Thoughts on the Tokenization of the Fixed Income Market in Hong Kong, China

Hong Kong, China is Asia’s leading bond trading hub. ADB’s issuance in Hong Kong ranks third in the Asian market and region (excluding Japan), after China and South Korea. Tokenization will have the opportunity to revolutionize the fixed income market in Hong Kong, making it more efficient, reliable and transparent.

In this article, we will discuss the following four points: the concept of tokenization of fixed income products, the regulatory situation of virtual assets in Hong Kong, how tokenization will affect the industry and the important role that digital asset custodians play in it.

Tokenized Fixed Income Products

Tokenization of fixed income products has clear advantages for both issuers and investors . At the same time, it also has certain disadvantages. Two key advantages of tokenization for issuers are efficiency and reliability . Issuers can program tokens to perform many functions, such as investor announcements, investor registration management, and coupon and principal payments. This saves costs, increases efficiency, and reduces the potential for human error, fraud and omissions.

Tokenization is particularly suitable for fixed income products because they can set dates for the payment of coupons and principal repayments. These dates and amounts can be programmed into smart contracts in advance and executed automatically when certain conditions are met. Tokenization is also beneficial for investors , especially in terms of due diligence , automation advantages and increased liquidity .

Tokenization can simplify investor due diligence. In conducting due diligence, investors may access certain materials that are untrue, incomplete or inaccurate due to factors such as fraud, omission or human error. The average investor will seek to disclose a counterparty’s representations and warranties and sue that party for false representations or breaches of warranties. However, immutably storing this type of information on the blockchain removes some uncertainty.

In addition to the aforementioned benefits for issuers, automation allows issuers to design the associated token economy . For example, tokenized fixed-income products can continuously pay investors real-time coupons. This aspect of management has been too burdensome for the issuer in the past, but using smart contracts would be much better.

Finally, unlike traditional exchanges, virtual asset exchanges never close their doors, thus facilitating more liquidity. Investors can respond to changes in the underlying asset in real time. Gas fees for token transfers can also be significantly lower than brokerage fees on traditional exchanges.

At the same time, tokenization also has some disadvantages. The above gas fees must be paid in cryptocurrencies such as Ethereum. One current criticism of cryptocurrencies is that “mining” and approving transactions requires a lot of electricity. In the “Proof of Work” model, computers as “miners” compete for computing power to obtain rewards in the corresponding cryptocurrency.

However, some blockchain protocols, including Ethereum, are changing their model to “Proof of Stake”. In this model, validators (equivalent to miners) approve transactions based on the amount of cryptocurrency they hold.

The virtual asset industry is still in its infancy and is changing rapidly. Regulators around the world are still figuring out how to best regulate it in their respective jurisdictions. During this period, the industry will have to deal with regulatory uncertainty.

The changing regulatory environment in Hong Kong

The Hong Kong Securities and Futures Commission (SFC) and the Hong Kong Monetary Authority (HKMA) issued a joint circular and appendix in January 2022, which will come into effect in mid-2022. It specifies new requirements regarding:

(i) distribution of virtual asset related products,

(ii) provide virtual asset trading services, and

(iii) Provide virtual asset advisory services.

The joint circular expands the remit of the SFC and the HKMA. Currently, many virtual assets may not meet the definition of “securities” in the SFO and are therefore outside the SFC’s purview. However, the joint circular stated that the SFC still expects them to comply with regulations governing securities trading.

The joint circular effectively restricts users of virtual asset-related products and services to professional investors , and stipulates that relevant consulting services can only be provided to professional investors. And virtual asset-related products that are considered “complex products” can only be provided to professional investors. The joint circular stated that the SFC may consider most products related to virtual assets to be “complex products,” which means that the SFC believes that retail investors do not have the ability to understand the investment risks of such products.

Intermediaries (broadly speaking, any person licensed or registered with the SFC) can only cooperate with virtual asset trading platforms licensed by the SFC to provide virtual asset trading services. Intermediaries need to “introduce customers to the compliance platform for direct transactions” or “allow users to open a comprehensive account on the compliance platform”.

Potential Impact of Regulatory Changes

Hong Kong regulators will have broader influence in the virtual asset space in the region. As their influence continues to expand, we believe the SFC and the HKMA must strike a balance between protecting investors and promoting the development of the industry .

For example, we learned that regulators restricted virtual assets to professional investors to protect retail investors. The move could affect the offering and trading of virtual assets in Hong Kong. In fact, restrictive thresholds for professional investors can affect the investor base of such products, potentially hindering the tokenization of fixed income products.

A comprehensive regulatory framework can boost investor confidence in the virtual asset industry. As the demand for virtual asset products increases, we hope that the SFC will license more intermediaries to facilitate the distribution, consulting and trading of such products.

The role of enterprise-level digital asset custodians

As tokens become more complex and useful and form more portfolios, they must be securely stored and hosted. This is especially important for investors in fixed income tokens that intend to hold for the long term. Custodians that meet compliance and security standards , integrate with leading emerging blockchain protocols , and support different token standards will play an important role in the growth of the industry.

Investors expect virtual assets to achieve similar levels of security and compliance as other traditional assets — including having policies and procedures on anti-money laundering and combating the financing of terrorism. Additionally, certain institutional investors may require that the underlying assets be held by a designated type of custodian. Investors should also consider their investment model and make sure to hire a compliant custodian. Over the past few years, the industry has seen the rise of institutional-grade colocation providers and infrastructure providers. They serve either investors in fixed income products by offering insurance and cold wallets ; or high-frequency traders looking for sophisticated hot wallets and automated settlement circuits . In conclusion, tokenization can benefit both issuers and investors of fixed income products. However, with Hong Kong’s increasingly stringent regulation of the virtual asset sector, the industry still faces the challenge of balancing investor protection and industry growth. However, the key to providing investor protection is the high security standards of third-party escrow for a wide range of on-chain services.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/thoughts-on-the-tokenization-of-the-fixed-income-market-in-hong-kong-china/
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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