license must meet a few key requirements. For one, the exchange must be based in Hong Kong and operated by one group entity only. Additionally, all trading business activities of the group in Hong Kong and the active marketing must originate from the same firm.
Opt-in Virtual Asset Trading Oversight
Once licensed, the exchange is subject to the SFC’s oversight. This requirement means that licensed exchanges must comply with the paper’s specific licensing conditions and additional terms. In the event that the exchange fails to do so, the SFC will take disciplinary action against licensed platform operators for breaches of the conditions listed in the paper.
Interestingly, non-security tokens traded on a licensed platform will not be authorized by the SFC. Basically, ICOs won’t require registration under the Winding-Up and Miscellaneous Provision Ordinance.
Regulatory Requirements for Licensed Platforms
As a licensed exchange, operators must seek the SFC’s prior written approval to offer new services or products to their users. This requirement extends to both securities tokens and non-securities tokens.
Also, all licensed exchanges must provide monthly business reports by the end of the second week of each calendar month. This is a common practice for traditional securities firms. On top of the monthly reports, these exchanges need to find an independent auditor to conduct an annual review of the licensed operator’s business operations. Exchanges need to submit reports for review to the SFC by the end of the fourth month of each year.
Opt-in Virtual Asset Trading Matches Securities Regulations
Importantly, nearly all the terms and conditions of the new licensing are based on the current existing framework for the regulation of securities and futures contracts. These terms fall under the SFO and it’s subsidiary legislation. This legislation includes the Code of Conduct for Persons Licensed by or Registered with the SFC, guidelines, and circulars issued by the SFC. In some cases, additional requirements applicable specifically to digital asset trading activities apply.
Additionally, all licensed exchanges need to maintain sufficiently liquid assets of at least 12 months of their actual operating expenses on a rolling basis according to the documentation. Also, exchanges are now responsible to conduct due diligence on each virtual asset prior to admitting it to the platform.
Hong Kong Regulations Moving Forward
Interestingly, the SFC stated it isn’t prepared to accept licensing applications from operators of decentralized platforms at this time. Decentralized exchanges differ from their centralized counterparts in operations in some key ways. Basically, these exchanges provide a direct peer-to-peer marketplace for investors.
Opt-in Virtual Asset Trading
You have to hand it to Hong Kong’s financial regulators. These guys understand that the market moves faster than regulations. As such, the new opt-in protocol provides much-needed guidance to virtual asset exchanges seeking to remain compliant as new regulations come into play. You can expect to see many exchanges make the leap towards full licensing to avoid future headaches.
Supreme Court Reins in SEC on Disgorgement
While the SEC holds a huge amount of influence and power, they do not operate without oversight, themselves. This was on full display on Monday, as the U.S. Supreme Court issued a new ruling on SEC authority surrounding disgorgement.
Essentially, it was ruled that, while the SEC will retain the ability to seek disgorgement from offending parties, it will be limited to their profits. This means that if a company raises $50M through illegal means, the SEC can only seek to retrieve funds up to the $50M minus any genuine operating costs.
The purpose for this limit is a simple one – disgorgement is permitted as a remedial, rather than punitive, action. If the SEC were to seek funds exceeding what was raised, it would no longer represent a retrieval of funds, but a punishment for their actions.
Furthermore, the ruling indicates that funds, retrieved through these means, are to be used as compensation for victims that have lost money.
For those unfamiliar with disgorgement, it refers to the repayment of funds received/generated by parties which violated existing laws.
In recent years, disgorgement has been a commonly used method of the SEC, as made evident in various cases stemming from the 2017 ICO boom.
For those interested, the entirety of the U.S. Supreme Court’s ruling can be found HERE. While there are various intricacies involved, the court’s decision can be broadly summarized by their statement, as follows.
“The Court holds today that a disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims is equitable relief permissible under §78u(d)(5).”
As aforementioned, the SEC has turned to disgorgement on various occasions, as of late. The following articles are a few examples of it being used in crypto based cases.
Based in the United States, the SEC is a government run regulatory body. This outfit is tasked with fostering safe, and transparent, markets surrounding securities. This entails both the creation, and enforcement, of laws surrounding the sector.
SEC Chairman, Jay Clayton, currently oversees operations.
In Other News
While Jay Clayton may still be in charge at the SEC, his time at the helm may soon be coming to a close. We recently touched on a tricky situation, currently evolving, which would see Clayton depart the SEC for a position as an Attorney General in Southern New York.
SEC Chairman Jay Clayton Moving On?
Caught in the Middle
Jay Clayton, Chairman of the SEC, has found himself caught in the middle of a tricky situation. The story goes like this:
On June 19th, U.S. Attorney General, William Barr, announced the Trump administration’s intent to name Jay Clayton the new U.S. Attorney for Southern New York.
This announcement soon became a major point of contention, as Geoffrey Berman (the current U.S. Attorney for Southern New York) had refused to abandon his post. This stance was changed, however, when assured that his departure would not derail current investigations.
Replacing Geoffrey Berman for the interim is Deputy U.S. Attorney, Audrey Strauss.
While pure speculation at this point, many believe that these actions were taken due to ‘burnt bridges’ between Berman and the Trump Administration. More specifically, Berman was/is at the helm of various corruption inquiries into associates of the POTUS.
The situation has seen various senators weigh-in on the situation. Notably, Senator Chuck Schumer believes an immediate investigation should be launched into the situation. Furthermore, he had strong words for Clayton, himself, stating,
“Jay Clayton can allow himself to be used in the brazen Trump-Barr scheme to interfere in investigations by the U.S. Attorney for SDNY, or he can stand up to this corruption, withdraw his name from consideration, and save his own reputation from overnight ruin.”
Back to Roots
If this move were to happen, it would not necessarily mark a return to his roots. Prior to his tenure at the SEC, Jay Clayton was a seasoned corporate lawyer, with decades of experience. What he lacks, however, is experience as a prosecutor – typically a prerequisite for Attorneys Generals.
While his duties stretched far beyond regulating the burgeoning blockchain sector, Clayton developed a complex relationship with the community through his time at the SEC, thus far.
Clayton has many detractors from the crypto community, as he has had a hand in the denial of many Bitcoin ETF applications.
At the end of the day, however, the world of crypto remains rife with scams,y. Despite having massive potential, Clayton has, for the most part, made sound decisions in regulating the growth of crypto base endeavours.
Be Careful what you Wish For
While Clayton may not be pro-crypto, there are many examples throughout his tenure of openness towards these young markets.
Those excited to see his potential exit should be wary, as his successor may very well adopt a strong anti-crypto sentiment – something which could prove to be very harmful for a sector still in its infancy.
A Short Run
If opting to leave his post at the SEC, Clayton will have completed a roughly 3 year stint at its head. So far, no word has been given on a possible successor as the Chairman of SEC.
For decades, the position of Chairman at the SEC has been a revolving door. The last individual to serve longer than 4 years was Arthur Levitt, during the Clinton Administration.
Word of Clayton’s potential replacement comes 1 year after the CFTC saw their very own chairman, J. Christopher Giancarlo, step down. During their time spent at the helm of their respective organizations, both, Clayton and Giancarlo, were vocal on their approach towards blockchain. While Clayton has remained more conservative, to this date, Giancarlo was viewed as more progressive and welcoming to change.
OSC Finds Extensive Evidence of Fraud/Theft by Gerald Cotten and QuadrigaCX
Over a year has passed since the demise of popular Canadian exchange, QuadrigaCX. Despite this length of time, new findings are still being released surrounding the peculiar chain of events that saw $215 million go missing – a total representing the holdings of over 75,000 clients.
While the actions of Gerald Cotten and QuadrigaCX are, without doubt, a blight on the cryptocurrency industry, it is important to remember the old adage ‘do not paint with a broad brush’.
The OSC has, thankfully, recognized this, and taken the time to ensure readers that they are not condemning the sector as a whole, in their report.
“The misconduct we uncovered in relation to Quadriga is limited to Quadriga and should not be understood as applying to the crypto asset platform industry as a whole. Properly conducted, crypto asset trading is a legitimate and important component of our capital markets. We remain committed to working with this industry to foster innovation. Financial innovation has always been critical to the health of our economy and the competitiveness of our capital markets.”
Now we move on to the bad. After a thorough investigation, the OSC has determined that QuadrigaCX operated, essentially, as a Ponzi scheme underneath a ‘layer of modern tech’. This Ponzi scheme is believed to be orchestrated by the late founder of QuadrigaCX, Gerald Cotten.
Furthermore, due to the custody model utilized by the exchange, the OSC believes QuadrigaCX to have been in consistent violation of securities laws.
“…whereby Quadriga retained custody, control and possession of its clients’ crypto assets and only delivered assets to clients following a withdrawal request—meant that clients’ entitlements to the crypto assets held by Quadriga constituted securities or derivatives.”
To this day, many of those affected by the debacle caused by Cotten have remained hopeful that the lost keys to his crypto wallets would be found. This was due to a belief that these wallets contained much of the missing funds. Unfortunately, the OSC has indicated that this is a fallacy. Rather, the vast majority of missing funds were due to Cotten’s illegal trading activity.
“It has been widely speculated that the bulk of investor losses resulted from crypto assets becoming lost or inaccessible as a result of Cotten’s death. In our assessment, this was not the case. The evidence demonstrates that most of the $169 million asset shortfall resulted from Cotten’s fraudulent conduct, which took several forms.”
If that wasn’t bad enough, the OSC concedes that, due to the circumstances (QuadrigaCX bankruptcy, and Cotten’s death), there exists very little room for recourse.
In their report, the OSC notes that roughly $215 million is owed to QuadrigaCX customers. They provide the following breakdown, shedding light on where the money has gone.
- $115 million
- Lost by Gerald Cotten through illegal trades on QuadrigaCX
- $46 million
- Recovered funds, now in the possession of a trustee
- $28 million
- Lost by Gerald Cotten through illegal trades on external exchanges
- $23 million
- Miscellaneous losses yet to be accounted for
- $2 million
- Funds stolen by Gerald Cotten to fund his lifestyle
- $1 million
- Operational losses
Whether through misappropriation, or illegal trades, the late Gerald Cotten is believed to be directly responsible for roughly $145 million lost in client funds.
Words of Warning
Throughout their report, the OSC doesn’t mince words when addressing companies still operating in the blockchain industry – Contact the OSC to see if registration is required under current laws.
They explicitly note, on multiple occasions, that securities laws apply in many instances, even when the traded assets are not securities. The deciding factor comes down to how these assets are handled by exchanges.
“A platform would generally not be subject to securities legislation if the underlying crypto asset being traded is not a security or derivative, and there is immediate delivery of a crypto asset to the client after a transaction…In contrast, if a platform retains possession and control of the crypto assets being traded on the platform, securities law may apply.”
While this distinction may be small, it is an important one. The OSC is imploring Canadian exchanges to reach out and determine where they fall within regulatory guidelines.
“Platform operators should be aware that, depending on their business model, they may have to register with the OSC and they should take appropriate steps to comply with Ontario securities laws…Platforms should review their operations to ensure that they have procedures in place to manage risks to clients and that they are accurately disclosing key information about their operations to clients.”
The Ontario Securities Commission (OSC), is a regulatory body, tasked with ensuring fair and transparent markets. This is done through the creation, and enforcement, of laws surrounding securities in the province of Ontario.
CEO, Grant Vingoe, currently oversees company operations.