Hong Kong Node

Introduction

It already has been about ten years since Satoshi Nakamoto, a still-pseudonymous person(s) or entity, published the concept and operation of Bitcoin in a white paper named “Bitcoin: A Peer-to-Peer Electronic Cash System,”1 Its original use case was (and still is) to facilitate payments among peers in the network through decentralized virtual currency recorded in a public ledger, which could effectively circumvent the need of intermediaries like banks and monetary authorities to regulate currency systems as well as payment infrastructures.

Yet what astonishes the world is not just Bitcoin itself, but also its backbone blockchain technology that has the potential to be widely applicable in many existing industries and business processes. Its decentralized public ledger enables more efficient and less costly data/information management, which in turn allows multiple parties to transact or to collaborate without necessarily placing trust in counterparties or intermediaries. Incorporation of smart contracts offers an even greater flexibility for developers and users to tailor-make programs on blockchains to suit particular business needs.

To facilitate discussion on how policymakers and legislators should address blockchain technology, on March 16, 2018 at the Graduate Law Centre of the Chinese University of Hong Kong, Hong Kong Legal Hackers hosted a panel discussion on for the Hong Kong node of the 2018 Computational Law & Blockchain Festival, moderated by Brian Tang, Founder of Asia Capital Markets Institute. Themed the “Blockchain Policy and Innovation Panel” (the “Panel Discussion”), it featured professionals in the blockchain field who offered the audience insights on prominent blockchain use cases in Hong Kong, and also on how the Hong Kong government should regulate the technology.

This report aims to capture the quintessence of the Panel Discussion, supplemented by relevant research to offer a more robust framework for exploring ways of addressing core policy areas related to blockchain technology and cryptocurrencies.

1. Economic Implications of Blockchain for Hong Kong

(a)   The “Next Base” Architecture Unlocking Economic Potential

Hugh Madden, Chief Technology Officer of ANX International, suggested that blockchain technology could be seen as a “next base” communications and network infrastructure that is able to transform how digital nodes connect with one another.

In fact, Iansiti and Lakhani2 have drawn similar parallels between TCP/IP and blockchain. The former model, introduced in 1972, enables transmission of information by disassembling information into packets at the sending nodes, taking any route over the shared public network once released on it, and reassembling back the packets at the receiving nodes without the need of dedicated private lines between the two ends. From relatively private use within companies to its unprecedentedly broad public application adoption on the World Wide Web in the mid-1990s, it has unlocked new economic potential by drastically reducing the cost of connections. Thus low-cost and broad Internet connectivity could be achieved through adoption of the protocol. It in turn bred innovative internet-driven applications built over the network, bringing about a global economic paradigm shift.

While blockchain technology itself is not a communications protocol, it provides a base layer of architecture that transforms the way data is managed and exchanged. Any digital record or pieces of information can be stored in a new block, which can then be securely chained to the previous one and form a chain of blocks. Different consensus mechanisms (e.g. proof-of-work, proof-of-stake, etc.) are adopted to validate and verify that the contents in the block are legitimate and untampered. The whole chain of information blocks is copied, stored and maintained in each node connecting to the network, and thus a “distributed ledger”’ is created. It systematically lowers the cost of transaction by removing the need for any centralized parties or trusted intermediaries, and fosters transaction and/or collaboration among different parties without necessarily sacrificing information security or data confidentiality.

Madden also referenced two particular categories of blockchain networks: private and public. As regards the former, numerous companies and organizations have already taken initiatives in building private blockchain networks that allow only vetted participants to be involved in ledger operation and maintenance. This consortium form of relatively controlled sharing of records and data can be usefully leveraged in supporting industry or partnership-level information management and sharing systems, helping accelerate and make more cost-efficient business processes.

On the other hand, a public blockchain is open to anyone’s contributions of data to the ledger,enabling access to the whole chain of record. Some believe that, rather than representing just another decentralizing technology, the public blockchain heralds a new system of economics with all economic actors collaborating around it through an open, flat and disintermediating protocol. Such a vision is not illusionary—it can be inferred from the ways in which Bitcoin and other cryptocurrencies already are disrupting orthodox monetary economics, and Ethereum smart contracts are further advancing auto-execution of transactions without human intervention.

(b)   Existential Risk Posed to Hong Kong

Hong Kong has long been relying on “middleman” economics to survive since British colonial rule. From the 1950s to 1960s, the economy gradually evolved from an entrepot trading centre into an export-oriented light manufacturing industrial city, before the Hong Kong financial intermediary businesses began thriving since the 1970s. Since the turning point of Hong Kong’s history in 1997, it has been actively promoting itself as a window for China’s policy of opening up tothe West. At each stage of its economic transformation, Hong Kong always has played the role of middleman or trusted intermediary to facilitate transactions by connecting counterparties and bridging the differentiated business needs of various economic actors.

Pindar Wong, Chairman of VeriFi and Founder of Belt and Road Blockchain Consortium, noted that the prominence of blockchain technology might pose an existential risk to Hong Kong as a “city of intermediaries.” Blockchain’s fundamental nature of decentralization and disintermediation may disrupt the businesses of many. One obvious example is seen in fundraising through ICOs, that pre-empt the necessity of going through complex and heavily-regulated IPO processes in Hong Kong financial markets.

Nonetheless, some still see the technology as an opportunity to improve existing business models, not only with respect to cost-efficiency but also for collaboration in bringing about industry-wide and region-wide partnerships in the future.

2. Regulatory Responses to Blockchain in Hong Kong

(a)   Hong Kong Regulators’ Responses to Blockchain

All speakers agreed that regulators in Hong Kong should maintain a balanced and ex-ante approach towards the regulation of blockchain technology.

The Fintech Facilitation Office (“FFO”) of the Hong Kong Monetary Authority (“HKMA”), the central bank of Hong Kong, issued two white papers in November 20163 and October 2017,4 respectively, on distributed ledger technology. Henry Chang, Senior Manager at FFO of HKMA, explained the key objectives of the white papers in carrying out in-depth examination of the use of the distributed ledger technology and exploring its potential applications to banking services.

It is clearly stated in the white papers that the HKMA is adopting a “risk-based” approach in regulating blockchain. Hugh echoed the concern of the white papers that money laundering would be one compliance issue arising out of blockchain implementation, as it involves the mobilization of assets (especially those crossing borders) through its public network that can be so easily achieved without passing the traditional banking system. The existing regulatory tools (e.g. KYC checks, intermediary licensing, etc.) are no longer useful for regulators in overseeing the public blockchain networks (e.g., Bitcoin), in light of the anonymity of users as well as the decentralization of operations.

Nevertheless, it was asserted that innovations will not be stifled simply because of the new challenges that they bring to our current system. We should rather engage in a learning journey on their correct implementation and regulation so as to unlock their full economic potential. While the HKMA has iterated that a “technology-neutral” approach will be taken, it plays a pioneer role in developing blockchain technology through initiating several proof-of-concept projects in collaboration with industry players to experiment with blockchain applications.

(b)   Use Case 1: Trade Finance

The HKMA is currently working on an industry-wide proof-of-concept blockchain-based platform for trade finance with Deloitte and a consortium of five banks including HSBC and Bank of China. It aims to provide a platform for banks, importers and exporters involved in global supply chains to digitalize the labour-intensive documentation process, so as to improve operational efficiency and increase transparency of the transactions. Smart contracts also will be employed so that banks can provide instantaneous trade finance to customers when specified terms in the smart contracts are triggered.

Chang expected that in 2019, the HKMA will team up with the Monetary Authority of Singapore (“MAS”) to build a highway linking the respective trade finance platforms, and to leverage blockchain technology in realizing cross-regional collaborative synergies.

(c)    Use Case 2: Digital Identity Management

Another major blockchain initiative of the HKMA regards digital identity management. The current KYC requirements in the banking industry are often complex due to heavy regulatory compliance needs in Hong Kong, which can inconvenience both banking officers and clients. To this end, the HKMA is working with banks to build a database of clients’ information on a blockchain, enabling access by multiple banks and financial institutions and continuously maintained by vested parties relying on the same source of digitalized customer information.

Meanwhile, the Belt and Road Blockchain Consortium led by Wong is also working on a cross-regional project to facilitate transnational digitalization of trading and financial services along the One Belt One Road (“OBOR”) program, the latest development strategy by the Chinese government to enhance connectivity and cooperation among Eurasian countries. One key component of the blockchain initiative is to build electronic identity certification for companies involved in OBOR program so that the counterparties transacting with them can reduce the cost of resolving cross-border electronic identity disputes, and to rely on blockchain governance and alternative dispute resolution mechanisms to lower the identity risks involved.

It is foreseeable that through the above proof-of-concept initiatives, Hong Kong regulators will encourage an open dialogue with industry that may yield novel regulatory approaches.