The announcement by Hong Kong Securities and Futures Commission’s (SFC) that it intends to limit access to digital asset exchanges to professional investors starting later this year has raised as many questions within the industry as it has answered. On the one hand, it is true that there are high-profile examples of hacks of digital asset exchanges that have led to significant losses or business disruptions for institutional and retail investors. While there is little doubt that these incidents should serve as credible rationale and justification for new regulation in this market, it is an open question whether an outright prohibition on retail investment strikes the right balance between the objectives of consumer protection and innovation and growth.

Stephen Richardson Fireblocks

Prior to the invention of digital asset ownership on a distributed blockchain, at no time in the modern history of monetary systems have individual customers actually possessed and controlled the greater part of the financial assets they own. This has been one of the primary roles of our legacy financial institutions and intermediaries: to safekeep that portion of our assets in excess of the limited amounts of cash or precious metals we carry on our persons or keep in our homes. It is precisely because financial intermediaries have had exclusive dominion over customer assets that, when left to operate without supervision and oversight, these intermediaries tend to become concentrated sources of systemic risk and catalysts for recession.  

In the case of digital assets, the customer is for the first time able to maintain direct ownership of its assets at scale without the participation of a financial intermediary. This feature of digital assets infrastructure allows retail investors to not only access the market venues where these assets are traded directly, but also to seamlessly store and manage their assets on their own away from any particular trading venue, exchange environment or centralized custodian.  

The issue that arises for digital asset investors in Hong Kong is that they are not able to fully realize these advantages because exchanges have become one-stop shops for all of their digital asset service needs. This vertical integration model puts exchanges on par with traditional financial intermediaries and creates significant counterparty risk for investors. In cases like QuadrigaCX, where custody of assets on the exchange was managed by an individual or small quorum of operators with no significant regulatory oversight, a single exchange can become a source of systemic risk with any associated losses falling disproportionately on individual and retail investors. 

The response to this issue to date has been to call for licensing of exchanges and to prohibit retail investors from accessing their services. But the question remains: Is there a better, more balanced approach that would preserve market access to retail investors in a substantially safer market environment? 

Hong Kong has long been a market leader in developing globally competitive marketplaces, and there is no reason to think Hong Kong might not emerge as a leader in digital asset markets as well. Denying retail investors access to digital assets marketplaces outright not only represents a significant break from that history of successful marketplace regulation, but it is also almost certain to discourage the development of an innovative marketplace in Hong Kong and damage its global standing as a venue for digital asset business. Perhaps that is the point.

If, however, an opportunity to revisit the SFC’s proposal arises, there are models that Hong Kong can draw from to create a marketplace that strikes a more even balance between customer protection and the commercial interests of the jurisdiction in being a global leader. 

A good starting point would be for regulators to propose, and exchanges to prepare themselves to embrace, a multi-faceted regulatory licensing structure led, managed and supervised by the SFC. The principal objective of such a proposal would be to ensure the safe and sound operation of Hong Kong exchanges through the imposition of principle- or rules-based prudential and operational guidelines. Many jurisdictions, like the United States and Singapore, have put licensing requirements in place that give institutional and retail investors confidence that they are operating with a properly regulated institution. Hong Kong should quickly follow suit.

The second change that digital asset operators in Hong Kong should support is the decoupling of exchange and market trading functions from other ancillary business services that are conducted under the umbrella of the exchange, such as OTC trading, proprietary market making, lending and custody. Exchanges that operate such a diversity of businesses look more like full-service financial conglomerates rather than pure digital asset execution venues — and they should be regulated as such. 

The caveat here is that parent entities of the exchanges do not need to fully divest custody operations from their business but rather distribute the control of customer assets across multiple operational groups. By embracing regulation that enforces a “Chinese Wall” type separation of these activities within exchange venues and regulating each function separately, digital asset operators in Hong Kong will help to ensure the proper safeguards around investor managed funds. This type of “functional” regulation is already the norm in places like the United States, where we are seeing many digital asset operators — such as Coinbase, Gemini and Paxos — operate successfully under this model.

Third, and finally, the SFC needs to urge Hong Kong digital asset operators to utilize best-in-class technology solutions — such as MPC (multi-party computation). MPC mitigates single points of compromise around the custody of investor assets while enabling stronger governance processes within the organizations, ensuring the right level of operational oversight and risk mitigation. If the issue that prompted the SFC to action in the first place was the concentration of risk due to inadequately secured assets, a large part of the solution will be the widespread adoption of technologies like MPC that disaggregate access credentials and diminish the risk that any single point of failure will lead to catastrophic loss.

In proposing to regulate Hong Kong’s crypto asset exchanges, the SFC has demonstrated an admirable commitment to curbing the excesses of an unregulated market and mitigating the risk of loss to investors. While the consumer protection concerns of the SFC are legitimate and worthy of attention, forward-thinking jurisdictions around the world and within the region demonstrate the viability of a middle path that better balances retail customers’ fundamental interest in accessing services without reliance on an intermediary against safety and fairness concerns. The implementation of the changes suggested in this article in tandem with broader engagement of digital asset operators with key regulators in Hong Kong will restore investor trust, provide incentives to innovation and a spur to growth, and ultimately put Hong Kong back on track to be the global leader in the digital asset space.