JC: It’s Saturday, January 27th 2018 and I am here with my colleague Kim Larkin and we’re going to spend some time talking about ICOs, cryptocurrency and what’s going on in this space in Hong Kong generally and from a legal perspective. Kim, in terms of ICOs, what kind of interest levels are you seeing in Hong Kong at the moment?

KL: Over the last year or so, interest in ICOs has really picked up. There have been quite a number of ICOs in Hong Kong in part because the regulatory framework is pretty favorable. We are seeing more and more of these enquiries particularly as other jurisdictions in the area, such as China, South Korea and even Singapore, are beginning to tighten up on regulation.

JC: So tell me a bit more about Hong Kong regulation – can we start with cryptocurrency perhaps, before we actually talk about the more complicated area of ICOs. What’s the situation in Hong Kong regarding cryptocurrency regulation?

KL: Basically cryptocurrencies such as bitcoin are intended to act as a means of payment, as an alternative to flat currencies such as the US or Hong Kong dollar. They provide a means of payment and to that extent they are unregulated at the moment in Hong Kong. The authorities have said they do not regard any cryptocurrencies as a legal means of payment. They are not regarded as money or as currencies but as “virtual commodities” which are generally unregulated.

JC: So why do you think the Hong Kong authorities are taking this line to towards regulating cryptocurrency?

KL: I would say that it is because to date, cryptocurrencies have not really presented a significant danger in Hong Kong. Bitcoin is not widely accepted by merchants as a payment means in Hong Kong, nor have we seen the scams and Ponzi schemes which have led regulators in other jurisdictions to clamp down on cryptocurrencies. If that were to change, then the regulators would very likely step in to protect investors, but certainly they don’t seem to be worried about the cryptocurrency related activities we are seeing in Hong Kong at the moment.

JC: Yes, that’s interesting isn’t it when you consider how regulated Hong Kong is in other areas. So does that mean that you could, for example, just set up a cryptocurrency exchange in Hong Kong? How would you go about doing that? Would you need a licence to do that?

KL: There are a couple of areas where you do need to think about regulation. Firstly, if you are exchanging cryptocurrencies for fiat currencies, e.g. U.S. dollars or Hong Kong dollars, or if you are receiving payments in any kind of real currency from outside Hong Kong or transmitting any real currency out of Hong Kong, then you come within the scope of the money service operator licence, which is a relatively easy license to obtain as compared to a securities licence or a banking licence. And so there are a number of cryptocurrency trading exchanges operating in Hong Kong with that licence. Your main obligation is to conduct anti-money laundering and counter-terrorist financing KYC procedures, including identifying and verifying the identity of your customers and their beneficial owners by obtaining copies of their identity documents and proof of address etc. There are no other regulations specifically covering cryptocurrency trading apart from these two areas, subject to none of the cryptocurrencies that you are trading being a “security”, which is where you fall into heavily regulated territory.

JC: So let’s move on to ICOs. What’s happening with ICOs in Hong Kong? Are there any ICOs going on and what is the attitude of the regulators to ICOs in Hong Kong?

KL: There are definitely ICOs going on in Hong Kong. They started in early 2017 and there seems to have been a continuous stream of ICOs ever since. I’ve read that some people say that Hong Kong is one of the best jurisdictions to do an ICO at the moment. As to what the regulators are saying about ICOs, the SFC issued a statement last September warning that if a coin has certain characteristics, then it could fall within the scope of securities regulation. And that really will depend on whether a coin has the characteristics of a share, which essentially means that it is a right of ownership, has rights to a share of profit or other return, or gives you rights on a winding up. Probably more likely is that the ICO could fall within a collective investment scheme, which is the pooling of money to invest in a projects or projects with a return in the form of a share of the profits or revenue stream which is distributed back to the coin holders. In any of those situations, the coin will be regarded as a security which brings a whole raft of laws and regulations into play.

JC: So say an ICO was regarded as a security. Does that mean you actually can go ahead with the ICO offering in Hong Kong at that point?

KL:  No, although there are ways you can still do it. One thing you can do is under the professional investor exemption, so you can restrict the offering to certain wealthy, sophisticated investors. Secondly, you could do an offering on a private placement basis with a very limited number of investors. The most difficult area is around the licensing requirements which are very strict. There is no professionals exemption for that. I think probably the only way of doing it in that case would be if you only offer securities in a private company which are excluded from the definition of securities, but then you have another problem in that a private company cannot offer to more than 50 potential investors. So any information you make available which is encouraging people to invest would somehow have to be restricted to a maximum of 50 people. That means providing access codes to websites and is not really practical given that an ICO is generally run in a way to generate maximum interest.

JC: Yes. So can you describe to me the sort of ICO you might see in Hong Kong which you would be reasonably confident would not fall within the definition of a security? What sort of characteristics would it have?

KL: Well most ICOs try to structure themselves as what is called a “utility token” which is where there is a specific use for the coin. Essentially the ICO operates like a digital gym membership. The coin is issued and that gives you the right to use the gym as and when it is open for business. In an ICO, the issuer plans to provide a service on a blockchain platform and the idea is that by purchasing the token, you provide funds to the coin issuer. They will then use those funds to develop technology on which certain services will become available, or to cover the operating costs of an existing platform. Then once it is up and running, you as the coin holder can then use your coin to access that platform and to use the services being made available.

JC: So do you think investors are really wanting to use these services or do you think they are looking at trading the coins?

KL: Well I guess given the scale of interest that some ICOs are seeing, there has got to be an argument that a lot of people are in it just for speculative purposes. But then you could say that about racing cars or expensive watches. But for the coin issuer, the key objective is just to raise funds which in Hong Kong is quite hard if you’re a start-up, and this is where ICOs are filling a gap in that they are providing a legal crowdsourced funding method for companies who need it. The fact that some people choose to speculate is not really something the coin issuer can control.

The other type of ICO we are seeing is where the coins are backed by assets, typically gold or another metal. Sometimes the coin proceeds fund a mining operation. Even in those cases, I don’t think that the ICO would be regulated since commodities are not generally subject to regulation in Hong Kong.

JC: Are there any particular things you would point out in relation to setting up an ICO exchange in Hong Kong? Is it possible in Hong Kong or are most of these operating outside of Hong Kong?

KL: There are exchanges operating in Hong Kong. I think from a legal perspective, setting up is not really that complicated as you really just need a money service operator licence. I think the main difficulty is not a legal issue at all, and that is the difficulty of opening a bank account which is not peculiar to Hong Kong – in any jurisdiction these days it is very hard for anybody operating in the cryptocurrency exchange business to actually open a bank account. And as we have seen in South Korea where they are tightening up the regulation of exchanges trading cryptocurrencies, the difficulty for traders to open bank accounts is actually going to slow down trading, and perhaps reduce the amount of business you get on the crypto exchanges.

JC: And so what do you think would happen if an ICO listed on a Hong Kong crypto exchange actually turns out to be a security – how would that affect the ICO exchange? That is the biggest danger for these exchanges – what would happen if that was to be the case?

KL: If one ICO  traded on an exchange turned out to be a security, then technically that exchange is then dealing in securities, which would require it to have as a minimum, a Type 1 securities dealing licence, and probably a Type 7 licence as well to conduct automated trading.

So the exchange would become something like Interactive Brokers, the online securities exchange, and would have to be licensed. So this would be a huge deal for any potential crypto exchange.

JC: So in terms of launching an ICO, how would a prospective issuer actually go about that?

KL: Well first of all they need to incorporate a company which could be a Hong Kong corporate entity, but could of course be elsewhere, e.g. in the BVI or Cayman Islands, or in European jurisdictions like Gibraltar or Cyprus etc. The most important thing is the blockchain technology and how the business model fits with the platform and an ICO.  Not every project is actually suitable for an ICO because not every good business idea gears itself to being offered through a coin on a blockchain. And so the technology is really the key issue. You need to consider what the problem is that the technology is intending to solve. There are a number of blockchains out there that people are using to host their ICOs.  The most popular ones include Ethereum and Wave, but there are also blockchains in Hong Kong that host ICOs.

So you either have to have your own blockchain or you have to approach a blockchain which is already providing a service for ICOs and there are a number of those. Then it’s really a question of drafting a whitepaper which is a technical explanation of what the platform will be doing and will include details kind of the process of distributing the tokens. Most ICOs will give early adopters a reduced price and then a number of months later, a public offer will be held. That process is not really subject to any real legal requirements, apart from the obvious that the whitepaper has to be accurate otherwise you are misrepresenting what you are doing.

Very simplistically, you develop a blockchain-based business, issue a whitepaper describing it and the ICO, publish relevant information with the whitepaper on a website, issue the coins, collect the money and get rich.

JC: So what do you see as the key difficulties for ICO issuers because what you’ve just described sounds quite easy actually?

KL: I think it sounds easier than it is in practice. I don’t know much about the actual technical side and developing the technology is I guess where the real brains are required. But there must be a considerable amount of time which must be spent developing whatever the project is and getting the ideas together, and maybe getting early investors to come in.  So I think the hard work is getting the business model right and getting over that initial level.

JC: And what do you think the regulatory outlook in future is for ICOs and cryptocurrency in Hong Kong?

KL: I think we need to distinguish between cryptocurrencies in terms of bitcoin and payment means on the one hand and cryptocurrencies in terms of ICOs on the other. In ICOs, cryptocurrencies really provide a legal crowdfunding method. I think there are a lot of concerns particularly around Bitcoin and other cryptocurrencies more from the aspect of money-laundering and terrorist financing. I think that is where Hong Kong, if it does introduce new regulation, is likely to focus its attention. Any financial institution, bank or SFC-licensed entity is already obliged to comply with anti-money laundering and counter-terrorist financing requirements in relation to cryptocurrencies. So are licensed money service operators. There are also various ordinances which must be complied with even if you are not a bank or licensed entity for example legislation aimed at countering terrorist financing, drug trafficking etc. which require the reporting of suspicious transactions. But I think we may see more regulation in that space. I see that Singapore is talking about licensing people who deal in crypto currencies which would apply to the kind of crypto exchanges which in Hong Kong currently have an MSO licence. MSOs are already subject to anti-money laundering obligations which technically apply not to the cryptocurrencies themselves, but to the remittance and exchange of fiat currencies. The Hong Kong regulators may actually tighten up the regulations so that they apply to cryptocurrencies themselves, but I think in terms of ICOs, there will not be any real regulatory developments.

JC: Well great. So we can look forward to a lot more ICOs in Hong Kong. That’s really interesting. Thank you so much, Kim.