(c) Hong Kong Institute of Certified Public Accountants. Contact HKICPA for permission to reproduce this article., Fintech, Information Technology

The blockchain that binds us

By James Kelly

Blockchain technology is creating a buzz in the worlds of banking and finance that it will lead to faster, cheaper and more secure services, but at what cost and is Hong Kong ready for the distributed ledger? James Kelly reports.

A popular way to explain blockchain technology, as a casual web search reveals, is to use Lego bricks. This technology, however, is far from kids’ stuff.

It had its origins as a platform for the cryptocurrency Bitcoin, which excited the start-up geeks and allowed for more nefarious activities related to the dark web. But blockchain technology is now stimulating the world of financial services and seen, ironically, as a path to greater transparency and accountability.

A blockchain is usually defined as a set of distributed ledgers, which are “mathematically signed” to prevent unauthorized tampering, thereby providing extra security for record-keeping for their users and making the transaction records more traceable. A PwC report titled What is Blockchain? introduces it as a decentralized ledger, or list, of all transactions across a peer-topeer network.

Blockchain has the potential to revolutionize the worlds of banking and financial services. According to a 2015 report by British bank Santander, venture fund Anthemis and research firm Oliver Wyman, blockchain technology could save banks US$15-20 billion by reducing “infrastructure costs attributable to cross-border payments, securities trading and regulatory compliance.”

“There are huge opportunities with the technology,” says EY’s Regional Managing Partner for Financial Services, Asia-Pacific, Gary Hwa. “The real benefit of the technology in longer term we see will be in the ability to create new business models, such as selfrunning, self-regulating marketplaces, decentralized autonomous organizations, or the integration of finance into the Internet-of-Things, each of which may fundamentally change the nature of commerce.”

In this year’s budget, the Financial Secretary John Tsang mentioned “blockchain,” the first time it has been specifically referred to in the annual address. “Government will encourage the industry and relevant organizations to explore the application of blockchain technology in the financial services industry, with a view to developing its potential to reduce suspicious transactions and bring down transaction costs. The Cyberport will provide training to the industry through its incubation programme to promote relevant technologies for developing more services and products,” Tsang announced.

This came 12 months after announcing in his previous budget the setting up of a high level Steering Group on Financial Technologies, tasked to advise the government on how to develop and promote Hong Kong as a FinTech hub. Its report was released two days after the 2016 budget.

Following the release of the report, the Securities and Futures Commission, acting on the recommendations, set up a FinTech contact point as a dedicated channel to encourage businesses involved in the development and application of financial technology in Hong Kong to engage with the SFC and understand the applicable regulations. The SFC has also established a high level advisory group, which will focus on the opportunities, risks and regulatory implications of developments related to FinTech.

Although several of the report’s recommendations have already been acted on, it has attracted criticism from FinTech start-ups. Joseph Wang, Chief Scientist of start-up Bitquant Research Laboratories, and a former vice president in the quantitative research division of JPMorgan, was disappointed with the work of the steering group.

“The effort of the Hong Kong government to develop Cyberport as a FinTech centre is extremely well in meaning, but the problem is that there is not as yet the critical mass of local FinTech to take a thought leadership role.”

However, the government’s approach is supported by Hong Kong Exchanges and Clearing, which agrees that Hong Kong’s financial services sector should explore the use of blockchain technology. “HKEx continues to monitor blockchain developments, particularly in financial services, and evaluate the potential opportunities arising from the developments,” says an HKEx spokesman.

Roadblocks ahead

The question of regulation of blockchain is proving as challenging for Hong Kong as it has in other jurisdictions.

According to Ian Wood, a Hong Kong-based Partner at law firm Simmons & Simmons, the development of FinTech requires the existence of a regulatory regime that enables start-ups to provide their services to the public legally. “The regulatory regime for financial business varies significantly across Asia but unlike the United Kingdom, for example, there has been little direct consideration of the FinTech sector by Asian regulators,” says Wood.

“Hong Kong has yet to introduce any regulation that specifically addresses FinTech businesses. There are a number of aspects of the Hong Kong regulatory regime which are likely to impact businesses that are providing financial services or that operate platforms on which investments are available.

“Without a clear regulatory framework for FinTech businesses, Hong Kong may find it difficult to encourage the use of innovative technology in financial services or business structures and there is also a risk of unscrupulous or inexperienced businesses damaging the industry generally.”

The Hong Kong Monetary Authority has recently established the facilitation office to assist the industry in understanding the local regulatory landscape and to facilitate a healthy development of FinTech in Hong Kong. The office has three main functions – working with the industry to promote research in FinTech solutions; providing a platform for industry communication and outreach activities; and acting as an interface and major point of contact between FinTech market participants and regulators.

The HKMA says it adopts a risk-based and technology-neutral approach in its supervision. This means that when developing and implementing regulatory framework and requirements, it will only base on the intrinsic characteristics of the financial activities or transactions, and the risks arising from them.

“As a regulator, we should fully understand the characteristics, potential and risks of FinTech. Take blockchain as an example: we must thoroughly consider the benefits and risks to the financial system should this be widely used at the retail or corporate customer level,” says Norman Chan, HKMA Chief Executive.

EY’s Hwa says there is no more a need for a regulatory framework for blockchain technology than there is for databases or networking. “Saying that, there should certainly be regulatory frameworks for particular applications of the technology as they are deployed, if they pose risks, financial or otherwise. This is one of the challenges of deploying this technology, as it creates paradigms which we haven’t had to deal with previously.”

Regional hub

Hong Kong’s ambition to be recognized as a regional hub for emerging blockchain technology has caught the attention of Australia.

In January, the Commonwealth Bank of Australia, one of the country’s big four banks, launched an innovation lab in Hong Kong with plans for a further lab in London later this year. Its inaugural lab in Sydney has already created a live demonstration blockchain.

“The Hong Kong lab will allow us to partner with the brightest minds across the city’s accelerator, government, university, start-up and FinTech communities to further develop creative and innovative solutions for our clients,” says the bank’s Group Executive, Institutional Banking and Markets, Kelly Bayer Rosmarin.

In April, a new Australian FinTech hub Stone & Chalk, which represents dozens of start-ups, met with Hong Kong’s key financial regulators – the SFC, the Office of the Commissioner for Insurance and the HKMA – to discuss the way forward. Stone & Chalk is looking to establish a FinTech ecosystem across the region.

In the same month, Australian FinTech company Austreme announced it was setting up its regional headquarters in Hong Kong. The company specializes in big data and website security, offering solutions to the banking and finance industries related to e-commerce and payment transactions.

Meanwhile, the Big Four have been busy recruiting experts and setting up dedicated blockchain teams. Earlier this year, PwC announced it has recruited 15 leading technology specialists to exploit and commercialize blockchain. The new team will be based in PwC’s Belfast office this year.

In Hong Kong, EY has dedicated blockchain experts operating within a global integrated team. “In addition, we are also looking at the technology to provide services to our clients not only of an advisory nature but also across tax, assurance and transaction advisory services,” says Hwa. “For example, there may be the potential to use the technology to streamline different types of audit processes, and so we are exploring how we may enable that. We also aim to leverage blockchain internally to operate more efficiently in the future.”

A matter of trust

Blockchain’s ability to create trust in the digital world among untrusted or semi-trusted parties is incredibly valuable according to Hwa, “particularly since the role of a trusted intermediary is the base of so many businesses and institutions.”

“But it is unlikely that current entrenched players will be displaced by the technology in the near future, as the technology is only the enabler: integrated business models have been built around the current technology paradigm, and it is hard to change those models without clearly identified savings.

“The timing and costs most people see in the financial sector has little to do with the technology: more often it has to do with the regulatory controls and operations, which blockchain technology does not solve.”

Bitquant’s Wang offers a note of caution on the way forward. “The main risk is premature regulation in which it gets regulated out of existence before it can do anything. Right now blockchain is 95 percent hype, and having regulators try to deal with a technology that for the most part doesn’t exist yet, is tricky.”

This article was originally published in the May 2016 edition of A Plus. You can also read this article in the digital edition.