HKMA issues white paper on distributed ledger technology

Introduction

The Hong Kong Monetary Authority (HKMA) on 11 November 2016 published a white paper on distributed ledger technology (DLT), demonstrating its ongoing commitment to the development of promising Fintech applications in Hong Kong’s financial sector, while identifying key areas of risk.

The white paper was commissioned by the HKMA’s Fintech Facilitation Office, established in March 2016 to facilitate the healthy development of the Fintech ecosystem in Hong Kong, and carried out by the Hong Kong Applied Science and Technology Research Institute (ASTRI) with the participation of several banks and other industry participants.

Howard Lee, Senior Executive Director of the HKMA, explains in a foreword to the white paper that the HKMA believes DLT “carries enormous potential”, while recognising that the technology also introduces new risks and new legal and governance issues.

The white paper provides a comprehensive and well researched exploration of the key features, benefits, risks and potential of DLT, including both ‘unpermissioned’ platforms (i.e., decentralised and open to everyone) and ‘permissioned’ platforms (ie, managed by a central trusted party and only open to authorised users). Also included is some analysis of the practical application of the technology through proof-of-concept work on three use cases for the banking sector.

Opportunities and challenges presented by distributed ledger technology

The potential benefits of DLT identified in the white paper include the capability of DLT systems to establish trust among participants, efficiency in broadcasting information in a speedy and secure way, the ability to achieve complete traceability of records and transactions, the possibility of lowering operational costs and the potential for high resiliency.

However, the authors of the paper have also highlighted areas of risk, including in relation to operational, legal and governance issues. These include several issues with DLT which are have been widely discussed, such as money-laundering, sales of drugs and other illegal assets, platform security issues, data privacy risks and challenges associated with regulatory compliance.

The HKMA/ASTRI white paper specifically considers legal risks. During a presentation for the HKMA Fintech day, which coincided with the publication of the white paper, Shu Pui Li, the HKMA’s executive director for financial infrastructure, said that “the most painful issue [in relation to DLT] is legal.”  Legal risks identified in the white paper include the following:

• Legal disputes: In a decentralised and/or anonymous system, it can be difficult to locate a defendant if a platform participant suffers loss.
• Terms in code: The rules governing DLT platforms may be largely written in computer code. Such terms and conditions may be less easy to understand by all parties involved than a traditional paper contract.
• Applicable law: In a decentralised, cross-border system it may not be clear what law governs the DLT arrangement and how it will be enforced.
• Privacy: Regulators, DLT platforms and participants all face a challenge when faced with the need to protect user privacy while also being required to assist law enforcement authorities and comply with data protection laws. How this challenge will be addressed remains an area of ongoing development.

Further developments

The HKMA views this white paper as the first phase of an ongoing research project. A second white paper on DLT is expected in the second half of 2017, which will focus on the regulatory implications of DLT, general control principles for DLT for the banking and payment industries, and providing more in-depth findings from the proof-of-concept work.

On the same day as the white paper was released, HKMA officially launched its Fintech Innovation Hub, which is to serve as a test bed for continued experimentation between Hong Kong’s financial services providers, start-ups and regulators. For further information on the Fintech Innovation Hub, please see the following elexica article: HKMA launch supervisory sandbox and fintech innovation hub.

These HKMA initiatives further underline the government’s desire to promote Hong Kong as a Fintech hub in Asia. While the first DLT white paper does not suggest innovative new approaches, it is a well informed and practical overview of the potential of the much-hyped technology.  The willingness of the HKMA to lay the groundwork for further development on DLT issues by Hong Kong’s regulators, particularly in areas of current legal and regulatory uncertainty, is welcome.

The full HKMA/ASTRI white paper on DLT can be accessed here.