JC: It’s Saturday the 10th of February and I’m Julia Charlton and I’m here with Kim Larkin, my colleague to talk about what’s been happening in the crypto space in Hong Kong this week, and it’s been an extremely busy week. First of all we attended a closed-door Cambodian Fintech Connection event where the Cambodian Securities and Exchange Commission were in Hong Kong to talk about blockchain and the launch of a crypto exchange in Cambodia by a Hong Kong-backed company called CamNext, and that was very interesting because the Cambodian minister and Securities and Exchange Commission were engaging very heavily in considering crypto as a way forward for developing Cambodia’s market. So it’ll be interesting to see where that goes.

The other major news we have in Hong Kong this week is that the Hong Kong SFC issued a warning headed “SFC warns of crypto currency risk” yesterday, the 9th of February. What this warning says is that they are alerting investors to the potential risks of dealing with crypto exchanges and investing in initial coin offerings. Those are two very different things of course, but they are put together in this statement, and this follows on from a statement which was released back in September 2017. Apparently, the SFC has taken regulatory action against a number of crypto exchanges and issuers of ICOs – in the statement they say they have sent letters to seven cryptocurrency exchanges in Hong Kong or with connections to Hong Kong warning them that they should not trade cryptocurrencies which are securities as defined in the Securities and Futures Ordinance in Hong Kong without a licence.

JC: Most of these crypto exchanges either confirmed that they did not provide trading services for such cryptocurrencies, or they took immediate rectification measures including removing crypto currencies from their platforms. The SFC says they may take further action where appropriate in particular against crypto exchanges which disregard the provisions of the Securities and Futures Ordinance and those which they say are repeat offenders. The SFC says they have also written to seven ICO issuers and most of them confirmed compliance with the SFC’s regulatory regime or immediately ceased to offer tokens to Hong Kong investors, and the SFC says they will continue to closely monitor ICOs and will not tolerate any violations of Hong Kong securities law. The SFC says that ICOs are essentially crowdfunding by blockchain startups and ICO issuers are typically assisted by market professionals such as lawyers, accountants and consultants for advice to structure the offering as one of utility tokens to fall outside the SFO and “to circumvent the scrutiny of the SFC”. Mr. Ashley Alder, the SFC’s chief executive officer, said “We will continue to police the market and enforce when necessary but we are also urging market professionals to do proper gatekeeping to prevent frauds or dubious fundraising and to assist us in ensuring compliance with the law”. Apparently investors have complained to the SFC that they were unable to withdraw fiat currencies or crypto currencies from their accounts opened with crypto currency exchanges. Some complainants claimed that crypto currency exchanges had misappropriated their assets or manipulated the market or that technical breakdowns of the exchanges platforms caused them significant losses. Several complaints were against ICO issuers’ alleged unlicensed or fraudulent activities.

JC: Investors are urged by the SFC to be wary of the increased risk of extreme price volatility, hacking and fraud when investing in cryptocurrencies and ICOs and using services of crypto exchanges where these occur in an online environment. Victims may have difficulty pursuing action against cryptocurrency exchanges or fraudsters to recover losses. The SFC says they may not have jurisdiction over cryptocurrency exchanges and ICO issuers if they have no nexus with Hong Kong or do not provide trading services for cryptocurrencies which are securities or futures contracts. If however there is suspicion of fraud the SFC is open to refer cases to the police for investigation. So Kim, what do you make of this. Does this statement actually clarify anything in the Hong Kong market, do you think?

KL: Yes and no. I think what is welcome is that it does say that ICOs which are structured as utility tokens are outside the scope of the SFO and thus beyond the regulatory scope of the SFC. I think that’s good news. That’s because it has been very uncertain so far as to which ICOs are securities and which are not. There are some which obviously are and those, I think, have generally decided not to offer in Hong Kong. But then there is a whole raft of ICOs which I think most lawyers think are not securities and that is because they are structured as the SFC says, as utility tokens.

KL: But there is a point when a utility token is no longer a utility token and that’s where we get into very muddy waters, and that is where the SFC statement does not really help us at all. And the other thing I think is a bit worrying is that the implication seems to be that advisers, particularly lawyers and accountants, are somehow assisting ICO issuers in circumventing the SFC’s requirements.  “Circumventing” to me tends to have quite a negative connotation in a bit in the way that reverse takeovers are seen by the regulators as an attempt to avoid compliance with the Hong Kong listing rules. But in fact if something is not covered by the legislation, I don’t think that necessarily means it is trying to get around the legislation, it just means it is something which is unregulated and falls outside of it.

JC: Yes, and I mean let’s take a step back here – it is very clear that cryptocurrencies like Bitcoin are not regulated in Hong Kong and there is a statement from the HKMA that it is not regarded as a currency and it is clearly not a security, therefore it is not regulated.

KL: Yes, what they have said is that it is a “virtual commodity”,  and virtual or any commodities in Hong Kong, are not regulated. So I think what would be welcome would be a slightly clearer statement from some of the regulators as to what is a utility token and in what circumstances does it not constitute a security. There was a case recently in the U.S. where there was a supposed utility token, but in that case it was very clear that the marketing materials were promising potential purchasers that it would increase in value and also that it would soon be traded on to currency exchange. And so the two statements together was pretty much saying, yes if you buy this, then six months down the road you will be able to make a handsome profit. It didn’t actually go to court but the SFC issued a cease and desist order which prevented it going ahead on the basis that those statements together were taken as it constituting a security in the U.S. as it was promising a profit, bearing in mind that the definition of what a security is in the U.S. is slightly different from the definition in Hong Kong.

JC: Yes. And of course we are not U.S. lawyers, we are Hong Kong lawyers, so we are only reading and repeating what we hear on that. But of course in Hong Kong if an ICO token does not provide a return to a holder arising from rights or to benefit in the property the subject of the ICO, the ICO is not a collective investment scheme and is probably outside the SFO. So while some ICOs may be securities, there are going to be many others that are not in Hong Kong.

KL: I think the problem is the definition of what is a security. The legislation was written for a very different time when things like ICOs were never even envisaged. Trying to apply a very old definition to something which is completely outside its scope is extremely difficult. So we will not actually know until the first case actually makes it to the courts, and the court goes through and says what the defining features are of a collective investment scheme, or a share or debenture, that anyone will be able to say categorically whether something is or is not a security – it is a question of degree in every case.

JC: Yes and of course the SFC under the Securities and Futures Ordinance could actually by notice prescribe that a particular type of instrument was a security, but they have not chosen to do that so far.

KL: Exactly. Or the other way they could do it would be by issuing a no-action letter to say that if something has certain qualities, they will not take regulatory action against people, which is another option which would avoid having to amend the legislation which is always very difficult in Hong Kong.

JC: Hong Kong professionals already are subject to quite onerous obligations in relation to money laundering checks and so on. So it is very difficult to see what the SFC is actually getting at when saying that Hong Kong professionals should somehow be gatekeepers of this, because Hong Kong professionals’ obligations are to comply with the law and to act in their clients’ interests obviously within the law. So I don’t find this clear. All in all it seems to somewhat muddy the waters rather than making the position any clearer.

KL: Yes that’s true as lawyers and accountants are under very strict obligations in terms of the inquiries they make of particular clients – they have to do anti-money laundering and counter-terrorist financing checks and are also under an obligation under a number of different ordinances to notify the JFIU of any suspicious transactions in terms of criminal conduct or drug trafficking etc. And so there are clear legal obligations on solicitors. So when the SFC is quoted as saying that it is up to professionals to help them in combating dubious fundraising – what is “dubious” fundraising and who is to decide what that is. If it is not against the law then presumably it must be allowed.

JC: Yes that should be the principle under which we operate in Hong Kong. Hopefully we will continue to do so. So in other jurisdictions, tell me what has been happening. I heard that there were some banks that have banned the use of credit cards to buy crypto.

KL: Yes, that’s been quite big news both in the UK and the US. In the U.K. it was Lloyds Bank and in the U.S. a number of banks including Citibank have banned cryptocurrency purchases using their credit cards. The motivation according to the banks is that because cryptocurrencies, and I think here they are really thinking of Bitcoin, have been very volatile, they are worried that if people essentially borrow money from them to buy cryptocurrencies, that if the price of these cryptocurrencies then drops as we’ve seen with all the cryptocurrencies in the first two months of this year, that they will not be able to repay the banks what they owe.

JC: So, what else has been happening in the US.

KL: Well obviously there have been hearings before the Senate. There’s going to be one on Valentine’s Day which seems quite appropriate. Both the chairman of the SEC and the Commodities Futures Exchange have come out with statements on their thoughts on cryptocurrencies. I think most commentators in the bitcoin space seem to think that the Commodities and Futures Exchange had a better grasp on what ICOs are. There has also been a statement from the SEC saying that for the rest of this year, one of their priorities will be cryptocurrencies and ICOs singling out in particular the risk disclosure which is made by ICO white papers warning investors. I think a big issue is the whole question of education of investors. Obviously there are some investors who are not well informed. They see stories of bitcoin millionaires in the press all the time. And so obviously people see this as an easy way to make money. I’m not quite sure how much activity is going on with some of the other ICOs and there are over fifteen hundred crytpocurrencies at the moment. It is only really the top four that have any real traction and I would guess that most of the purchasers of some of the other ones which are far more specialized are venture capitalists or people who really specialize in this area rather than Joe Average who is buying into bitcoins. So even within their cryptocurrency market there are huge differences between investing in bitcoins or investing in some rather obscure ICOs which have a very precise use function.

JC: Well that’s interesting isn’t it. So, do we think that they’re actually going to do anything more in the States perhaps from a commodities angle or is the jury still out on that?

KL: I think they’re still keeping quite a long step back. What they are doing is where they see ones which are obviously securities being marketed not in compliance with the U.S. law, the SEC is stepping in to prevent that. Otherwise it looks like they might encourage more disclosure by ICO issuers. I think we’re also seeing more and more self-policing by the industry itself.

JC: Yes, that’s interesting. And the other thing I think is relevant to note in Hong Kong is that we  have never really had much of a commodities market here. Even our securities regulator was called the Securities and Futures Commission they do not really regulate commodities and perhaps it is going to be some of the expertise in regulating commodities trading which exists more in the States and in London which might be more relevant actually to crypto. Thank you very much, Kim.