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1、Decentralised FinanceCurrent Landscape and Regulatory DevelopmentsJune 2024Hong Kong Institute for Monetary and Financial ResearchHKIMR Applied Research Report No.1/2024PagesForeword2Acknowledgements3Executive Summary4Chapter 1DeFi and its ApplicationsIn a rapidly evolving landscape,DeFi is developi

2、ng its potential as an alternative financial system that actualises the ethos of blockchain technology.7Chapter 2Risks and VulnerabilitiesDeFi activities highlight a combination of existing and new vulnerabilities that are attracting the attention of financial authorities.17Chapter 3Regulatory Chall

3、enges and International Approaches to RegulationAuthorities in various jurisdictions are adopting diverse approaches to guide the development of DeFi in the spirit of recommendations made by international organisations.26Chapter 4Views of Market Participants in Hong KongOur survey revealed Hong Kong

4、s growing interest and adoption of virtual assets,despite challenges.43Chapter 5Views and Considerations for Fostering a Healthy DeFi EcosystemEffective regulation and deep-dive research can facilitate the development of a healthy and vibrant DeFi ecosystem.56Conclusion66Appendix A:Background of the

5、 Virtual Assets/DeFi Survey67Appendix B:List of Abbreviations68Appendix C:Glossary of Technical Terms69Appendix D:References71ContentsOver the past two decades,the pace of technological advancement has been accelerating at an unprecedented rate,particularly since the emergence of the third generatio

6、n of the Internet(Web3)encompassing individual control of personal data and the use of crypto-assets and blockchain.The attractiveness of Web3 is that it is decentralised,meaning that an intermediary is not necessary for virtual transactions between parties.This represents vast potential to transfor

7、m existing business models,especially in the financial services industry.Playing a prominent role within Web3,Decentralised Finance(or DeFi henceforth)is the delivery of financial services without traditional financial intermediaries,offering a potentially faster and more cost-effective,accessible,a

8、nd secure alternative to conventional financial systems.As the regulatory environment surrounding DeFi is still evolving,a robust regulatory framework is essential,not only managing the potential risks effectively but also promoting the sustainability of financial innovations.Against this backdrop,t

9、his report provides the investigation of the DeFis existing landscape,covering opportunities,risks and a comprehensive discussion of the international regulatory experience,aiming to draw attention to regulatory developments and highlight potential areas for collaborations between market participant

10、s and regulators that may be important to Hong Kongs developments.To enrich readers understanding of the virtual asset ecosystem in Hong Kong,this report also presents the findings of a survey commissioned by the Hong Kong Institute for Monetary and Financial Research summarising the views of local

11、financial services practitioners on the current market landscape and potential challenges of virtual asset markets.The survey participants included traditional financial institutions(such as banks,asset managers,and insurers)as major institutional customers and virtual asset service providers as maj

12、or institutional providers.The report concludes by proposing some considerations for the healthy development of the DeFi market in Hong Kong.As Hong Kong is progressively fostering a vibrant virtual assets industry,we hope that this report provides market participants and regulators,locally and inte

13、rnationally,with an informed perspective on regulatory developments that support DeFi innovation while managing the emerging risks with consumer protection measures in place to promote the growth of the virtual asset ecosystem.Mr Enoch FungChief Executive OfficerHong Kong Academy of FinanceExecutive

14、 DirectorHong Kong Institute for Monetary and Financial Rsearch2Decentralised FinanceForewordThis report has greatly benefitted from the contributions of various external collaborators.We thank the Financial Services and the Treasury Bureau,the Insurance Authority,the Mandatory Provident Fund Scheme

15、s Authority,the Securities and Futures Commission,and various divisions of the Hong Kong Monetary Authority,including the Communications Division,the Digital Finance Division,the External Division,the Fintech Facilitation Office,the Banking Supervision(Supervisory Technology)Division,and the Market

16、Development Division for their comments and suggestions.We wish to extend our gratitude to Dr Philip Turner of the University of Basel for his inputs to Chapters 2,3.1,and 5.2.We are also grateful for the collaboration of PricewaterhouseCoopers Limited in designing and administering the survey entit

17、led Current Landscape and Developments of Virtual Assets/DeFi in Hong Kongs Financial Services Industry from May to July 2023,and in conducting interviews with various market participants,including banks,insurers,asset managers,and virtual asset service providers.Finally,we thank the HKIMR Council o

18、f Advisers for Applied Research for their continued support for and guidance of the research activities of the Institute.3Hong Kong Institute for Monetary and Financial Research June 2024AcknowledgementsExecutive SummaryDeFi,short for Decentralised Finance,is a revolutionary concept that aims to cha

19、nge the traditional financial system by leveraging blockchain technology and smart contracts.It aims to provide various financial activities,such as lending,borrowing,and trading,without relying on centralised institutions.However,DeFi remains in its nascent stage and faces several challenges.One of

20、 them is the regulatory landscape.As DeFi is inherently decentralised,it often falls outside the purview of existing financial regulations.This lack of regulatory oversight can create uncertainty and hinder broad adoption.This report provides a comprehensive overview of the opportunities and challen

21、ges created by DeFi activities and the regulatory approaches advocated by international organisations and individual jurisdictions for crypto-asset and DeFi markets.The discussion is complemented by the findings of a survey and a set of interviews commissioned by the Hong Kong Institute for Monetary

22、 and Financial Research to solicit the views of key market participants in Hong Kong,including financial institutions and virtual asset service providers(VASPs),on the current and future applications of virtual assets(VAs).Finally,the report offers some considerations for facilitating further develo

23、pments of DeFi in Hong Kong,with the aim of contributing to the discussions on improving the ecosystem and its implications for the financial services industry in Hong Kong.Since blockchain appeared as a decentralised payment alternative in 2008,it has grown to include a broad spectrum of crypto-ass

24、ets that have attracted widespread investor interest.Beginning as a small segment of the crypto-asset market,DeFi market capitalisation surged from US$6 billion to a high of approximately US$170 billion in 2021 within two years,before stabilising at approximately US$80 billion in 2023.These numbers

25、demonstrate that DeFis potential cannot be ignored.Owing to its unique characteristics ranging from atomic settlement,composability,and programmability to permissionless accessibility,DeFi has the potential to provide new financial services,such as liquid staking,flash loans,and automated market mak

26、ers,with reduced transaction speed and enhanced innovation,automation and financial inclusion.Moreover,DeFi replicates many traditional financial services,including exchanges,borrowing and lending,derivatives,insurance,and asset management.The decentralised nature of DeFi protocols also enable their

27、 operation by forms of community-driven governance without being controlled by centralised institutions,highlighting the potential of this innovative technology to transform the financial landscape.Nonetheless,the opportunities afforded by DeFi are not without risk.Significant losses due to failures

28、 in DeFi markets in 2022 highlighted some risks and vulnerabilities,leading to enhanced scrutiny by the international regulatory community to understand and mitigate the risks that DeFi poses to financial stability.With reference to published reports by international organisations and the emerging a

29、cademic and policy literature,the risks and vulnerabilities of DeFi markets can be summarised into several key areas.First,governance issues arise from the fact that DeFi protocols often claim to be decentralised but are effectively centralised,leading to misrepresentations and moral hazards.Second,

30、compliance and legality issues stem from the borderless nature of blockchain and the lack of cohesion among jurisdictions regarding legislation and its enforcement in DeFi markets.Third,economic 4Decentralised FinanceExecutive Summaryand technological vulnerabilities across multiple layers of the De

31、Fi stack can result in the exploitation or operational failure of DeFi protocols.Fourth,the DeFis interconnectedness with traditional finance(TradFi)and centralised crypto-asset finance(CeFi)can amplify financial contagion in the overall financial system.Fifth,the high leverage and collateralisation

32、 prevalent in the DeFi market make it volatile,especially during economic downturns.Sixth,investor and consumer protection measures for DeFi markets are still insufficient compared with those for TradFi markets.The risks and vulnerabilities inherent in DeFi markets may also pose several challenges f

33、or financial authorities.Specifically,in the DeFi context,it is particularly difficult for financial authorities to identify parties to hold accountable for DeFi protocols(i.e.,regulatory hooks)in the absence of obvious centralised actors.The smart contracts used to facilitate DeFi transactions may

34、not be legally enforceable,which limits the legal protections for investors.A lack of standardised taxonomy and cohesive regulations,together with DeFis cross-border nature,has made global coordination to regulate DeFi difficult.Furthermore,the increasing connectivity between DeFi and TradFi could l

35、ead to heightened financial instability.In the face of the emergence on new corporate structures providing financial services,many financial authorities over the globe advocate for same activity,same risk,same regulation as the guiding principle.Along this guiding principle,international organisatio

36、ns have also provided high-level recommendations for these authorities to mitigate major risks and regulatory challenges.They put emphases on enhancing international collaboration and monitoring interconnections across markets,minimising regulatory arbitrage opportunities,and supervising entities th

37、at providing crypto-asset services.In case different regulations are needed to address different levels of risks,some leading jurisdictions in DeFi have undertaken regulatory actions by clarifying existing regulations through statements or circulars,by extending regulatory frameworks,or a combinatio

38、n of both approaches.Turning to developments in Hong Kong,the Government has welcomed the growth of the VA industry and have been working with the financial regulators to support its sustainable and responsible development,as noted in their Policy Statement published in 2022.Against this background,

39、our survey of local VA market participants revealed their growing involvement with VAs in their business operations and expressed keen interest in expanding their involvement with VAs and related businesses in the near future.Most VASPs were among the first movers to involve VA in their business ope

40、rations,while most TradFi entities are planning to incorporate VA in the near future,expecting it to create new revenue streams,reduce costs,enhance customer experiences and provide diversification benefits in the longer run.Several major VA types,such as cryptocurrencies,non-fungible tokens,tokenis

41、ed traditional assets,and stablecoins,are expected to remain prevalent in the next few years.Therefore,various products and services are expected to become increasingly popular,such as tokenisation,payment and custodian solutions,conversion and exchange services,and other technology-related solution

42、s.In relation to DeFi activities undertaken by market participants,reported 5Hong Kong Institute for Monetary and Financial Research June 2024use cases ranged widely,including mining/staking-related businesses,yield aggregators,liquidity pooling activities,and decentralised exchanges/trading.In term

43、s of the challenges related to their engagement in VA,the survey respondents identified several regulatory challenges,such as overall uncertainty surrounding permissible activities,difficulty in complying with anti-money laundering and counter-financing of terrorism(AML/CFT)requirements,and concerns

44、 about cybersecurity and data risks.They also identified some non-regulatory challenges,such as limited functionality and scalability,technology complexity,lack of user adoption,and volatility in the VA market.Overall,market participants in Hong Kong agree that a well-defined regulatory framework,a

45、robust financial infrastructure and network,and a supply of talent with blockchain-related skills are crucial to foster further development of the local DeFi and VA markets.On the regulatory side,policymakers and financial authorities in Hong Kong have been supportive of the sustainable and responsi

46、ble development of VA markets by engaging in pilot projects to explore the potential benefits of distributed ledger technology and crypto-assets.Through a review of the insights provided by market participants and those drawn from international experiences with DeFi,this report provides some conside

47、rations to further develop DeFi markets in Hong Kong.First,the regulation of DeFi should continue to be inspired by the guiding principle of same activity,same risk,same regulation,with deep-dive research being of paramount importance to enhance the understanding of the risks associated with DeFi de

48、velopments.Second,it would be worthwhile to assess the possibility of co-developing centralised and decentralised financial infrastructure as a hybrid model to enjoy the benefits of both worlds while bringing these activities within regulatory remits.Third,promoting blockchain-related talent develop

49、ment is also essential for addressing the knowledge gaps that hinder the adoption of VA and DeFi.Finally,strengthening public-private sector dialogue and collaboration can allow financial authorities to resolve regulatory uncertainty and better understand market needs,contributing to a healthy and v

50、ibrant DeFi ecosystem in Hong Kong.6Decentralised FinanceExecutive SummaryChapter 1DeFi and its ApplicationsIn a rapidly evolving landscape,decentralised finance(DeFi)is developing its potential as an alternative financial system that actualises the ethos of blockchain technology.HIGHLIGHTS:DeFi off

51、ers a variety of financial products,services,activities,and arrangements supported by permissionless smart contract platforms.DeFi enables the replication of existing financial services and the creation of new financial services with numerous potential benefits.After a strong market correction in 20

52、22,interest in DeFi is gradually recovering.1.1.DEFI:DEFINITION AND RELEVANCEDeFi is commonly known as an ecosystem of decentralised applications with finance functionalities built on blockchain technology that enables peer-to-peer interactions without intermediaries.1 DeFi operates on smart contrac

53、ts,which are self-executing contracts in which the terms of the agreement between the buyer and seller are directly written in lines of code,to facilitate transactions and ensure that all parties involved in a transaction are held to their contractual obligations(Figure 1.1).Although these operation

54、s are largely independent of the traditional finance(TradFi)system,DeFi and TradFi are indirectly connected through the centralised crypto-asset finance(CeFi),which commonly serves as an entry point for users outside the DeFi ecosystem(Figure 1.2).These decentralised applications,commonly known as D

55、eFi protocols,operate on decentralised networks,allowing users to access financial services directly and securely,in an open,transparent,and efficient manner.Figure 1.1:Difference between TradFi and DeFi BuyerSellerBuyerSellerManaged by financialintermediariesManaged by smartcontract protocolsTradit

56、ional financesystemDecentralised financesystemSource:HKIMR staff compilation1IOSCO(2023c)highlighted that DeFi is a term used in industry and broader discussions and has no generally accepted definition.8Decentralised FinanceChapter 1:DeFi and its ApplicationsChapter 1As the ethos of DeFi,decentrali

57、sation can have three main dimensions(Figure 1.3).The primary contribution of blockchain technology is decentralised record-keeping in which each node of the network keeps its own full or partially full copy of a ledger,thereby eliminating inaccurate or fraudulent record keeping at a single point.Th

58、e notion of decentralisation in the DeFi context extends to decentralised governance and operation of financial services(i.e.,decision-making)and financial risks(i.e.,risk-taking).TradFi,in contrast,is centralised along all three dimensions as it relies wholly on centralised financial institutions a

59、nd conventional financial market infrastructure for decision-making,record-keeping,and risk-taking.CeFi represents a middle ground of partial decentralisation as it leverages blockchain technology to achieve decentralised record-keeping,but retains centralisation in decision-making and risk-taking.F

60、igure 1.2:Conceptual representation of the relationship between TradFi,CeFi and DeFiDecentralised Finance(DeFi)Centralised Crypto-asset Finance(CeFi)Blockchain Infrastructure ServicesCrypto-asset SystemFinancialinterconnectionsInformational/operational interconnectionsTraditional Finance(TradFi)Sour

61、ce:HKIMR staff compilation and FSB(2023a)To achieve decentralisation,DeFi protocols can also be distinguished by several defining characteristics.These characteristics include:(i)community driven management;(ii)non-custodial design;(iii)public blockchain with smart contract functionality(i.e.permiss

62、ionless smart contract platform);and(iv)composability(Figure 1.4).It is also important to note that while full decentralisation is an ideal,it remains more of an aspiration than a concrete reality,as DeFi protocols typically do not embody all these characteristics.The extent to which they fulfil the

63、se characteristics can vary throughout its lifecycle,reflecting the complex and dynamic nature of the DeFi landscape and the necessity of efforts to understand these protocols and their potential impact to the financial system.9Hong Kong Institute for Monetary and Financial Research June 2024Chapter

64、 1:DeFi and its ApplicationsChapter 1Figure 1.4:Characteristics of DeFiCommunity-drivenmanagementNon-custodialdesignDeFi protocols are managed via a decentralised business structure(i.e.DAOs)DeFi protocols do not have access to or control of users crypto-assetsDeFi protocols can be combined in a man

65、ner akin to Lego blocks,allowing for the creation of customised productsPermissionless blockchain ensures trust minimisation;smart contracts enable programmable transactionsComposabilityPermissionless smart contract platformSource:HKIMR staff compilationFigure 1.3:Three dimensions of decentralisatio

66、nRecord-KeepingDecision-Making Risk-TakingRecord keeping of transactions is transferred from a single,central database to a broad range of stakeholdersFinancial risks,such as credit and liquidity risks,are transferred from the balance sheets of individual firms towards a more direct matching of indi

67、vidual users and financial service providersManagement authority is transferred from a single,centralised institution to a broader group of stakeholders,which can include users of financial servicesThree Dimensions of DecentralisationSource:HKIMR staff compilation and FSB(2019)10Decentralised Financ

68、eChapter 1:DeFi and its ApplicationsChapter 11.2.POTENTIAL BENEFITS AND MAIN APPLICATIONSGiven its innovative features,DeFi activity has a large room to grow and become mainstream due to the increasing adoption of crypto-assets and the expansion of real-world applications for DeFi(FSB,2023a).Several

69、 benefits of DeFi support this reasoning(Figure 1.5).First,securities and other real-world assets can be issued or represented in digital token form on blockchain networks,and the settlement of these tokenised securities can be expedited to shorten the standard settlement cycle of T+1 or T+2 days to

70、 instant and simultaneous settlement(i.e.,atomic settlement),enhancing operational efficiency and reducing counterparty risk.Second,the decentralised governance of DeFi protocols through decentralised autonomous organisations(DAOs)allows governance token owners to directly participate in management

71、decisions through community voting,thereby democratising decision-making and control of financial services.Third,blockchain programmability enables automated crypto-asset transactions(i.e.self-executable transactions based on programmed terms and conditions)through the use of smart contracts Figure

72、1.5:Potential benefits of DeFiDecentralised decision making and controlOpen innovationEnabling complex business logicMonitorable financial activityReduced transaction timeGreater financial inclusionSource:HKIMR staff compilation11Hong Kong Institute for Monetary and Financial Research June 2024Chapt

73、er 1:DeFi and its ApplicationsChapter 1and facilitates the introduction of complex business logic.Fourth,the interoperability of smart contracts allows DeFi protocols to be combined(posability),providing flexibility that allows anyone to rapidly develop innovative products and solutions to cater to

74、market needs.Along with the tokenisation of securities and other real-world assets,composability in DeFi can unlock liquidity in traditionally illiquid assets such as artwork and real estate.Fifth,the permissionless accessibility of the DeFi market can promote greater financial inclusion as any cons

75、umer can access DeFi protocols without restriction.Finally,smart contracts are fully transparent and visible to all parties,allowing all stakeholders to understand the risks and mechanism of a DeFi protocol before and after they engage with it.DeFi not only replicates many TradFi activities but also

76、 has the potential to offer more.Currently,popular categories are decentralised exchanges(DEX),borrowing and lending,derivatives,insurance,and asset management(Table 1.1).Moreover,the technological underpinnings of DeFi protocols offer novel features or products that have yet to exist in TradFi.For

77、example,many DeFi protocols across all categories are no longer controlled by TradFi counterparts but are operated by DAOs with a form of community-driven governance;and several innovations,including automated market markers(AMMs),flash loans and liquidity staking,are uniquely introduced in the DeFi

78、 ecosystem(Box 1.1).These novel features and products demonstrate the potential of this innovative technology.Table 1.1:DeFi categories and potential benefitsCategoryDeFi Product DescriptionPotential BenefitsExchanges Allow trade of one crypto-asset for another between two users with no central coun

79、terparty AMMs2 are a type of DEX that provide income to liquidity providersBorrowing and Lending Allow crypto-asset holders to earn interest by depositing their crypto-assets into a smart contract that simultaneously allows others to borrow these assets Most DeFi protocols do not require any form of

80、 credit assessment due to the pseudonymity of blockchain participants Some DeFi protocols offer flash loans,which have no TradFi equivalentDerivatives Allow users to create crypto-asset derivatives,which are crypto-assets whose market values reference an underlying asset.The permissionless nature of

81、 DeFi markets increases the accessibility of users to create,buy,or sell derivativesInsurance Allow users to hedge against the risk of an event in relation to their crypto-assets(e.g.,crypto-assets being stolen)Deposit crypto-assets into a pool to sell event contracts to buyers who pay a small premi

82、um and receive a larger payout if the covered event occurs DeFi insurance protocols play an important role in the ecosystem as TradFi entities rarely provide insurance for the crypto-asset market Any DeFi user can become an underwriter and potentially earn returns from insurance premiums2Definitions

83、 of technical terms used throughout this report can be found in Appendix C.12Decentralised FinanceChapter 1:DeFi and its ApplicationsChapter 1CategoryDeFi Product DescriptionPotential BenefitsAsset Management Provide asset management or advisory services for crypto-assets by analysing DeFi protocols

84、 for favourable investment opportunities Reallocate crypto-assets automatically between DeFi protocols to optimise returns The openness and transparency of blockchain transactions can reduce the opacity of asset managementDeposit Deposit their crypto-assets into a liquid staking protocol,and receive

85、 a staked token representing their pro-rata interest Earn validation rewards in proportion to their contributions Liquid staking enables DeFi users to earn yield from their crypto-assetsBox 1.1:Innovations in DeFiAutomated Market Makers(AMMs)AMMs are a new type of DeFi exchange protocol.Unlike tradi

86、tional financial markets,which rely on buyers and sellers,AMMs aim to maintain liquidity in the protocol through liquidity pools of two or more crypto-assets.These crypto-assets are supplied by market makers(known as liquidity providers)which deposit crypto-assets into the liquidity pools.Paying tra

87、nsaction fees to the pools,market takers(known as liquidity takers)can then exchange crypto-assets for another.The exchange rates between these crypto-assets are algorithmically determined according to the ratio of the crypto-assets in the pools.The exchange rate fluctuation is influenced by the siz

88、e of the trades and the depth of the liquidity pools(akin to market liquidity in TradFi exchanges).AMM protocols employ various economic incentive mechanisms to maintain a higher level of liquidity in their liquidity pools.Liquidity providers primarily earn transaction fees as passive income and may

89、 also receive from AMM protocols a new crypto-asset known as a liquidity provider token(LP token),which can be sold,transferred,traded,or used as collateral in any other DeFi protocols.Furthermore,leveraging these AMM protocols,DeFi aggregators can query a range of AMMs to find the best yields and p

90、rices for liquidity providers or takers.These features of AMMs and LP tokens opens up numerous possibilities for DeFi users to engage in new financial activities.13Hong Kong Institute for Monetary and Financial Research June 2024Chapter 1:DeFi and its ApplicationsChapter 1Flash LoansFlash loans are

91、instant loans that do not require collateral from the borrower,provided that the loan amount is repaid in the same transaction.In other words,the borrower receives the funds,uses them,and repays them plus interest in the time it takes for a new block to be added to the blockchain.If the borrower is

92、unable to repay the funds with interest at the end of the transaction execution cycle,the transaction is invalidated and its results are reverted.Flash loans have zero counterparty or duration risks for the lender as the transaction becomes invalid if the borrower defaults.Meanwhile,the borrower can

93、 take advantage of arbitrage opportunities without having the principal needed to execute the arbitrage by(i)receiving the funds through the lending protocol;(ii)purchasing tokens from an exchange protocol;(iii)selling the tokens on another exchange protocol;and(iv)repaying the loan on the lending p

94、rotocol,all within the same transaction.Flash loans facilitate rapid access to liquidity in DeFi markets,increasing the accessibility of investment opportunities that typically require having large amounts of capital on hand.Liquid StakingParticipants in staking can earn a reward by contributing to

95、the validation of a ledger on a distributed network,such as a blockchain.Specifically,a distributed network requires that all nodes in the network agree on the order and validity of transactions.The validation is completed by network participants who are selected by a bidding process,in which intere

96、sted participants commit an amount of crypto-assets(i.e.the stake)to bid for their participation in validation.The network state is said to be agreed upon by consensus of the network when validators are able to create a matching alphanumeric string together.This consensus mechanism incentivises hone

97、st behaviour as successful validators(i.e.those whose proposed blocks are attested to by a majority of other validators)earn a reward,whereas validators who have been found to have acted maliciously would have their stake confiscated or deducted.One problem with staking however,is that the committed

98、 crypto-assets become illiquid,as they cannot be accessed or withdrawn once they are staked.Liquid staking protocols have emerged as a solution to address this problem as it issues a new token(called a staked token)that represents a claim on the underlying staked asset.This staked token reintroduces

99、 liquidity into the staking process as the staked token can once again be sold,transferred,traded,or used as collateral.This enables DeFi users to enjoy the benefits of conventional staking activity while retaining liquidity of their crypto-assets.14Decentralised FinanceChapter 1:DeFi and its Applic

100、ationsChapter 11.3.GLOBAL TRENDSBetween 2020 and 2021,DeFi was the fastest growing sector in the crypto-asset ecosystem,drawing considerable attention from retail and institutional investors because of its high expected returns and the flexibility it offers for leveraged and speculative investments.

101、During those two years,which are known as the DeFi Summer,the market capitalisation of DeFi products and services swelled from US$6 billion in June 2020 to a record high of US$174 billion in November 2021,representing a 28-fold increase(or,in terms of total value locked(TVL),an 101-fold increase fro

102、m US$1.87 billion to a record high of US$191 billion)(Figure 1.6a).3 During the same period,the total number of crypto-asset wallets linked to DeFi protocols increased from approximately 200,000 to approximately 5 million.DeFi was the fastest growing sector in the crypto-asset ecosystem because of i

103、ts high expected returns and flexibility for leveraged and speculative investmentsAfter the DeFi Summer came the Crypto Winter,with a dramatic reduction in the size of the crypto-asset and DeFi markets in 2022.The positive market sentiment during the DeFi Summer mostly disappeared amid concerns abou

104、t market vulnerabilities uncovered by the collapse of major crypto-asset service providers,such as crypto venture capital firm Three Arrows Capital,CeFi trading platform FTX and the TerraUSD/Luna algorithmic stablecoin pair(among the top 10 stablecoins in circulation at the time),undermining many in

105、vestors belief in the promise and future viability of DeFi.Crypto-asset prices fell by as much as 75%from their peaks in late 2021(ESRB,2023),while DeFis market capitalisation shrank to US$34 billion(or US$40 billion in terms of TVL)by the end of 2022.Since then,interest in and market sentiment towa

106、rds the crypto-asset and DeFi markets gradually improved,as evidenced by a rebound in DeFi market capitalisation from October 2023 onwards.DeFi remains a small subsector of the crypto-asset ecosystem and has a high degree of market concentration.At the end of March 2024,the market capitalisation of

107、the DeFi market was US$112.3 billion(or US$92.2 billion in terms of TVL),representing only 4%of the total crypto-asset market value of US$2.82 trillion.Moreover,the DeFi ecosystem is highly concentrated as more than half of the DeFi market was built on the Ethereum blockchain(Figure 1.6b),which was

108、the first blockchain that enabled the deployment of smart contracts.As of the end of March 2024,approximately 57%of the TVL in DeFi protocols was on the Ethereum blockchain,followed by other blockchains such as Tron(11%)and Binance Smart Chain(6%).In addition to DeFi protocols,stablecoins are critic

109、al elements for the growth of DeFi.The Bank for International Settlements(BIS)highlighted that stablecoins play a crucial role in bridging the crypto-asset and TradFi markets,allowing DeFi market participants to avoid frequent conversion to and from fiat currency and facilitating fund transfers acro

110、ss platforms and between users(BIS,2021).Moreover,stablecoins are a stable and liquid form of crypto-asset,which helps to solve the issue of price volatility of crypto-assets,thereby enhancing the functionality of DeFi protocols.Concurrent with the growth of the DeFi market,stablecoins have experien

111、ced exponential growth since June 2020(Figure 1.6c),with a total market capitalisation of US$151 billion at the end of March 2024.3Market capitalisation refers to total market value of all tokens being minted,calculated by multiplying the circulating supply of each token by its market price,while TV

112、L is defined as the total market value of crypto-assets staked/locked on smart contracts or DeFi protocols.15Hong Kong Institute for Monetary and Financial Research June 2024Chapter 1:DeFi and its ApplicationsChapter 1Figure 1.6:DeFi market statistics01,0002,0003,0004,000USD bn050100150200USD bnDeFi

113、 market capDeFi TVLCrypto market cap(RHS)12/201803/201906/201909/201912/201903/202006/202009/202012/202003/202106/202109/202112/202103/202206/202209/202212/202203/202306/202309/202312/202303/2024All stablecoinsUSDTUSDCDAI0408012020016003/202105/202107/202109/202111/202101/202203/202205/202207/202209

114、/202211/202201/202303/202305/202307/202309/202311/202301/202403/2024USD bn08/202010/202012/202002/202104/202106/202108/202110/202112/202102/202204/202206/202208/202210/202212/202202/202304/202306/202308/202310/202312/202302/202404/20240%20%40%60%80%100%EthereumTronBSCSolanaArbitrumBaseBlastBitcoinOt

115、hers(a)Total market capitalisation of crypto-asset market and DeFi market,and DeFis TVL(b)Top blockchains used in DeFi protocols in terms of%in DeFi TVL(c)Total market capitalisation of stablecoin market and top 3 stablecoinsSources:HKIMR staff compilation,DefiLlama,Coingecko16Decentralised FinanceC

116、hapter 1:DeFi and its ApplicationsChapter 1Chapter 2Risks and VulnerabilitiesDeFi activities highlight a combination of existing and new vulnerabilities that are attracting the attention of financial authorities.HIGHLIGHTS:Aiming to replicate the roles of TradFi intermediaries and market infrastruct

117、ures,DeFi presents new risks and vulnerabilities that are attracting the attention of financial authorities.These risks and vulnerabilities can be varied and cover issues of governance,compliance and legality,economic and technological fragilities,interconnectedness,leverage,liquidity and maturity m

118、ismatches,and investor and consumer protection.Although DeFi offers many promises of financial disintermediation and presents substantial innovative potential,it also gives rise to a number of vulnerabilities some inherent to blockchain technology and others specific to DeFi.Based on major discussio

119、ns of DeFi risks,4 DeFi vulnerabilities can be separated into six broad categories(Figure 2.1).2.1.GOVERNANCEWhile many DeFi protocols purport to be decentralised,their governance structures often exhibit de facto centralisation.As highlighted by the International Organisation of Securities Commissi

120、ons(IOSCO),decentralisation can be viewed as a spectrum ranging from fully centralised to fully decentralised(Figure 2.2),but in fact,many DeFi protocols are centralised at an economic reality level.5 Holdings of governance tokens,which represent voting power in DAOs,can be disproportionately concen

121、trated in a small number of stakeholders,such as initial venture capital investors which receive governance tokens from protocol developers as compensation or third parties whose voting rights are delegated by governance token holders.Various international organisations have also emphasised that DeF

122、i protocols are highly centralised at the founding and development stages,as it is customary for software developers to retain administrative privileges to be able to fix flaws or bugs or make upgrades.6 In their empirical study of DAO governance systems,Feichtinger et al.(2023)found that 17 of the

123、21 DAOs sampled were controlled by fewer than 10 participants.These findings suggest that DeFi protocols are rarely,if ever,fully decentralised and can still be vulnerable to manipulation by a small number of stakeholders.Box 2.1 provides an overview of DAOs in DeFi.The de facto centralisation of go

124、vernance ownership structures,combined with the lack of disclosure requirements in the broader crypto-asset market,can introduce a number of misrepresentations and 4These reports are BoF(2023),FSB(2023a),FSI(2023),OECD(2022),and WEF(2021).5Numerous international organisations have also described thi

125、s phenomenon as decentralised in name only or the decentralisation illusion.6Major references include IOSCO(2022),WEF(2021),and OECD(2022).Figure 2.1:DeFi vulnerabilitiesDeFi VulnerabilitiesInvestor and Consumer ProtectionGovernanceCompliance and LegalityEconomic and Technological FragilitiesInterco

126、nnectednessLeverage,Liquidity and Maturity Mismatches Source:HKIMR staff compilation18Decentralised FinanceChapter 2:Risks and VulnerabilitiesChapter 2Box 2.1:Innovation in DeFi:DAOsDAOs are a novel organisational form that has emerged from the crypto-asset ecosystem in recent years.There is no univ

127、ersally accepted definition of DAOs,but DAOs are typically organisations created with one mission in mind:to achieve decentralised governance by coding their rules into smart contracts(Harvey et al.,2021;IOSCO,2022).Proponents of DeFi and DAOs argue that their decentralised nature can address the sh

128、ortcomings of centralised governance,providing a more equitable form of management.Rather than a management committee or a board of directors as is the case with a centrally governed entity,management decisions in a DAO are made by its users through community voting,and membership and voting rights

129、are granted by the issuance of governance tokens by the DAO(FSI,2023).In principle,any member of the DAO can submit a proposal to its user community and governance token holders are asked to vote for the approval or rejection of the proposal(OECD,2022).Figure 2.2:Decentralisation spectrumFullyDecent

130、ralisedFullyCentralisedFull deploymentPermissionless blockchainLow governance token concentrationDevelopment lifecycleTechnical constructionEconomic realityEarly stagePermissioned blockchainHigh governance token concentration Source:HKIMR staff compilationmoral hazards.For example,Feichtinger et al.

131、(2023)found that DAOs can be used as a marketing tool,or worse,as a way to justify and hide the decisions of the major governance token holders behind the facade of a community.The Organisation for Economic Co-operation and Development(OECD)identified that,in extreme cases,malicious actors can purch

132、ase enough DAO governance tokens to manipulate the outcome of a vote to the detriment of minority token holders(OECD,2022).The number of governance tokens held by founders,developers,or venture capital investors is rarely disclosed or understood by retail investors or financial authorities,and the e

133、conomic incentives for developers and founders of DeFi protocols are yet to be fully understood.This creates an opportunity for retail 19Hong Kong Institute for Monetary and Financial Research June 2024Chapter 2:Risks and VulnerabilitiesChapter 2Like the internet,the crypto-asset and DeFi markets ar

134、e borderless and have a global reach,and DeFi transactions are often cross-border in nature.Key stakeholders of a DeFi protocol can also span multiple jurisdictions,with developers and operators located in different countries.In addition to the systemic risks arising from the cross-border nature of

135、DeFi protocols,this presents challenges in determining the host jurisdiction and geographic location of operators,as well as the jurisdictions to which products or services are provided.This jurisdictional uncertainty can impede the ability of DeFi operators to comply with applicable regulations and

136、 hinder the ability for financial authorities to supervise DeFi(OECD,2022).A lack of cohesion across jurisdictions in terms of the enforcement on DeFi protocols increases the risks associated with AML/CFT.The USDOT(2023)revealed that the greatest risk of illicit financing linked to crypto-assets com

137、es from crypto-asset service providers operating in countries with deficient AML/CFT programmes.However,an assessment conducted by the Financial Action Task Force(FATF)in June 2022 showed that the majority of the 53 jurisdictions evaluated still needed progress in applying relevant AML/CFT standards

138、 to crypto-assets and crypto-asset service providers(FATF,2022).In its subsequent assessment,conducted in June 2023,the FATF determined that 75%of the assessed jurisdictions were only partially compliant or not at all compliant with its requirements.Excluding jurisdictions that have completely banne

139、d crypto-asset service providers,more than half have not implemented the FATFs Travel Rule to request personally identifiable information for all digital fund transfers(FATF,2023).8 The current inadequate and uneven implementation of AML/CFT requirements allows malicious actors to use DeFi for illic

140、it financing activities and regulatory arbitrage.97Rug pulls are a form of fraud in the crypto-asset market whereby developers create a new product and then disappear with investors money.8Introduced in June 2019,the Travel Rule requires a senders service provider to obtain and hold personally ident

141、ifiable information about the sender and recipient for VA transfers.9For example,the USDOT(2023)detailed how Tornado Cash,a DeFi protocol providing crypto-asset mixing services,was used to obfuscate the movement of over US$455 million in stolen crypto-assets.investors to become victims to fraud or r

142、ug pulls,in which retail investors are misled about the nature of a DeFi protocol and are exposed to substantial financial losses(BIS,2023a).72.2.COMPLIANCE AND LEGALITYPurported decentralisation can be misused as an excuse to circumvent existing regulatory requirements.While the decentralised and d

143、isintermediated nature of DeFi raises questions about the applicability of existing intermediary-focused regulatory approaches,many DeFi activities may,when broken down into its components,constitute regulated activities for which comprehensive frameworks are already in place to preserve financial s

144、tability,protect consumers and investors,and mitigate illicit finance risks.(OECD,2022).As shown in Figure 2.2,the degree of decentralisation of a DeFi protocol depends on the specific facts and circumstances surrounding its financial activities and its underlying architecture.In principle,as long a

145、s a financial service is provided,the service provider is liable,regardless of their purported level of decentralisation.However,many developers continue to use the decentralised and disintermediated nature of DeFi protocols as an argument to escape regulatory requirements and legal liability.As not

146、ed by the US Department of the Treasury(USDOT),some crypto-asset service providers claim that transitioning to a DAO will exempt them from anti-money laundering(AML)and counter-financing of terrorism(CFT)obligations and protect their operations from regulatory oversight and accountability in the hos

147、t jurisdiction(USDOT,2023).Some DeFi protocol operators even claim not to have a headquarters or host jurisdiction in which they are subject to regulatory obligations.The borderless nature of crypto-asset transactions present challenges for DeFi supervision and compliance.20Decentralised FinanceChap

148、ter 2:Risks and VulnerabilitiesChapter 22.3.ECONOMIC/TECHNOLOGICAL FRAGILITIESA number of economic and technological vulnerabilities across multiple layers of the DeFi stack can lead to the exploitation or operational failure of DeFi products and services(Figure 2.3).The Federal Reserve Bank of St.L

149、ouis(FRBSL)noted that the layers of the DeFi stack are hierarchical,meaning that each layer is only as secure as the layer below,and none of the subsequent layers will be secure if the settlement layer blockchain is compromised(FRBSL,2021).At the settlement layer,the settlement blockchain can be sub

150、ject to scalability limitations and market manipulation risks.DeFis settlement blockchains may struggle to process increased transaction volume without compromising security due to the blockchain trilemma,which is a challenge faced by all public blockchains.This trilemma states that all blockchains

151、can only fulfil two of three desired properties:security,scalability,and decentralisation.Security,which refers to the ability of the blockchain network to ensure the integrity and immutability of recorded transactions,can be enhanced through increased decentralisation and incentives,although increa

152、sing incentives leads to congestion and limited scalability(BIS,2023a).Conversely,a blockchain that prioritises high transaction volume(i.e.scalability)can be achieved by limiting the number of network validators to expedite the consensus process and imposing higher hardware requirements to process

153、more transactions at the same time.However,both possibilities will make the blockchain more vulnerable to attacks.10 Blockchains may also be susceptible to market manipulation,as validators can rearrange or censor transactions that have been posted to the blockchain to maximise their own profit.11Fi

154、gure 2.3:The technical design of DeFi products and servicesSettlement LayerAsset LayerProtocol/Smart Contract LayerAggregation LayerBottom-up hierarchy Consists of aggregators,which combine relevant information and allow users to perform complex tasks Consists of protocols which provide a standard f

155、or specific DeFi use cases,and smart contracts which autonomously execute transactions as specified by a protocol Consists of native token as well as stablecoins and other crypto-assets Consists of the blockchain and Layer 2 solutionsSource:HKIMR staff compilation,FRBSL(2021)and Schuler et al.(2024)

156、10These types of attacks,namely 51%attacks,refer to the case where a majority(more than 50%)of the validators in a blockchain network are compromised,allowing attackers to manipulate blockchain transactions and disrupt the security and integrity of the network.11Referred to as Maximal extractable va

157、lue,an example of market manipulation activity involves taking advantage of the transparency and reorderability of blockchain transactions to perform front-running,in which malicious actors pay higher transaction fees to place the front-running transaction at the front of a queue and receive more fa

158、vourable transaction terms.21Hong Kong Institute for Monetary and Financial Research June 2024Chapter 2:Risks and VulnerabilitiesChapter 2At the protocol/smart contract layer,smart contracts may be subject to economic or technological exploitation.A logic error or software bug can cause a DeFi proto

159、col to fail operationally,leaving users crypto-assets locked in the smart contract with no method of recovery.Alternatively,even without a logic error or software bug,a DeFi protocol can be subject to economic exploitation,whereby a malicious actor influences market conditions to profit at the expen

160、se of the protocol(Harvey et al.,2021).Furthermore,due to the immutability of blockchain transactions,any financial loss due to an error in the smart contract may not be rectifiable even after the vulnerability is discovered.12 In addition to these economic and technological vulnerabilities,the issu

161、es raised by considering a smart contract as applicable law between the participating parties remain controversial.Using the code is law ethos as an excuse,a hacker or malicious actor outwitting a smart contracts protocol may argue that their actions are permitted by the smart contracts design.13 Th

162、us,DeFi users should be mindful of various potential issues related to the use of smart contracts.Infrastructure services that support DeFi functionality are susceptible to exploitation by their operator or external parties.These services include oracles that bring external data to DeFi systems,cros

163、s-chain bridges that enable transactions across different blockchains,and Layer 2 solutions that improve the processing capacity of the base(i.e.Layer 1)blockchain(Figure 2.4).These services can reintroduce a vector of centralisation in DeFi protocols.A high degree of centralisation in these infrast

164、ructure services can effectively override the security and decentralisation provided by blockchain consensus mechanisms and DAO governance-ownership structures(BIS,2023a).Centralisation in these infrastructure services pose major risks to the DeFi protocols they help support.If the cost of corruptio

165、n is lower than an attackers potential profit from corruption,these infrastructure services will be extremely vulnerable to attacks(Harvey et al.,2021).12These DeFi activities may be considered less acute owing to the transparency of blockchain transactions.Malicious actors may face increased commun

166、ity scrutiny and struggle to cash out by moving their funds to centralised platforms,leading to arbitration and an agreement to partially return the funds.For example,a hacker stole US$197 million in crypto-assets from a DeFi protocol named Euler Finance in March 2023 and then returned over US$177 m

167、illion in the same month.Another protocol named Curve Finance was drained of over US$60 million in July 2023 and recouped around 70%of the hacked funds in the following month after negotiation.13More discussions can be found from an online article TradFi and DeFi:Same Problems,Different Solutions by

168、 Cecchetti and Schoenholtz.That said,in Canada,the Ontario Superior Court of Justice granted a preservation order against a hacker who misappropriated tokens on a DeFi platform using the code is law defence,posing that code is law as a defence argument remains debatable.Figure 2.4:Overview of blockc

169、hain infrastructure servicesBlockchain(s)Cross-chainBridgesLayer 2SolutionsOraclesSource:HKIMR staff compilation22Decentralised FinanceChapter 2:Risks and VulnerabilitiesChapter 214FTX held a significant stake in the Solana blockchains native token,SOL.It also largely controlled a DEX named Serum,wh

170、ich was built on the Solana blockchain.The collapse of FTX raised investor concerns about the integrity of both Serum and the Solana blockchain,leading to the near collapse of the price of SOL and the cessation of Serum.More details can be found in FSB(2023a).2.4.INTERCONNECTEDNESSHigh systemic risk

171、 can be technically inherited from the composability feature of smart contracts.By design,each smart contract is a self-contained component serving a specific function that can be assembled in certain combinations with other smart contracts to form a DeFi protocol.Multiple DeFi protocols can be comb

172、ined to form a new protocol or become part of protocol groups,making these protocols highly interdependent.Given this interconnectedness,the failure of a single smart contract can affect other smart contracts that depend on it and extend to all protocol groups and,in the worst case,spread to the ent

173、ire DeFi market(BIS,2023a).These multiple interconnected contracts can amplify the scope and speed of financial contagion in DeFi or lead smart contracts to behave in unexpected ways(FSB,2023a).Besides technical reasons,a possible source of systemic risk lies in the financial linkages between DeFi a

174、nd CeFi.The level of risk is high when the DeFi and CeFi ecosystems are highly interconnected through financial and operational dependencies(Figure 1.2).As a notable example,centralised crypto-asset exchanges(CEXs)have a number of interlinkages with DeFi protocols through various channels,namely(i)C

175、EXs serve as user-friendly interfaces to interact with DeFi protocols;(ii)some CEXs offer products that indirectly enable participation in DeFi protocols;(iii)crypto-assets generated by DeFi protocols can be traded on CEXs;and(iv)DeFi users can realise their DeFi investment profits on CEXs,linking C

176、EXs to counterparties across the DeFi ecosystem.As such,a crash in one market can cause financial contagion in another.The importance of such interlinkages has been demonstrated by market events such as the FTX crash in November 2022,which raised concerns among investors about the integrity of the b

177、lockchain platforms involved,leading to a substantial decline in the prices of the associated tokens and the closure of these platforms.14As demonstrated in the Crypto Winter of 2022,TradFi entities have been involved in contagion linked to the crypto-asset market.The rapid decline in crypto-asset p

178、rices in 2022 has brought to light many unsuspected connections between the crypto-asset market and the banking sector.For instance,the collapse of FTX led to a flight of deposits from two US banks with heavy exposure to crypto-assets(Silvergate and Signature)through their proprietary distributed le

179、dger technology(DLT)trading platforms,which enabled customers to make payments 24 hours a day and 7 days a week.Similarly,contagion in the crypto-asset market has been shown to originate from the banking sector.Specifically,the bankruptcy of Silicon Valley Bank(SVB),triggered by an outflow of US$42

180、billion in deposits within 5 hours,led to a drop in the prices of several major stablecoins,including one of the major stablecoins in circulation to trade at a steep 12%discount due to the deposit of US$3.3 billion of its reserve assets in SVB by its operating entity.These examples demonstrate that

181、financial institutions exposure to crypto-assets and the wealth effects arising from fluctuations in the market capitalisation of crypto-assets are valid transmission channels that can lead to spillover risks between DeFi and TradFi,which has caught attention of various international organisations,s

182、uch as the Basel Committee on Banking Supervision(BCBS),Financial Stability Board(FSB),International Monetary Fund(IMF),and IOSCO.The rapid decline in crypto-asset prices in 2022 brought to light unsuspected connections between the crypto-asset market and the banking sector23Hong Kong Institute for

183、Monetary and Financial Research June 2024Chapter 2:Risks and VulnerabilitiesChapter 22.5.LEVERAGE,LIQUIDITY AND MATURITY MISMATCHESThe DeFi market features high levels of leverage and collateralisation.Because of the pseudonymity of blockchain and DeFi users and the inherent price volatility of unba

184、cked crypto-assets,DeFi lending protocols often require over-collateralisation(with the exception of flash loans,which are uncollateralised but carry their own risks)to provide lenders with additional security.Borrowed crypto-assets can be re-collateralised repeatedly to form collateral chains,meani

185、ng that borrowed crypto-assets can be used as collateral again and again for additional loans.Given this market feature,reportedly,many trading platforms once reached 100-fold leverage for perpetual derivatives,suggesting that the over-collateralisation and re-collateralisation of crypto-assets in t

186、he DeFi market can intensify the financial linkages between the underlying crypto-assets and TradFi assets,and therefore potentially result in a highly complex and fragile system(Makarov and Schoar,2022).The DeFi market features high levels of leverage and collateralisationHighly leveraged investors

187、 in crypto-assets may react to financial shocks more procyclically,further exacerbating price volatility during economic downturns.Research studies identified that shocks caused by external factors such as monetary conditions in the US can be profound,and along with the sell-off pressure induced by

188、automated liquidation mechanisms embedded in DeFi protocols,can cause the prices of all associated crypto-asset collateral to collapse during times of financial stress,thereby calling into question the financial stability of the DeFi market(HKMA,2023;FSB,2023a).Liquidity and maturity mismatches are

189、another concerning DeFi vulnerability,resulting from imbalanced assetliability profiles of relevant entities(FSB,2023a).These types of mismatches may be more prominent in stablecoins,which can give rise to redemption runs from stablecoins whose reserve assets quality are questionable,and negative sp

190、illovers to other parts of the financial system in extreme circumstances(HKMA,2022a&2022b).For example,the collapse of the algorithmic stablecoin system created by TerraUSD and Luna in June 2022 was partly arising from its endogenous backing design which failed to control the stablecoin supply and m

191、aintain their peg to the backing assets.The collapse also led to the failure of its closely linked DeFi lending protocol,Anchor,and was one of the main factors contributing to the Crypto Winter of 2022.In comparison,fiat-collateralised stablecoins in which the issuer maintains reserves invested in m

192、ore liquid TradFi assets are less subject to run risk.These mismatches can also arise in other segments of DeFi(and CeFi)intermediation,notably in the context of lending protocols.One way in which some lending protocols offer high returns is by promising investors immediate redemption while investin

193、g deposit proceeds in less liquid assets,often using borrowers collateral to borrow and invest more.When inflows exceed outflows,the model allows a fund or platform to benefit from a liquidity/maturity premium.However,when market sentiment changes and redemption demand increases,the fund or platform

194、 may fail to meet these redemptions(FSB,2023a).24Decentralised FinanceChapter 2:Risks and VulnerabilitiesChapter 22.6.INVESTOR AND CONSUMER PROTECTIONDeFi protocols lack comprehensive investor and consumer protection measures(OECD,2022).Due to the permissionless accessibility of the crypto-asset mar

195、ket,any developer can create and deploy a DeFi protocol and attract investments without any auditing or testing,increasing the risk of post-launch malfunctions or failures,which can lead to significant losses for investors.Unlike many TradFi products and services that provide clear disclosure statem

196、ents regarding their features,risks,and costs in plain language,as required by law,the nascent and technically complex nature of DeFi protocols can be difficult for an average retail investor to fully comprehend.Any developer can create a DeFi protocol and attract investments without any auditing or

197、 testing,increasing the risk of post-launch malfunctionsInvestor and consumer protection risks are exacerbated by the immutability of crypto-asset transactions,while regulatory responses are still at an early stage of development.In other words,when fraud or malicious activity is involved,the recove

198、ry schemes or resolution mechanisms for the loss of crypto-assets may only rely on the collective effort of the community to monitor the subsequent fund flow of malicious actors and negotiate the return of the stolen crypto-assets,which is not necessarily successful.As crypto-asset regulations have

199、not yet reached the level of refinement and maturity of their TradFi counterparts,defrauded users may find it difficult to identify the responsible regulatory authority to turn to for recourse.From a regulatory standpoint,these limitations present supervision and enforcement challenges and increase

200、the likelihood that fraudulent activity will occur.25Hong Kong Institute for Monetary and Financial Research June 2024Chapter 2:Risks and VulnerabilitiesChapter 2Chapter 3Regulatory Challenges and International Approaches to RegulationAuthorities in various jurisdictions are adopting diverse approac

201、hes to guide the development of DeFi in the spirit of recommendations made by international organisations.HIGHLIGHTS:DeFi presents a number of challenges for regulators due to its risks and vulnerabilities.In evaluating the coverage of existing regulatory perimeters for DeFi innovations,many interna

202、tional organisations have used the guiding principle of same activity,same risk,same regulation.International organisations and financial authorities have considered diverse approaches to address these challenges.Some leading jurisdictions in DeFi have clarified existing regulations;others have amen

203、ded relevant laws or introduced bespoke regulations.Hong Kong is one of the jurisdictions that explicitly welcomes the virtual asset(VA)industry and seeks to support its sustainable and responsible development with a comprehensive and balanced regulatory framework and risk-based guardrails.Owing to

204、their vulnerabilities and technological construction,DeFi protocols present new challenges for authorities.The question of how to best address these challenges remains open,but the regulatory challenges posed by new technologies are not an unprecedented phenomenon.There are relevant parallels betwee

205、n DeFi today and past innovations enabled by the digital revolution.Learning from past cases of FinTech and non-banking financial intermediaries(NBFIs),international organisations,which include international bodies(e.g.the BIS,FSB,IMF,and OECD)and international standard-setting bodies(e.g.IOSCO,FATF

206、,and BCBS),have developed high-level regulatory principles to set a baseline level of comprehensiveness and consistency in terms of regulatory approaches to crypto-assets and DeFi,and jurisdictions have taken stock of these principles and adopted various regulatory responses accordingly.3.1.REGULATO

207、RY CHALLENGES The rapid evolution and international nature of the DeFi and crypto-asset markets have increased the potential for regulatory fragmentation and arbitrage.This section summarises several key challenges identified by international organisations and major research studies that merit atten

208、tion from authorities when developing a regulatory framework for these markets(Figure 3.1).i)Accountability behind Disintermediation/DecentralisationThe lack of easily identifiable regulatory hooks in DeFi protocols can cause the problem of who to hold accountable.Current regulatory tools,such as co

209、mpany registration and licencing regimes,rely on the existence of centralised entities that can serve as regulatory hooks.However,many DAOs do not have centralised entities due to their decentralised governance structures,creating challenges to regulatory agencies efforts to identify who to hold acc

210、ountable.Beyond the intentional non-compliance of DAOs,many key participants are actually involved in facilitating the development and operation of DeFi protocols(IOSCO,2022,2023c),including i)venture capital investors funding the development of the protocols;ii)the creators and developers of the pr

211、otocol;iii)significant holders of governance tokens;iv)operators of applications that facilitate access to DeFi protocols;15 v)operators of blockchain infrastructure services such as oracles and bridges;and vi)operators of the settlement layer blockchain(i.e.miners and validators).The large number o

212、f primary participants in DeFi protocols further complicates financial authorities efforts to identify decision-making entities and accountable parties that should be subject to applicable regulatory frameworks.16 Figure 3.1:DeFi regulatory challengesAccountability Behind Disintermediation/Decentral

213、isation Legal Enforceability of Smart ContractsRegulatory Fragmentation/Global CoordinationFinancial StabilitySource:HKIMR staff compilation 15These applications are typically third-party centralised entities that facilitate institutional investors access to DeFi protocols as these institutional inv

214、estors prefer keeping their crypto-assets in the custody of a third-party centralised entity for the purposes of internal control and risk management(IOSCO,2022).16In some jurisdictions,a DAO can be considered a partnership by law and be held accountable in a manner consistent with its legal charact

215、erisation,and may therefore incur personal liability for its members.27Hong Kong Institute for Monetary and Financial Research June 2024Chapter 3:Regulatory Challenges and International Approaches to RegulationChapter 3The large number of primary participants complicates efforts to identify accounta

216、ble partiesSome international organisations have provided high-level regulatory recommendations to identify and supervise de facto centralised actors in a purported DeFi protocol.The FATF(2021)suggested that creators,owners,operators,or others who retain control or sufficient influence over DeFi arr

217、angements,even if these arrangements appear decentralised,should be considered a virtual asset service provider(VASP)and the responsible party.Likewise,IOSCO(2023a,2023c)recommended that regulators work to identify the natural persons and entities that are de facto centralised actors in a purported

218、DeFi project as regulatory hooks,by weighing their roles,abilities,control or influence,and economic benefits in relation to DeFi activity.Nevertheless,these recommendations remain at a high level and certain practical and fundamental difficulties,such as the pseudonymity of DeFi users,may continue

219、to be a major challenge for financial authorities.ii)Legal Enforceability of Smart ContractsUnlike legal contracts,smart contracts used to facilitate DeFi transactions may not be legally enforceable.17 Despite their name,smart contracts are not by default considered legal contracts under civil law.S

220、mart contracts are not considered to fully fulfil the functions of a legal contract because(i)the pseudonymous,irreversible,and immutable qualities of blockchain technology may lead to complications in the identification of contracting parties and post-contract adjustment mechanisms;(ii)determining

221、liability becomes challenging when a smart contract fails to perform due to coding or design issues;and(iii)blockchain technology is borderless and is not readily subjectable to any particular jurisdiction or applicable law(DiMatteo et al.,2019).18 All of these factors raise questions about the suit

222、ability of existing regulatory frameworks in ensuring the regular performance of basic and legal regulatory functions such as ascertaining liability,determining applicable regulations,and carrying out supervision and enforcement(OECD&KDI,2021).As such,DeFi users may only benefit from limited legal p

223、rotections under contract law.As legal uncertainty regarding the enforceability of smart contracts may result in corresponding legal uncertainty regarding rights arising from smart contract-based services,any fraud,transaction errors,or contractual disagreement in DeFi has no method for court adjudi

224、cation or legal recourse.While some financial authorities have already issued guidance,others will need to explore the applicability of existing contract laws to enforce agreements encoded in smart contracts and provide methods for dispute resolution.iii)Regulatory Fragmentation/Global Coordination

225、Regulatory oversight and supervision may become less effective,given that the DeFi and crypto-asset markets are borderless and global in nature,with DeFi entities,actors,and activities often spanning multiple jurisdictions.In fact,regulatory views and approaches to crypto-assets and DeFi vary across

226、 jurisdictions,with some seeking to adopt a light regulatory approach,and others seeking a stricter approach,or even a complete ban on crypto-asset activities(WEF,2023b).This regulatory fragmentation across jurisdictions creates opportunities for regulatory arbitrage,where non-compliant operators an

227、d service providers can relocate to and exploit jurisdictions with weak or no 17A legal contract is an agreement between the contracting parties giving rise to obligations recognised and enforceable by law,the key elements of which include i)the intention to create legal relations;ii)offer;iii)accep

228、tance;iv)consideration;v)capacity to contract;and vi)certainty.The prevailing view is that smart contracts are not legal contracts by default but can either be i)the means of entering into a legal contract;or ii)a complete or partially complete legal contract,depending on its design.18Only a few jur

229、isdictions providing an interpretation of legal status of smart contracts,although these interpretations vary.Some parties have argued that existing contract law is sufficient to address the novelty of smart contracts,while others have recognised the need to adapt regulations to create a mechanism t

230、o enforce smart contracts as legal contracts.Details can be found in FSI(2023).28Decentralised FinanceChapter 3:Regulatory Challenges and International Approaches to RegulationChapter 3supervision,while financial regulators may have difficulty collecting relevant information,compromising their abili

231、ty to achieve satisfactory regulatory outcomes in areas such as AML/CFT controls and investor protection guardrails within their own jurisdictions.19 Regulatory fragmentation creates opportunities for regulatory arbitrage,where non-compliant operators can exploit jurisdictions with weak or no superv

232、isionGlobal cooperation in the regulation of crypto-assets and DeFi is further hampered by the lack of standardised definitions,classifications,and taxonomy.To date,there is no universally accepted classification of crypto-assets or financial service activities based on smart contracts(FSI,2023).At

233、the market participant level,DeFi users often use informal or heterogeneous vocabulary to refer to crypto-assets that may not accurately reflect their technological construction or economic use.This presents challenges for financial authorities seeking to analyse and ascertain the true nature of var

234、ious crypto-asset products.At the financial authority level,many authorities have created their own classification based on the economic functions of crypto-assets(such as payment,utility,or security tokens),but these classifications differ across jurisdictions and present challenges for cross-borde

235、r business activities,requiring collaborative supervision and communication between multiple authorities.Different classifications may also have implications for the relevant authority in charge of regulating an asset or for the laws and standards applicable to a particular crypto-asset,presenting a

236、nother set of concerns about the legal compatibility of crypto-asset regulation at the international level(FSI,2023).iv)Financial StabilityWithout the necessary regulatory guardrails,the growing interconnections between the DeFi and TradFi markets could potentially generate financial shocks to the T

237、radFi market.The degree to which DeFi vulnerabilities can generate systemic risk to financial stability hinges on the nature and strength of the connections and channels between DeFi and TradFi,such as financial institutions exposure to DeFi,the confidence and wealth effects stemming from the involv

238、ement of households and firms in DeFi,and the extent to which DeFi protocols can facilitate the use of crypto-assets for payments and settlements(FSB,2023a).Given DeFis limited interconnectedness with TradFi,the likelihood that a disturbance in the DeFi market will substantially affect the broader e

239、conomy remains limited,as evidenced by the modest impact of the 2022 crypto-asset market crisis on TradFi stability(FSB,2023a).Nevertheless,DeFi could play a larger role in the future,in view of the technological advancements and growing use of digital technology in finance.20 The inherent volatilit

240、y of the crypto-assets that underpin DeFi activity,coupled with DeFis complex web of interdependencies and its reliance on smart contracts and collateralisation,could give rise to liquidity mismatches,excessive leverage,and operational vulnerabilities.These factors could lead to contagion risks,in w

241、hich disruptions to the DeFi market could spill over into the broader financial system,particularly if DeFis links to TradFi deepen(BIS,2023a).19Regulatory fragmentation is also reflected in the low level of compliance with the FATFs Travel Rule(as discussed in Chapter 2),which highlights the issue

242、of delays in implementation and different enforcement timelines across jurisdictions,giving rise to what the FATF called the sunrise issue,which allows VASPs(including applicable DeFi entities)to operate with foreign counterparties that are not subject to relevant AML/CFT measures and creates challe

243、nges for both DeFi arrangements seeking to comply with the regulatory requirements of different countries and for jurisdictions in mitigating the risk of DeFi-facilitated illicit financing activities.Details can be found in FATF(2023).20The widespread adoption of crypto assets could also bring macro

244、economic risk and fiscal sustainability issues(IMF,2023a,2023b).This may be attributable to the fact that wider adoption of crypto assets would intensify cryptoisation(i.e.,substitution of domestic fiat currency with crypto-assets),which could weaken the effectiveness of monetary policy and bypass e

245、xisting capital flow regulations.Furthermore,the spread of crypto assets could increase fiscal risks for public finances,arising from the fact that crypto-assets may not be applicable to existing taxation regimes given its crypto-assets pseudonymous and borderless natures,which presents significant

246、challenges for tax revenue collection and compliance.These factors illustrate the continued need for authorities and international bodies to monitor DeFi and crypto-asset market developments.29Hong Kong Institute for Monetary and Financial Research June 2024Chapter 3:Regulatory Challenges and Intern

247、ational Approaches to RegulationChapter 33.2.INTERNATIONAL REGULATORY INITIATIVESWith the emergence of new business structures providing financial services,many financial authorities around the world are advocating the guiding principle of same activity,same risk,same regulation.According to this gu

248、iding principle,any business activity that performs the same economic function and produces the same risks should be subject to the same regulatory treatment,to ensure that all businesses compete on a level playing field,without any entity or underlying technology benefiting from favourable regulato

249、ry coverage or comprehensiveness(i.e.technology neutrality).In applying the guiding principle,regulators should first consider applying existing regulatory frameworks,as applying existing rules to new institutional forms is often consistent with the intent of the original legislation.The considerati

250、on should also take into account some subtleties,such as:(i)the risks associated with an activity may vary considerably depending on the underlying technologies used;(ii)the same regulatory treatment does not imply identical treatment;the guiding principle seeks to ensure the achievement of common r

251、egulatory outcomes,which may require equivalent rather than identical regulation(IIF,2022);and(iii)different regulations for the same economic activity may be warranted to the extent that technological innovation can help firms circumvent existing measures.Alongside this guiding principle or close v

252、ariants of it,international organisations have recommended potential approaches to mitigate major risks and regulatory challenges in the ecosystem.These high-level policy recommendations are designed to(i)assist financial authorities in achieving the same regulatory outcomes for crypto-asset activit

253、ies as those for TradFi business activities and capturing new risks specific to crypto-assets and DeFi not covered in the frameworks;(ii)clarify the application of existing principles to crypto-asset and DeFi activities;and(iii)promote the development of effective and internationally consistent regu

254、latory frameworks.At the G20s request,the FSB(2023b)finalised a set of high-level recommendations for crypto-asset activities and markets,including those conducted through DeFi,which seek to establish a global regulatory baseline for jurisdictions and promote greater consistency in formulating relev

255、ant regulatory and supervisory approaches around the world(Figure 3.2).Based on these recommendations and those developed by other international organisations,the IMF-FSB(2023)have also set out a synthesis paper to clarify how the recommendations developed by different international organisations fi

256、t together and interact with each other.Figure 3.2:The FSBs 2023 high-level recommendations for the regulation,supervision,and oversight of crypto-asset activities and marketsHigh-level recommendations for crypto-asset activities and marketsRegulatory powers and toolsGeneral regulatory frameworkCros

257、s-border cooperation,coordination and information sharingGovernanceRisk managementData collection,recording and reportingDisclosuresAddressing financial stability risks arising from interconnections and interdependenciesComprehensive regulation of crypto-asset service providers with multiple functio

258、nsSource:HKIMR staff compliation,FSB(2023b)30Decentralised FinanceChapter 3:Regulatory Challenges and International Approaches to RegulationChapter 3Table 3.1:Regulatory initiatives by international organisations for crypto-asset marketsPublicationKey risks addressed Key suggestions for financial au

259、thoritiesIMF(2023a)Interconnectedness Other risks(macroeconomic risk,data gaps)Mitigate substantial risks to the effectiveness of monetary policy,exchange rate management,capital flow management measures,and fiscal sustainability;also banks deposits losing and so lending being curtailed Require chan

260、ges in central bank reserve holdings and global financial safety net Develop more granular,relevant,and consistent data across countries to inform policymakingIMF(2023b)Interconnectedness Compliance and legality Investor and consumer protection Technological fragilities Other risks(macroeconomic ris

261、ks,fiscal risks)Safeguard monetary sovereignty and stability,maintain effectiveness of capital flow management measures,and adopt unambiguous tax treatment Establish legal certainty of crypto-assets,and develop and enforce requirements to all actors Establish international collaborative arrangements

262、,and strengthen global cooperation to develop digital infrastructuresIOSCO(2023b)Interconnectedness Governance Technological fragilities Investor and consumer protection Adhere to the Same activities,same risks,same regulation Require CASPs to have effective governance arrangements and disclose conf

263、licts and other information Encourage CASPs to adopt international data standards Monitor media to mitigate market manipulation Enhance cross-border co-operation and information sharing In addition to the guiding principle,international organisations have placed emphasis on overseeing the governance

264、 of the crypto-asset ecosystem at a high level(Table 3.1).The most common emphasis is on international cooperation,focusing on mechanisms for communication and data sharing among regulators,particularly to minimise regulatory arbitrage opportunities.Emphasis is also placed on AML/CFT measures for mo

265、nitoring and supervision of VASPs(FATF,2021),retail investor protection and media monitoring(IOSCO,2023c),and minimum capital requirements for banks exposure to crypto-assets(BCBS,2022).Although these recommendations remain at a high level,they provide insight for financial authorities in supervisin

266、g the crypto-asset market.31Hong Kong Institute for Monetary and Financial Research June 2024Chapter 3:Regulatory Challenges and International Approaches to RegulationChapter 3PublicationKey risks addressed Key suggestions for financial authoritiesBCBS(2022)Leverage,liquidity and maturity mismatches

267、 Strengthen regulation and supervision of banks worldwide for financial stability Classifying crypto-assets into Groups 1 and 2 based on risk levels under the consolidated Basel framework,subject to different minimum capital requirementsFATF(2021)Compliance and legality Take a risk-based approach Ap

268、ply relevant FATF Standards to supervise VASPs Enhance global co-operation and information sharing Keep VASPs supervision away from self-regulatory bodiesSource:HKIMR staff compilationTable 3.2:Regulatory initiatives by international organisations for DeFiPublicationKey risks addressedKey suggestion

269、s for financial authoritiesFSB(2023a)Interconnectedness Governance Technological fragilities Other risks(macroeconomic risks)Gauge DeFis vulnerabilities,evolution,and spillover risks to TradFi and the real economy Fill data gaps and promote data sharing and market intelligence Assess the regulatory

270、perimeter across jurisdictions and identify DeFi users entry points IOSCO(2022,2023a,2023c)Interconnectedness Governance Compliance and legality Technological fragilities Adhere to the same activity,same risk,same regulation Analyse DeFi at the economic reality,functional and technical levels Requir

271、e Responsible Persons to address conflicts of interest and material risks Assess interconnections among markets and enhance global co-operationIn addition,international organisations have proposed several specific recommendations to deal with the unique characteristics and risks of the DeFi market(T

272、able 3.2).For instance,in light of the rapid evolution of DeFi,the FSB(2023a)and OECD(2022)emphasised the importance of continuously monitoring DeFi development and its interconnectedness with TradFi and potential spillover risks.IOSCO(2023c)focused on identifying key players exercising significant

273、control or influence over a purported DeFi arrangement,requiring them to identify and address conflicts of interest,material risks,and disclosure issues.32Decentralised FinanceChapter 3:Regulatory Challenges and International Approaches to RegulationChapter 3For stablecoin markets,the FSB,the BIS Co

274、mmittee on Payments and Market Infrastructure(CPMI)and IOSCO suggested that systemically important stablecoins widely adopted within and across one or more jurisdictions should be required to build comprehensive governance structures to ensure appropriate risk management,data storage and reporting,d

275、isclosure,and settlement;otherwise,their failure or distress could have a significant impact on the entire financial system(Table 3.3).The FSI(2024)and FSB(2023c)recognised the importance of global cooperation and information sharing among regulators to ensure a consistent regulatory framework to ad

276、dress risks posed by stablecoins and prevent regulatory arbitrage to ensure a level playing field.Table 3.3 Regulatory initiatives by international organisations for stablecoinsPublicationKey risks addressedKey suggestions for financial authoritiesFSI(2024)Interconnectedness Governance Compliance an

277、d legality Technological fragilities Investor and consumer protection Strike a balance between fostering innovation and mitigating risks,along with continued monitoring,research and global co-operation Allow stablecoins and other tokenised assets to coexist on the same programmable platform Explore

278、stablecoins relationship with other digital assetsFSB(2023c)Interconnectedness Governance Adhere to same activity,same risk,same regulation Enhance global cooperation and information sharing Put global stablecoin arrangements in place to ensure appropriate governance,data reporting,resolution plans,

279、disclosure,timely redemption,and legal claimsCPMI-IOSCO(2022)Interconnectedness governance investor and consumer protection Adhere to same business,same risks,same rules Apply the Principles for Financial Market Infrastructures to systemically important stablecoin arrangements(SAs)Require SAs to enh

280、ance governance and risk-management,and define the point of irrevocability of stablecoin transferSource:HKIMR staff compilationPublicationKey risks addressedKey suggestions for financial authoritiesOECD(2022)Interconnectedness Governance Compliance and legality Technological fragilities Leverage,liq

281、uidity and maturity mismatches Investor and consumer protection Require enhanced disclosure Provide investor protection updates and education to raise awareness of DeFi risks Implement prudential treatment on TradFi intermediaries exposure to crypto-assets Enhance global co-operation Recentralise De

282、Fi to hold at least one party accountable Source:HKIMR staff compilation33Hong Kong Institute for Monetary and Financial Research June 2024Chapter 3:Regulatory Challenges and International Approaches to RegulationChapter 33.3.REGULATORY APPROACHES ADOPTED BY FINANCIAL AUTHORITIES3.3.1.Crypto-asset m

283、arketsWhen applying the guiding principle of same activity,same risk,same regulation,in some cases authorities could conveniently classify a crypto-asset into an existing asset class and apply the relevant existing regulatory framework to supervise it(i.e.clarify existing regulations).However,this c

284、ould leave crypto-assets which cannot be classified under a broad category or fall under more than one category unregulated(Blandin et al.,2019).According to the same principle,in certain cases where existing regulatory frameworks are considered insufficient to cover a crypto-asset,regulators could

285、extend their regulatory perimeter by amending existing law or developing bespoke regulations(Figure 3.3).Indeed,some jurisdictions have amended existing laws or regulations to explicitly cover specific crypto-asset activities(Table 3.4).For instance,Switzerland adopted a blanket act on DLT in 2021,c

286、alled the Federal Act on the Adaptation of Federal Law to Developments in Distributed Electronic Register Technology(Swiss DLT Act),which involved amending several federal laws to provide a legal basis for digital assets held on DLT,covering areas such as property rights,custodians,and licences;Japa

287、n amended its Payment Services Act(Japan PSA)to regulate crypto-assets and stablecoins in June 2023;and Singapore amended its Payment Services Act(Singapore PSA)and subsidiary legislation in April 2024 to bring third-party custodian services within its regulatory framework and impose additional requ

288、irements on AML/CFT,user protection,and financial stability on regulated crypto-asset activities.In comparison,taking a further step by issuing bespoke regulations on crypto-assets is currently less popular.The European Union(EU)was one of the first to set out a specific regulatory framework for cry

289、pto-asset activities and market infrastructures.The framework,known as the European Commissions 2020 Digital Finance Package,covers two regulatory aspects.The first aspect,namely Markets in Crypto Assets Regulation(MiCAR),applies to crypto-asset issuers and service providers not covered elsewhere in

290、 EU financial legislation.Having integrated these market participants into its regulatory scope,MiCAR provides the EU with regulatory oversight over existing regulatory gaps and harmonises previously fragmented regulatory regimes into a sound and predictable legal environment(EPRS,2023).The second a

291、spect of the Figure 3.3:High-level regulatory approaches under the guiding principle of same activity,same risk,same regulationSame activity,same risk,same regulation guiding principleClarify existing regulationsExtend regulatory frameworkIssue bespoke regulations for new activityIssue statements/ci

292、rculars to classify new activity into existing regulated categoryAmend law/ordinance to explicitly cover new activity(e.g.Swiss DLT Act)(e.g.EU MiCAR)Source:HKIMR staff compilation34Decentralised FinanceChapter 3:Regulatory Challenges and International Approaches to RegulationChapter 3framework,name

293、ly Regulation on a Pilot Regime for Market Infrastructures based on DLT,applies EU financial instruments issued with DLT not covered by MiCAR.Besides the EU,other examples of bespoke regulatory responses include Maltas Virtual Financial Assets Act,Abu Dhabis Crypto Asset Spot Framework,and Mexicos L

294、aw to Regulate Financial Technology Institutions in 2018,but these frameworks have yet to be fully tested given the rapid evolution of the crypto-asset ecosystem.Table 3.4:Examples of extending regulatory frameworks to supervise crypto-assetsAmending existing lawIssuing bespoke regulationsSwitzerlan

295、dEUSwiss DLT ActMiCARRegulation on a Pilot Regime for Market Infrastructures based on DLTEffective dateSeptember 2021 June 2024(Titles III and IV)December 2024(all other provisions)March 2023Assets coveredDigital assets held on distributed ledgers Asset-backed stablecoins collateralised by fiat curr

296、encies,commodities,or other cryptocurrencies Utility tokens EU financial instruments issued with DLT not covered by MiCARHighlightsAmended several federal laws to provide a legal basis for DLT assets Introduce DLT rights as a new type of right for digital assets Allow crypto-assets to be segregated

297、from other assets as off-balance sheet for FIs in event of bankruptcy Waived the banking licence requirement for custodians of crypto assets qualified as custodial assets Establish a new licence category for DLT trading systems on which securities registered on distributed ledgers can be tradedFirst

298、 cross-jurisdictional regulatory framework for crypto-assets Any crypto-asset service provider and issuers of asset-referenced tokens and electronic money tokens shall be licensed by the jurisdictional authority Issuers are required to publish a crypto-asset white paper to disclose information on th

299、e issuer,offeror,project,rights and obligations during the public offeringRegulations to facilitate the regulatory sandbox for companies to test and develop DLT-based solutions Establish requirements on DLT market infrastructures and their operators,such as obtaining prior specific permission and su

300、pervision as well as conditional temporary exemption from EU TradFi regulationsSource:HKIMR staff compilation35Hong Kong Institute for Monetary and Financial Research June 2024Chapter 3:Regulatory Challenges and International Approaches to RegulationChapter 3Nevertheless,some jurisdictions prefer a

301、more restrictive approach for crypto-asset activities.One approach is to insulate TradFi entities from crypto infection by limiting the fund flow into and out of the crypto-asset market and curbing any crypto links with TradFi and with the real economy(BIS,2023a).Some jurisdictions,such as Mainland

302、China and Bolivia,have introduced a complete ban on crypto-asset activities.Overall,these regulatory responses are not mutually exclusive.Jurisdictional regulators may adopt a combination of regulatory responses to meet their jurisdictions needs,based on the risk implications of different crypto-ass

303、et activities.In addition,given the global nature of the crypto-asset market and its use to circumvent national laws,regulators must be aware of policies in other jurisdictions and may on occasion need to adjust their own policies.3.3.2.DeFi marketsRegulations specific to DeFi activities remain rare

304、,as DeFi is still in the early stages of development.A more relevant example is the DLT Foundations Regulations 2023(DLTFR 2023)introduced by the Abu Dhabi Global Market Registration Authority(ADGM RA)of the United Arab Emirates(UAE).As an example of bespoke regulation directly relevant to DeFi,the

305、DLTFR 2023 aims to provide legal recognition for DAOs by creating a new legal structure that captures the characteristics of DAOs called DLT Foundations.Registered DLT Foundations are required to provide the necessary information(e.g.governance structure,minimum asset values)and fall within the ADGM

306、 RAs regulatory perimeter defined by the DLT Foundations Regulations 2023.A brief summary of the DLT Foundations Regulations 2023 is provided in Box 3.1.Box 3.1:DLT Foundations Regulations 2023 introduced by ADGM RAThe DLTFR 2023 was created by the ADGM RA in October 2023 as a bespoke regulation for

307、 blockchain-enabled organisational structures(ADGM RA,2023).It defined an entity structure called DLT Foundations as any legal entity with separate legal personality established to use,deploy,facilitate or support DLT or to issue tokens,with the aim of capturing the features and characteristics of D

308、AOs,thereby bringing DAOs within its regulatory perimeter and allowing the ADGM RA to introduce regulatory requirements on DAOs operating within its jurisdiction.There are several requirements for an entity to register as a DLT Foundation.For example,the founder is required to submit a charter to a

309、designated registrar,clarifying the objects,activities,governance,and beneficiaries of the DLT Foundation,as well as the rights and obligations of token holders.Registered DLT Foundations must also have a minimum initial asset value,and the assets of a DLT Foundation are subject to separate custody

310、requirements.Registered DLT Foundations are also subject to governance requirements.The DLT Foundations Regulations 2023 stipulates that registered DLT Foundations must be governed by a foundation council,a guardian,and its token holders.The governance council must be composed of at least two and no

311、 more than 16 councilors subject to knowledge and competency requirements.Finally,DLT Foundations are subject to reporting obligations.They must keep accounting records and prepare annual records,which are audited by an independent auditor.36Decentralised FinanceChapter 3:Regulatory Challenges and I

312、nternational Approaches to RegulationChapter 3In comparison,many jurisdictions are at the stage of publishing analytical papers and conducting research to prepare the formulation of a DeFi-specific regulatory framework.For example,the UK Law Commission is exploring the legal characterisation of DAOs

313、,given that a DAO does not necessarily represent a particular type of organisational structure and therefore cannot,on its own,imply any particular regulatory treatment.21 The EUs MiCAR has brought crypto-asset issuers and activities within the regulatory perimeter,however,DeFi protocols are conside

314、red out of scope.3.3.3.StablecoinsStablecoins are considered increasingly crucial to the crypto-asset ecosystem,as their interconnectedness with TradFi increases and the associated spillover risks to the financial system are expected to be more direct and imminent.In view of this development,a numbe

315、r of financial authorities in developed economies have already taken important steps to expand their regulatory framework to regulate stablecoins(Table 3.5).22 For example,in Europe,the Swiss Financial Market Supervisory Authority(FINMA)was among the first to issue guidelines on stablecoins in 2019,

316、while the MiCAR provisions for stablecoins will soon apply(mid-2024).The UK passed the Financial Services and Markets Act 2023(FSMA 2023)in mid-2023,then issued proposals in late 2023 to consult on the regulation of fiat-backed stablecoins in Phase 1 and other crypto-assets in Phase 2.In general,the

317、se regulations aim to impose requirements on stablecoin issuers in terms of reserve assets,redemption rights,prudential obligations,governance and risk management,technology and cyber security,AML/CFT,and disclosure and marketing(FSI,2024).In Asia,Japan and Singapore were among the early movers in s

318、tablecoin regulations.In the amendment of Japan PSA,the legal status of fiat-referenced stablecoins in 2022 has been newly defined,which prompted key stablecoin issuers to partner with local Japanese financial institutions to enter the market after the Japan PSA took effect in mid-2023.The Monetary

319、Authority of Singapore(MAS)developed its stablecoin regulatory framework by amending the Singapore PSA in August 2023.After the Act took effect,a series of in-principle licence approvals were granted to stablecoin issuers in the second half of 2023.In the US,the development of federal regulatory fra

320、meworks on stablecoins and crypto-assets have remained underway.The recent framework called the Clarity for Payment Stablecoins Act seeks to change the way stablecoins are regulated in the US.Proposing a regulatory framework and licencing process that will provide a common approach across all states

321、,the Act was first passed by the US House Financial Services Committee in July 2023 and is awaiting full approval by the House.Meanwhile,individual states such as New York,Texas,and Nebraska have more relevant regulatory developments on stablecoins.2321Many DAOs establish a formal entity structure s

322、uch as a corporation,limited liability company,partnership,or foundation to define their legal treatment and conduct administrative tasks that require the establishment of a legal entity.The entity structures adopted by DAOs vary greatly across the crypto-asset landscape,with important implications

323、for the applicability of existing regulations.Further discussions can be found in the UK Law Commissions website on DAOs.22Details of these developments can be found in official websites,such as State Secretariat for International Finance SIF(Switzerland),BoE/FCA(UK),MAS(Singapore),NYDFS(US).23Detai

324、ls can be found in a review titled 50 State Review of Cryptocurrency and Blockchain Regulation published by the Stevens Center for Innovation in Finance,University of Pennsylvania,in March 2024.37Hong Kong Institute for Monetary and Financial Research June 2024Chapter 3:Regulatory Challenges and Int

325、ernational Approaches to RegulationChapter 3Table 3.5:Regulatory developments related to stablecoins in recent yearsAreaJurisdictionRegulatory developmentPermitted stablecoin issuersEuropeSwitzerland September 2019:Published stablecoin guidelines by FINMA outlining the continued adoption of substanc

326、e over form and same risk,same rules towards stablecoins There is no specific regulations for stablecoins so farEUJune 2023:Published MiCAR in the EUs Official Journal and entered into force June 2024:MiCARs provisions for stablecoins to take effect Banks and licensed NBFIso Banks and electronic mon

327、ey institutions established in the EU can issue e-money tokensUKJune 2023:Passed FSMA 2023,introducing a preliminary regulatory framework for crypto-assets November 2023:Published discussion paper outlining their proposed approach to regulating fiat-backed stablecoins Any entity that obtains a crypt

328、o-specific licenseo All entities,regardless of business type,are required to seek authorisation from the FCA to issue stablecoinsAsiaJapanJune 2022:Passed bill to impose a licensing regime on stablecoin issuers(Japan PSA)December 2022:Lifted a ban on foreign-issued stablecoins June 2023:Japan PSA to

329、ok effect24 Banks and licensed NBFIsHZJ6o Fund Transfer Service Providers can issue stablecoins as claims on outstanding obligationso Trust Companies can issue stablecoins as trust beneficiary rightsSingapore October 2022:Issued Consultation Paper on Proposed Regulatory Approach for Stablecoin-Relat

330、ed Activities August 2023:Finalised the stablecoin regulatory framework labelling stablecoins as MAS-regulated stablecoins25 Banks and licensed NBFIso Banks are exempt from licensing regimeo NBFIs are required to apply for a license to issue stablecoins24After the PSA takes effective,Circle,the seco

331、nd largest stablecoin issuer of USDC,partnered with Japans SBI Holdings in November 2023 aiming to circulate the USDC in Japan in 2024.25In November 2023,the MAS granted approvals in-principle to StraitsX and Paxos to issue fiat currency-pegged stablecoins(e.g.USD-backed and SGD-backed).38Decentrali

332、sed FinanceChapter 3:Regulatory Challenges and International Approaches to RegulationChapter 33.4.HONG KONGS POLICY APPROACH TO THE CRYPTO-ASSET ECOSYSTEM27Hong Kong has welcomed the VA industry and seeks to support its sustainable and responsible development(FSTB,2022).As stated in the Financial Se

333、rvices and the Treasury Bureau(FSTB)s policy statement on the development of VAs in Hong Kong,the HKSAR government(HKSARG)acknowledges the legitimacy of VAs and their role in finance and welcomes VASPs in Hong Kong,with an emphasis on putting in place timely and necessary guardrails(Table 3.6a).The policy statement also mentions considering a future review of property rights for tokenised assets a