Over the past few years, new innovations under the umbrella term of decentralised finance (“DeFi”) has caught the attention of retail investors, financial institutions and regulators alike. DeFi generally refers to financial products and services which are powered by distributed ledger technologies and  provide permissionless peer-to-peer access to users. The DeFi ecosystem is a complex topic which contains numerous sub-topics and concepts in finance, law, data privacy, cryptography and many other realms of knowledge.

One of the largest components of DeFi is decentralized exchanges (“DEXs”). As centralised exchanges and service providers in the virtual assets industry are subject to more and more regulations, and are even prohibited from offering services to retail investors in certain jurisdictions such as Mainland China, it has been suggested that users of centralised exchanges are gradually migrating to DEXs due to lower barriers of entry, speed of product innovation and the preservation of users’ pseudo-anonymity. This article will focus on the relevant considerations when mapping out how DEXs might be regulated.

What are DEXs?

Currently, DEXs vary in terms of the scope of services offered. At its most basic level, DEXs are decentralised applications which allows users to exchange from one virtual asset to another on a peer-to-peer basis. Other DEXs have evolved to offer more services, such as lending and borrowing or a marketplace for non-fungible tokens (NFTs). The term “DEXs” as used in this article will refer to the first kind.

DEXs are non-custodial and therefore users retain control over the virtual assets in their wallets. The lack of a centralized intermediary creates two main implications for DEXs. First, users of DEXs retain control over their virtual assets at all times (as opposed to centralised exchanges having control or access to users’ virtual assets). Second, the matching of buy and sell orders are done via smart contracts, usually through an “automated market maker” commonly known as an“AMM”.

DEXs stakeholders can generally be classified in the following categories:

  • Developers. The developers are the core team which take the lead in developing the DEX. This may be done via the implementation of new features (such as the lending and borrowing of virtual assets or marketplace for non-fungible tokens.)). It is not uncommon for DeFi developers to be anonymous.
  • Liquidity Providers. DEXs utilize a mechanism called an AMM to match buy and sell orders, with the pricing determined by a mathematical formula. Due to the lack of a centralized intermediary and an orderbook for which market makers can provide liquidity, DEXs rely on third parties to provide liquidity. These liquidity providers deposit two or more virtual assets into a liquidity “pool” on a DEX, which facilitates the users’ swapping of virtual assets. A DEX can have numerous liquidity pools, which each being separate and distinct from one another, and the liquidity on one DEX is not accessible by a user of another DEX. Liquidity providers are often rewarded with (i) a portion of the trading fees charged by the DEX in respect of the pool to which the liquidity provider deposited virtual assets; and (ii) a native reward token issued by the DEX (sometimes called a liquidity mining reward).
  • Users. These users are the individuals who use DEXs to carry out a decentralized peer-to-peer exchange of one virtual asset for another virtual asset.
  • DEX Token Holders. Some DEXs issue a native reward token to liquidity providers (and, in some cases, “airdropped” to users of the DEX based on past trading volume and/or other usage metrics). These DEX tokens vary in terms of their structure, but a common feature is that they purport to grant the holder the right to participate in the governance of the DEX. Specifically, holders of DEX tokens are permitted to vote on governance proposals, with such holders’ voting weight pro-rated based on the number of DEX tokens held and the circulating supply of such tokens. Other characteristics of DEX tokens may include entitling the holder to a portion of the trading fees generated by the DEX and being used as a medium of exchange for access to certain services offered by the DEX. As some DEX tokens can be bought and sold on non-native DEXs and centralised exchanges, DEX token holders are not necessarily liquidity providers on the native DEX.

Imagining the Regulatory Framework

Proponents of DeFi assert that DeFi platforms, including DEXs, are unable to be regulated due to the absence of a central party over which regulators would exercise oversight. However, some regulators take the opposite view, being that while some aspects of a DeFi platform may be decentralised, the DeFi platform is still centrally operated and designed by a centralized party. On this basis, they assert that DeFi is not immune to regulation. While it is unclear how DeFi platforms will be regulated across the world, what is clear is that virtual assets are here to stay and DeFi presents a new paradigm for which a considered and thoughtful regulatory approach is required.

Hong Kong’s regulatory approach for DEXs, and more generally virtual assets, is in its developing stages. Currently, the Securities and Futures Commission (“SFC”) maintains an “opt-in” framework for virtual asset trading platforms, whereby operators of such platforms can choose to be subject to the SFC’s supervision by offering at least one virtual asset that satisfies the definition of “securities”. There is also the proposed regulatory framework outlined by the Financial Services and the Treasury Bureau (“FSTB”), which will require any person operating a virtual asset exchange, even if such exchange does not offer any “securities”, to obtain a virtual asset service provider licence from the SFC. With these two frameworks operating in tandem, there will be a licensing requirement for virtual asset trading platforms irrespective of whether “securities” are available for trading.

However, neither of these frameworks appear to be appropriate for DEXs. The SFC has indicated that it would not accept licensing applications from platforms which only provide a direct peer-to-peer marketplace for transactions by users who typically retain control over their assets. The FSTB has similarly carved out peer-to-peer trading platforms from its proposed regulatory regime. However, if DEXs continue to grow in popularity, regulators will eventually need to consider regulating DEXs as well. In this case, what would that regulatory regime look like?

  • Which regulator(s) should assert jurisdiction? A key difficulty in regulating DEXs would be in determining which regulator(s) should assert jurisdiction over the intended licence holder. In particular, the decentralized nature of DEXs means that it is not operated in any one single jurisdiction, and those that assume control or responsibility over the day-to-day operations of a DEX are often based in multiple jurisdictions. It would obviously be impracticable for multiple regulators to exercise supervision over the same DEX, particularly in light of the varying standards and requirements applied by regulators.
  • Who is/are the stakeholder(s) which should be licensed? Another pertinent question is who should be the licence holder(s)? Based on our description , it may be tempting to conclude that the obligation should fall on the developers. However, there are several difficulties with this position. First, the developers may be anonymous, which poses practical issues relating to enforcement. Second, since a DEX is essentially a series of smart contracts on the blockchain which can exist independently of any additional input from the developers once it is launched, it is unclear what the regulatory position will be if the developers step down from their roles. Lastly, the SFC does not typically require technology staff from “traditional” licensed corporations to hold any licences. It would therefore be a deviation from the SFC’s “technology neutral” approach to adopt a different stance in respect of DEXs.
  • How can a platform be regulated? As the DEX exists on the blockchain as a series of smart contracts, there are practical difficulties with how it could be regulated. For example, due to the nature of smart contracts, it may not be possible to amend the logic of an already-deployed smart contract. Instead, a new smart contract would need to be written and deployed onto the blockchain, but there is no guarantee that liquidity providers or users would adopt and use the new smart contract. Other regulatory requirements that apply to licensed corporations, such as the requirement to conduct customer due diligence and maintain a certain level of regulatory capital, would likely also encounter practical difficulties.

As illustrated, there are a number of difficulties in fitting a novel concept such as DEXs into existing regulatory regimes. The topic is made even more complex due to the law in this area being unsettled, the speed of innovation in DeFi and the lack of consensus among regulators and legislators as to how virtual assets should be approached generally. However, we are optimistic that an appropriate regulatory regime – one that can safeguard investors and foster continued innovation – can be crafted to allow society as a whole to enjoy the benefits of DEXs and DeFi generally. Approaches such as the Safe Harbor Proposal put forward by Hester Peirce, Commissioner of the United States Securities and Exchange Commission would be an appropriate (and welcomed) starting point.

To discuss how Hong Kong’s regulatory approach to DEXs, DeFi and virtual assets might affect you and how we can assist, please contact Kristi Swartz, Alan Lee, or Winson Lau.