Explaining the “Qualified Investor System” 丨Why there is a need for investor classification

The investor grading and qualified investor system, on the one hand, is to protect investors and ensure that ordinary people do not lose all of their investments because of failure.

Explaining the "Qualified Investor System" 丨Why there is a need for investor classification

Compliance is an inescapable topic in the financial market. This is true even in the emerging cryptocurrency and blockchain markets, where users need to complete complex KYC (know your customer) processes and AML (anti-money laundry) reviews to respond to the regulatory needs of different countries.

In traditional financial markets, especially in high-risk and high-return areas (e.g. private equity, equity investment, venture capital), there is another term that cannot be avoided – “qualified investor”.

In the financial markets, QI access is one of the most important ways to protect investors. And in the cryptocurrency space, it is this area of investor protection that is most valued by national regulation.

It is unclear about the future of digital currencies, but we must admit that regulation is effective regulation and supervision is an inescapable part of cryptocurrencies, and the requirements for investors themselves must be an important part of the regulatory rules.

This brings us back to the core question: why do we need a ‘qualified investor’ system?

It is a well-known fact that risk and return are directly proportional to each other. Different investors have different risk preferences, different perceptions, and different tolerance for risk. This predetermines that high-risk and high-return investments such as venture capital and private equity can only be a game that a few people can participate in, and ordinary investors may not have sufficient knowledge reserves and risk tolerance to participate.

The purpose of setting up an investor grading system is to allow investors with different risk tolerance to purchase products with different risk levels, so as to reduce the overall risk of market operation and improve and regulate the capital market.

Back to the crypto world, no matter how grand our narrative is, it needs to return to logic in the end. And history is always similar. Going back to the chaotic days of the private equity industry twenty years ago, we can also review how it was rectified and regulated from the development of the traditional financial market, and map it onto digital currencies.

Mark Twain once said, “History does not repeat itself, but it is always strikingly similar”. In this article, I will give a brief introduction to the ‘qualified investor’ system and how it may impact digital currencies in the future.

Where did the QI system come from?

According to Wikipedia, “qualified investors” are institutions and individuals who have the appropriate risk identification and risk-taking ability, and whose assets, background, and market experience meet the relevant criteria.

All markets are bound to go through a process from chaos to order, from indulgence to regulation. The qualified investor system originated in the United States. The capital market in the U.S. has experienced the process from fragmentation to centralization and from complete deregulation to being centrally regulated. Due to the initial improper regulation, the market order was in a chaotic and disorderly state for a long time, which led to the manipulation of capital prices and forced positions in futures.

After the big fall (Great Depression) in 1929, the United States began to reflect on the lessons of securities market regulation and started securities legislation. In the Securities Act of 1993, it was proposed that investors needed to be protected, and although no specific regulations were specified, a theoretical foundation was laid for the subsequent “qualified investors”, and in subsequent decades, it was proposed that investors should have certain abilities to support their investments financially and in terms of financial market experience, but these regulations still could not determine whether the requirements were met on a case-by-case basis.

It was not until 1982 that the SEC enacted “Regulation D” (also known as Reg D), which clarified that only financial institutions or individual investors who meet certain asset requirements could be permitted to participate.

Subsequently, the SEC introduced Regulation A (or Reg A) to allow public offerings by non-listed companies, and in 2016, Republic, AngelList and other teams lobbied to lower the threshold for private equity again through Regulation CF (Reg CF crowdfunding regulations).

In 2020, U.S. regulators again relaxed the regulations, including raising the Reg CF cap to $5 million and expanding the list of “qualified investors” to include individuals and some institutional investors with expertise who do not meet the financial criteria.

Wider application of the QI regime
Regulation is one of the most important signs of the maturity of the financial system. Many developed countries, such as the UK and Japan, have followed the experience of US regulation and reformed their internal legal system of financial regulation.

For example, although the UK also advocates free competition and complete openness to the outside world, the investment style is still more conservative than that of the US; the Japanese capital market, after a series of market problems caused by the strong speculative overtones in the early days, began to adopt a series of austerity policies, showing a more conservative and cautious attitude.

Each country has developed its own set of regulatory system due to different economic development, international geography and guiding ideology. The same applies to the regulation of the crypto world, and “island countries” such as Singapore and Malta are naturally more friendly to the crypto world.

Back in China, the regulatory development history has not been a smooth one either.

China’s financial market developed late, and private equity, as an ‘import’ from the Western capital market, has been growing wildly in China for two decades, interspersed with many incidents of capital management products plunging into mines one after another. In the earlier days, the grandparents exercising downstairs could discuss with glee what private equity products they held.

But as the market heats up and the industry progresses in practice, China’s regulatory system is gradually becoming more perfect.

The revised Securities Investment Fund Law in 2012 began to define the concept of “qualified investors”, and the SFC’s Interim Measures for the Supervision and Administration of Private Investment Funds in 2014 set out the specific criteria for qualified investors. Since then, the issuance of compliant private equity products requires the identification of investors, and some products also set the number of investors to achieve the purpose of risk control.

The New Regulations on Capital Management released in 2017 also updated the identification of qualified investors, introducing concepts such as family assets and market experience.

The “risk assessment” that we now need to fill out when buying funds or securities to open an account is part of the investor grading management. Banks, brokerages, etc. are required to understand the risk tolerance of investors and properly inform them of the possible risks.

Comparison of Qualified Investor Determination Standards by Country
Although qualified investor systems exist in the financial regulatory systems of many countries, there are some differences in the judging rules of each country. Here, I have collected data from the Internet and compared the criteria for determining qualified investors in each country.

From the above table, in fact, it can be seen that although the general direction of each country in the definition of qualified investors is the same, but in fact the definition of the concept is still a certain difference.

The U.S. assessment approach favors a more relaxed principle-oriented, has formed the concept of “investors should be able to implement self-protection”, in the assessment process more emphasis on the grasp of the assessment principles rather than specific terms and rigid figures, with greater flexibility and subjectivity.

The UK’s assessment approach reflects a combination of principle-oriented and rule-oriented features, including a combination of qualitative and quantitative tests for investors, with rules between lenient and cautious; Japan and China are more typically rule-oriented, emphasizing clarity of assessment rules.

Still, the regulatory styles of each country are explored in financial practice. In short, the qualified investor system is designed to protect the investors themselves and, more importantly, to protect this market.

Rational investors bring rational markets
Why do regulators place such importance on restrictions on investors? The answer is obvious. Investors have a unique position and role in the capital market and can directly influence whether the market can develop healthily.

To a certain extent, what kind of investors determine what kind of market.

If investors are rational and mature, the market will be relatively stable and the difference between market price and intrinsic true value will be small; if investors lose their minds and become fanatical, the market will be like a pendulum that has lost control, vibrating wildly and generating huge bubbles or unreasonable discounts.

However, limiting investor participation is itself a seesaw-like thing. If there is no investor participation, there will be no buyers for securities or private equity, and the market will lose its upward momentum; and if it is relaxed, anyone can join without any threshold, then the avalanche of funds will surely occur after the frenzy, a typical case is the subprime crisis in 2008.

Before the subprime crisis, when Americans applied for various loans, banks would conduct strict vetting procedures, background checks on borrowers, and continuous tracking of loan repayments. It wasn’t until the advent of ABS securitization that non-performing loans could be packaged into products for distribution.

Some lenders began to lend to people with poor creditworthiness, low income or poor debt repayment ability. The infusion of capital caused home prices to rise, and as securitized loan assets stepped in, which in turn allowed other financial institutions to purchase mortgage assets, lenders’ risk appetite was increased and risk began to spread across the financial system.

An example was told in the documentary about a stripper in Florida who purchased four houses through bank loans. The lender packaged such ‘non-performing assets’ into high-quality assets and had the lenient rating agency give a higher rating and sold them to the investment bank. Even the investment banks then sold further to investors.

Home prices rose, loans increased, and money was blowing bubbles in a frenzy. Until the housing loans defaulted on a large scale, the bubble burst and the beauty of the dream was awakened.

The causes of the subprime crisis are many, consumerism, poor risk control awareness of financial institutions, the mass herd mentality, regulatory delays, etc.. But one of the most important reasons is that the financial market allows the “non-qualified investors” who do not have the ability to participate to participate, and actively on the leverage.

Finance is like acrobats walking a tightrope, the most important thing is balance.

Investor grading and qualified investor system, on the one hand, to protect investors, to ensure that ordinary people do not lose all because of investment failure, or even the wife and children rooftop see. On the other hand, it is also to regulate the participants in the market and help create a rational and prosperous capital market.

But will such a system bring about the Matthew effect and exacerbate the inequitable distribution of social wealth? To a certain extent the answer is yes. In the past decade, we have created a large number of Internet giants (Tencent, Google, Facebook), etc., and the greatest value of this has been captured by venture capitalists. We, as users, can only watch such a feast from the sidelines.

But in reality there is never a free lunch. We are always prone to survivorship bias, but always ignore the risks behind it. The only ones that stood out after the 100-group war were Meituan and VW Dianping, and the leading travel company Drip, which is still struggling to get listed, always has others waiting on its side.

The capital market is never as good as it seems, and even professional investment institutions with capital, knowledge and professional teams often suffer losses in the game, not to mention ordinary investors.

The crypto world moves towards regulation and maturity
We want to see a boom in the crypto world, but a boom will inevitably mean a return to sanity in the crypto market. In the past few months, we have seen the entrance of institutions and the irrational meme coin boom and crash.

It takes time for a market to mature, it takes cycles to change, and it definitely needs regulatory intervention. The regulatory intervention may bring pain, but it must be beneficial in the long run.

In my opinion, whether in the primary market or secondary market, regulatory intervention will definitely bring a stricter investor grading system to the crypto world. The primary market mainly regulates illegal securities offerings and fundraising from non-qualified investors. The secondary market, on the other hand, regulates high-risk trading products, such as the UK and the US, which require exchanges to provide spot business only for ordinary investors, while high-risk products such as futures and leverage are prohibited from opening.

A well-established tiered system for qualified investors also means that more large capital can enter the market from compliant channels. We have seen Multicoin complete hundreds of millions of dollars in fundraising and grayscale positions of up to 650,000 bitcoins.

The peculiarities of the crypto world of unrestricted trading hours, asset offerings that are difficult to be restricted, and participating entities that are difficult to be limited all pose a higher test for regulators, and even fewer tools that regulators can use against the crypto world. Therefore a stricter investor grading system must be inevitable, but exactly how such regulation should be put in place, we do not yet know.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/explaining-the-qualified-investor-system-%e4%b8%a8why-there-is-a-need-for-investor-classification/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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