How tokenization could transform Hong Kong’s fixed income markets

Hong Kong is a leading Asian bond hub. The Asian Development Bank ranks it third in issuance volumes in Asia ex-Japan, after mainland China and South Korea. Tokenization has the potential to revolutionize Hong Kong’s fixed income market by making it more efficient, reliable and transparent.

In this article, we discuss the concept of tokenizing fixed income products, Hong Kong’s virtual asset regulatory landscape, how upcoming changes could affect the sector, and the vital role of institutional digital asset custodians.

Tokenizing fixed income products

Tokenizing fixed income products has clear advantages for both issuers of, and investors in, such products. However, tokenization is not without disadvantages.

Two key advantages for token issuers are efficiency and reliability. Issuers can program tokens to carry out many functions that are currently performed by a company secretariat, such as investor announcements, investor register management, and coupon and principal payments. This saves costs, is efficient, and could reduce the likelihood of human error, fraud and negligence.  

Tokenization is particularly well-suited to fixed income products because they have set dates for coupon payments and the repayment of principal amounts. Such dates and amounts can be programmed into smart contracts ahead of time and will execute automatically once certain conditions are met.

Tokenization is also advantageous for investors, particularly with respect to due diligence, automation benefits and increased liquidity.

Tokenization can simplify investors’ due diligence investigations. When conducting due diligence, an investor might seek access to certain material which may not be true, complete or accurate due to factors including fraud, negligence or human error. Traditionally an investor would seek representations and warranties from a disclosing counterparty and could sue that party in the event of a misrepresentation or a breach of warranty. However, immutably storing information on a blockchain removes some of that uncertainty.

In addition to the above-mentioned benefits for issuers, automation allows issuers to devise fixed income products with innovative tokenomics. For example, a tokenized fixed income product could pay investors continuous real-time coupon payments. This would be too administratively burdensome for traditional issuers, but possible using smart contracts.

Lastly, unlike traditional exchanges, virtual asset exchanges never close and can therefore facilitate more liquidity. Investors can respond to changes in the underlying asset in real time. Gas fees for transferring tokens are also likely to be substantially lower than traditional exchanges’ brokerage fees.

However, tokenization has some disadvantages.

The above-mentioned gas fees must be paid in a cryptocurrency, such as Ether. One criticism of cryptocurrencies is that the electricity required to “mine” them and approve transactions consumes a lot of energy. This is certainly true for blockchain protocols that use “proof-of-work” models whereby powerful computers known as “miners” compete to solve algorithms and accordingly receive cryptocurrency rewards.  

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

The virtual assets sector is still in its infancy but is rapidly changing. Regulators around the world are still determining how best to regulate them in their respective jurisdictions. During this period the industry will have to grapple with regulatory uncertainty.

Hong Kong’s evolving regulatory landscape

The Securities and Futures Commission of Hong Kong (SFC) and the Hong Kong Monetary Authority (HKMA) released a joint circular and appendix in January 2022 that will come into effect in mid-2022. It prescribes new requirements with respect to:

(i) the distribution of virtual asset-related products,

(ii) the provision of virtual asset dealing services, and

(iii) the provision of virtual asset advisory services.  

The joint circular extends the remit of the SFC and the HKMA. Currently, many virtual assets might not satisfy the definition of “securities” in the Securities and Futures Ordinance and accordingly fall outside the SFC’s purview. However, the joint circular states that the SFC nonetheless expects compliance with its regulatory requirements for dealing in securities.

The joint circular effectively restricts virtual asset-related products and services to professional investors and states that virtual asset dealing and advisory services can only be provided to professional investors. It also states that virtual asset-related products regarded as “complex products” should only be offered to professional investors. The joint circular notes that the SFC is likely to consider most virtual asset-related products to be “complex products”, meaning that the SFC would not consider retail investors to be reasonably likely to understand the risks of investing in such products.

Intermediaries (broadly, any person licensed by or registered with the SFC) can only partner with SFC-licensed virtual asset trading platforms to provide virtual asset dealing services either by “introducing clients to the platforms for direct trading or establishing an omnibus account with the platforms.”  

Implications of Hong Kong’s regulatory changes

Hong Kong’s regulators will have a much wider reach in the city’s virtual assets space. As their reach grows, we consider that the SFC and the HKMA must balance protecting investors with facilitating the development of the sector.

For example, we understand that the regulators are limiting virtual assets to professional investors to protect retail investors. However, this could dissuade the offering and dealing of virtual assets in Hong Kong or lead to their being offered and dealt outside Hong Kong and not directly to Hong Kong investors. In fact, the professional investor restrictions could represent a disincentive to tokenize fixed income products because doing so would limit such products’ potential investor base.  

A comprehensive regulatory framework could spur increased investor confidence in the virtual assets sector. As demand for virtual asset products increases, we hope that the SFC will license more intermediaries to distribute, advise on, and facilitate the trading of such products.

The role of institutional digital asset custodians 

As tokens become more complex and valuable, and form more of investors’ portfolios, they must be stored safely. This is particularly important for fixed income tokens, which investors might intend to hold for extended periods. Institutional-grade custodians that operate within regulatory frameworks to meet compliance and security standards, integrate with the top emerging blockchain protocols, and support an extensive range of token standards will become increasingly important to the growth of the sector.

Investors will expect levels of security and compliance — including policies and procedures regarding anti-money laundering and counter-financing of terrorism — akin to their other traditional assets. Furthermore, certain institutional investors might require assets to be held by a prescribed type of custodian. Investors should also consider how they invest and ensure that they engage custodians that support their activities.  

The past few years have seen the rise of institutional-grade custody and infrastructure providers that can serve investors in fixed yield products that might prioritize generous insurance and secure cold wallet functionality as well as high-frequency traders seeking sophisticated hot wallets and automatic settlement circuits.  

In summary, tokenization could benefit both issuers of and investors in fixed income products. However, as Hong Kong increasingly regulates the virtual asset space, the challenge lies in balancing investor protection and assurance with the growth of this sector. A key element in providing this investor protection and assurance will be the broad range of on-chain services designed with the high security standards of institutional-grade digital asset custodians.