Hong Kong as a Legal Centre of Excellence for Digital Finance

Many crypto exchanges and institutions already choose Hong Kong as the place to resolve their disputes, but more need to be done, says Troy Song.

Hong Kong’s dual reputation in financial markets and cross-border disputes gives it a natural competitive advantage as more and more digital assets and products emerge.

Given Web3’s ability to “own” something on the internet in a decentralised manner, its imminent introduction will only accelerate this trend.

Blockchain technology supports many beneficial innovations, from digital contracts and supply chain tracking to faster traditional banking and the secure sharing of health and property records. But, as digital assets and data move onto the blockchain, legislation, regulation and dispute resolution will have to follow.

Recent crypto events have only heightened nervousness around the security of digital assets.

DeFi still needs reg-fi

Many Web3 pioneers dream of building a fully decentralised world, governed by computer code without any government oversight or intervention. However, as long as we live in a physical world, transactions will still be governed by laws enforced by centralised authorities to secure our data and assets.

The BIS (Bank for International Settlements) has already described this as the ‘DeFi delusion’ – just as lawyers cannot draft a contract that covers every eventuality, it is also impossible to develop code or an algorithm that covers every contingency. When people cannot find solutions from the code, they will still turn to laws and human beings to make decisions and judgments.

However, digital asset businesses are less restrained by geographical locations and can base themselves in any jurisdiction that they consider attractive.  So the race is on amongst financial centres to become the disputes and governance centres of excellence in this new blockchain-enabled world.

Australia, Dubai, Singapore, the UK and the US are already taking credible steps to win this race, but Hong Kong is well placed to compete. The city has already introduced changes to build on its existing reputation and become the global digital legal hub of the Web3 era.

Hong Kong is well placed

The HKMA (Hong Kong Monetary Authority) is developing a CBDC bridge for cross-border transactions, is considering the issue of tokenised green bonds, and is discussing the correct regulatory approach to crypto assets and stablecoins.

The SFC (Securities and Futures Commission) meanwhile has licensed one virtual asset trading platform and granted in-principle approval to another. It has also published guidance on intermediaries’ virtual asset-related activities, and will be tasked with administering Hong Kong’s new licensing regime for virtual asset service providers.

The imminent adoption of outcome-related fee structures for arbitration in Hong Kong will also be attractive to companies involved in virtual asset disputes. These regulatory moves have been well received by the market, and many crypto exchanges and institutions have already chosen Hong Kong as the place to resolve their disputes.

Hong Kong’s close connection with Mainland China offers the city another competitive edge. Despite its crackdown on crypto, China has been developing its own blockchain infrastructure and has chosen Hong Kong as its operating location.

China’s state-backed blockchain network is operated by a Hong Kong company and its terms of service again choose Hong Kong law and provide for arbitration in Hong Kong. In future, this Hong Kong-based network could become the “bridge” between public blockchains such as Ethereum and China’s domestic blockchain network.

Reaping the rewards

But, there is more the city can do to win this race. Legislators and regulators will need to understand new concepts such as DeFi and DAOs, decide whether the current legal regime can accommodate them – and address any underlying risks.

The legal industry profession itself can assist in this process, for instance by building sandboxes – safe and secure online spaces to test innovative legal services such as smart legal contracts. Further digitalisation of court and arbitration proceedings, such as electronic filing and discovery systems, will also serve to advance online dispute resolution.

Hong Kong already has a considerable advantage in this competitive area of innovation. If it can successfully manage the balance between risk and innovation, it could reap the rewards of being the first “safe town” in this Digital Wild West.

Troy Song is an associate at the Hong Kong office of Herbert Smith Freehills, and a member of the firm’s Digital Law Group.

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