On Monday, February 20, the Securities and Finance Commission of Hong Kong issued a long-awaited consultation on expanding its regulation of crypto services to include retail investors.
But before discussing this, let’s talk about food trucks.
Food trucks emerged in their modern form in Los Angeles, offering cheap but high-quality and often very inventive meals. Food trucks don’t have the costs of a brick-and-mortar restaurant. They are run by entrepreneurs and contrast with corporate chains. Their chef-owner-operators have the freedom to mix things up and continually innovate dishes.
In short, food trucks are badass disrupters that provide an alternative to corporate-dominated restaurants, give up-and-coming chefs a direct link to their customers, and deliver tasty and affordable meals to a community.
Food trucks have been a huge success and the model was copied across the US and the world. Including Hong Kong.
Rebel eats in Hongkers
In the mid-2010s, a few foreign-run eateries and entrepreneurs imported food trucks to Hong Kong. Hong Kong has a vast array of five-star restaurants but its hawker street food culture was bowdlerized long ago. The dai-pai-dong stalls and cha-chaan-teng diners have succumbed to health regulations and crazy rents. Casual eating for white-collar workers in Hong Kong is expensive.
Hong Kong’s rebel food trucks proved a hit at concerts, outside office towers, and corporate events. They were mobile so they could bring their unique menus to multiple locations. They were not authorized – these were, after all, handling food, which requires some basic hygiene rules – but they were so popular that the government decided to license them.
After much study, the Hong Kong bureaucracy in 2017 launched a Food Truck Pilot Scheme.
And that was the end of food trucks in Hong Kong.
Well, that’s not technically true. The scheme was axed in 2022 but revived to allow a handful to operate around the West Kowloon Cultural District’s arts park.
But it’s basically true. The government strangled the food-truck movement in its cradle. Maybe some grumpy real-estate billionaires whispered into bureaucrats’ ears, or maybe the government was just clumsy. The Covid pandemic certainly didn’t help. But food trucks were doomed.
Licensing food trucks to death
First, the pilot was driven by the then-financial secretary, John Cheng, who gave it to the Tourism Board to manage. Maybe because food trucks are a foreign idea, the government thought they should only cater to tourists. Or for whatever reason, the government didn’t want them competing with traditional restaurants.
Trucks were limited to a handful of fixed, sometimes obscure locations. Licenses required chefs outline vehicle design and list their entire menu (no creativity on the fly, please). And, as if offering a wealth product, the entrepreneurs had to convince the government of their own financial soundness.
This micro-management, all of which was unnecessary to the purpose of supporting a dynamic food-truck industry, made the costs too high and removed the opportunity for chefs to make money. They also denied food-obsessed Hongkongers of quirky, cheap and readily available alternatives.
In the end only 15 entrepreneurs signed up in 2017 and there are only four still operating, all contained within the West Kowloon museum zone. For food trucks, it was death by licensing.
Dear reader, you know where this is going. But there’s a twist.
Protecting retail
DigFin has been among those who welcomed the idea that the SFC should expand its regulatory umbrella of virtual assets to retail investors. This wasn’t because we like the idea of retail people speculating on these assets, but a recognition that they’ll do it regardless, so they need guardrails.
The SFC created a regime for licensing virtual-asset service providers (VASPs) for accredited investors, but these are arguably the types of investors that don’t require investor protections.
For many in the crypto space, the idea of Hong Kong delivering a clear regulatory framework for both institutional and retail investors is very attractive. Especially as the United States’ Securities and Regulatory Commission is now bringing heavy regulation to the sector.
For Hong Kong’s government, the move is also designed to shore up the city’s primary role as a crypto-finance hub, that is, a place that attracts assets and where key industry leaders operate. The city was an early pioneer in crypto but seen Singapore and Dubai advance.
Does the SFC’s consultation paper on the proposed regulatory requirements for licensed virtual-asset trading platform operators achieve this?
The SFC’s dilemma
That depends on what is motivating the SFC. If its primary motivation is to “democratize finance” and open innovative blockchain-based platforms to retail investors, the answer is no. It’s just food trucks all over again.
If the answer is the SFC wants to appear to be pro-crypto without actually being pro-crypto, then this is a good start.
It’s also possible that the answer is a bit of both. The SFC was as alarmed as everyone else by last year’s various crypto meltdowns and the industry’s circularity. It was an early mover in shifting regulation away from the edges of the industry (for KYC and AML), to instituting licensing requirements. Now, with retail investors, it is adding investor protection.
Its assumption is that crypto is a financial game as opposed to pure gambling, and therefore should be regulated just like financial products and services – as if there is a market-integrity issue at stake, as with, say, stocks.
The toxic legacy of mini-bonds
When it comes to investor protection, the SFC is remarkably stringent in traditional finance. This stems from the 2008 global financial crisis, when a slew of retail investment products sold to Hongkongers, cutely marketed as “mini-bonds”, went bust because their returns were backed by Lehman Brothers. (Oops.)
This led to the biggest wave of protests since the 1960s, with legions of uncles and aunties demanding their money back. The SFC and Hong Kong Monetary Authority cajoled banks’ wealth desks to settle with the protesters, but the episode was so awful that the SFC created very onerous rules for selling even basic, low-risk mutual funds.
Only the recent advent of digital platforms has begun to ease the situation, but for most products it takes an hour-long recorded interview in a bank branch for a retail customer to buy an investment product. They must demonstrate their knowledge and their capacity for risk, and then they are profiled for suitable products (whose suitability is judged extra conservatively).
This is the mindset now coming to retail crypto. Think of it as food-truck finance. The mere whiff of trouble will be eliminated.
How so?
New rulz
The SFC rightly insists on anything that’s a security to come under its remit, and any venue handling even one such token, regardless of whether it’s an exchange or a broker, must obtain a license, or leave the city, and not market to Hong Kong residents. These firms will have to adhere to the following conditions.
Custody: assets must be held in trust, with no more than 2 percent of client virtual assets held on a hot wallet. The rest must sit offline. This is prudent, but will make it hard to offer trading or staking strategies. Any tokens meant to earn yields must by definition move around.
Legally this raises the question of the nature of the client relationship. In the unregulated world, a lot of investors who thought they were, well, investors, turned out to be unsecured lenders to operators such as Celsius, BlockFi and FTX. Under the SFC laws, they will be treated as investors, but this means their assets cannot be used the same way. This may be good for society and the right thing to do, but it will make the business unappealing for both operators and investors. Food trucks!
Moreover, operators holding client assets must provide insurance to cover risks. It is hard to find insurance companies that will underwrite crypto, and if they do, it will be expensive. Who bears that cost?
And: proof of reserves. That’s all a crypto exchange needs to show to prove it’s solvent, right? …Right?
Know Your Client: It’s not enough to simply ensure the customer isn’t a bad actor. Operators must also determine the client’s financial situation and knowledge of crypto. Expect suitability rules to apply that will be at least as stringent as those in the tradfi funds world.
Trading: Operators have to be able to halt trading on customer assets if there’s a problem. This suggests it will be difficult to put client virtual assets into DeFi programs. This is centralized crypto.
Prevention of Market Manipulation and Abusive Activities: “A platform operator should establish and implement written policies and controls to identify, prevent, and report market manipulative or abusive trading activities on its platform.”
In crypto. OK.
Clients also have to pre-fund accounts. In the name of good risk management, platforms can’t front people the assets or an equivalent. Does this even work in the world of margin and swaps?
What the SFC’s given
DigFin is not arguing that the SFC is getting this wrong, if crypto is indeed meant to be treated as a financial asset. The SFC was bashed for licensing institutions and rich people to play in a protected way, but not retail, and now it’s extending protections to retail – the people who actually need protecting.
The crypto industry has said for years it welcomes regulation and clarity. Well, here it is. It’s a regime that will make doing business in Hong Kong very costly. Retail investors will be limited to Bitcoin and Ethereum, and in the future, maybe other coins with large market caps. But they will not be able to do all the stuff that they really like: participate in Ponzi schemes.
The SFC is creating a framework that is designed to make crypto pretty boring. If you are of the opinion that crypto is generally bad, especially for retail sheeple, then the SFC has done the right thing. Similarly, if you believe that tradfi should be isolated from the vagaries of crypto, this is good.
If you think that the future of blockchain finance is DeFi, staking on Ethereum or other infrastructure layers, tokenomics, and warp-speed trading and innovation, then you will probably take your business somewhere else. As-salaam alykum, Dubai!
China play?
Here’s the twist.
There could be one reason to put up with this regulation, which is that Hong Kong is a conduit to an ocean of mainland Chinese money. Now that Covid-era restrictions are falling, lots of mainlanders will visit Hong Kong. Eager to do something with their money, especially if it’s in a format that travels easily, they might line up for blocks to open a crypto brokerage account.
This could be the next big wave, like those multi-million dollar single-premium life policies that floated the insurance industry for years. These “investors” are less sensitive to price and less focused on staking etc. They’ve got Macau for that sort of thing.
The SFC will not want this to be the next big thing. The last thing they need is to attract Beijing’s ire.
Problem solved? Hong Kong has signed up to the Travel Rule, which means anyone transacting in virtual assets worth more than $1,000 must provide proof of identity. This will make it difficult to open the floodgates to capital flight.
The SFC has scored the trifecta: Hong Kong asserts its “one country, two systems” credentials, allowing activities in virtual assets that are banned in China. It extends its licensing regime to include retail investors, a global first. And it keeps Beijing authorities onside.
Impressive!
But…
The road not taken
There could have been another way, which is to decide that crypto isn’t a financial asset (which implies a liability, which Bitcoin et al lack) but a purely speculative asset, and regulate it like the casino that it is. This would have allowed the industry to thrive, given punters the access they crave, while keeping the industry in its box, without sacrificing the KYC that China requires.
Governments regulate gambling to ensure it doesn’t facilitate criminal activity, that it is conducted fairly, and that it doesn’t harm children and the vulnerable. There is a lot of overlap between regulating casinos and regulating banks or brokers, but gaming law is focused on keeping the casino ringfenced and giving customers clear rules but otherwise the freedom to lost their shirts.
Financial law is by necessity broader and deeper. It must ensure people and companies have access to savings, investments, risk management, and credit. It ensures the stability of payments, the soundness of money, and the integrity of capital markets.
If crypto is a casino, then it could be made safe so long as its risks were contained within its own ecosystem. The government wouldn’t need to tell the food trucks where to park and what to cook.
If crypto is indeed a financial asset, and coins and products are securities, then it needs the full weight of financial regulation. The industry perhaps brought this on itself with its messaging: “the future of money” etc etc. The result is the platform operators must be told where to park and what to cook. Ask a food truck’s chef how this is likely to turn out.
