This article first appeared in Personal Wealth, The Edge Malaysia Weekly on February 25, 2019 - March 3, 2019

Financial planners welcome the Securities Commission Malaysia’s (SC) decision to amend its Guidelines on Recognised Markets and introduce new requirements for electronic platforms that facilitate the trading of digital assets such as bitcoin and ethereum. The new regulations require digital asset exchange (DAX) operators to be registered with the regulator and meet its standards and requirements in their role as recognised market operators (RMOs).

According to Felix Neoh, director of products and advisory at Wealth Vantage Advisory Sdn Bhd, this allows digital assets to be assessed in the same way as other investments in Malaysia. “We do not want our Malaysian clients to be victims of what happened to cryptocurrency investors in other parts of the world, such as the now-bankrupt Mt Gox bitcoin exchange and Canada’s leading cryptocurrency exchange QuadrigaCX, which has been unable to access its funds since its founder died. With the enforcement of the new guidelines, our hope is that cryptocurrency investing will become a safer asset class available to Malaysians,” he says.

Bryan Zeng, general manager of FA Advisory Sdn Bhd, says he is excited that the SC has started to regulate DAX operators. He points out that this is a big step towards bringing digital assets into the mainstream.

“One of the SC’s main functions is investor protection. Clearly, the new guidelines provide oversight and accountability to ensure market integrity,” he adds.

“The main criteria for a successful marketplace is trust. When one deals in a marketplace, one would expect all counterparties in the deal to carry out their obligations and not default. If any party reneges on its obligations, there should be punitive actions taken against it to maintain market integrity. When there is trust and order in the marketplace, it will encourage growth.”

On Jan 31, the SC released a statement saying that any party interested in operating a digital asset platform is required to apply by March 1 to be registered as an RMO. This was part of the SC’s efforts to promote innovation while ensuring investor protection in the trading of digital assets, said SC chairman Datuk Syed Zaid Albar in the statement.

According to the amended guidelines, market operators must actively safeguard clients’ interests by maintaining up-to-date records of investors and the money and digital assets held, segregating trust accounts that receive money from and pay to licensed financial institutions and making arrangements to protect against risks, loss and theft, among others.

The SC previously announced that operators would not be permitted to accept new investors before March 1 and would only be allowed to facilitate the withdrawal of client assets with the written instructions of the investor. While the framework for DAX operators has been released, the SC has yet to introduce regulations for initial coin offerings (ICOs).

Nevertheless, despite the stricter regulations, financial planners say they are currently not recommending cryptocurrency investments to their investors. MyFP Services Sdn Bhd managing director Robert Foo says he has been getting inquiries from his clients about adding digital currencies to their portfolios. But he is not recommending this asset class due to the lack of information on its value-add in one’s portfolio over the long term.

“We are part of the financial market industry and profession, we need to understand cryptocurrencies and distributed ledger technology. However, I would still advise my clients to invest in something that provides them with real consistent returns,” says Foo.

Zeng says the cryptocurrency market is largely speculative at the moment and there is no hard evidence that these assets will be beneficial to one’s portfolio. In fact, they may have an adverse effect due to the unpredictable huge swings in prices, he adds.

Neoh concurs. He thinks it is premature to consider cryptocurrencies as an investment asset class at this juncture. “Anyone who is looking to invest in cryptocurrencies needs to be prepared for the following: price volatility, technology risks associated with hacking or loss of security keys, the impact of regulations and future changes, holding the investment for the long term and losing it all,” he says.

If investors still insist on investing in digital currencies, Neoh suggests that they only allocate a small percentage (1% to 2%) of their investable assets or an amount they can afford to lose without having a negative impact on their financial position. “My best advice now is for investors to increase their knowledge and understanding of blockchain and cryptocurrencies so they will be in a better position to decide whether these currencies will be a suitable asset class for them in the future,” he says.

Reflections on the new guidelines

From an industry player’s perspective, while the new regulations are a welcome move, there is still room for improvement.

As a victim of the Mt Gox hack himself, Vardiz Commerce Sdn Bhd CEO Affendi Ariffin learnt early on the hard lesson of how important it is to regulate DAX operators. Regulations are needed to address the concerns of investors such as the authentication, authorisation and confidentiality limitations of cryptocurrency transactions, he says.

The former investment banker currently runs a company that provides investors with professional courses and over-the-counter bitcoin brokerage services. The company’s pipeline includes plans to introduce a bitcoin-to-ringgit exchange as well as custodian and merchant tools for cryptocurrencies.   

While Affendi is a proponent of stricter regulations, he has some thoughts on the new guidelines. First, he thinks that they bear a lot of similarities to the New York State Department of Financial Services’ BitLicense that was introduced in 2015. Heavily opposed by the cryptocurrency community in its early days, the licence has been awarded to fewer than 20 companies thus far.

The SC requires DAX operators to be locally incorporated and have a minimum paid-up capital of RM5 million. Affendi points out that Coinbase, one of the largest DAX operators in the world today, started with a seed round funding of US$600,000 in 2012, which is less than RM3 million. Back then, the company only had a minimum viable product and a small pool of users. So, he thinks this is an arbitrary barrier that could dissuade those who are genuinely interested from trying.

Additionally, the SC states that DAX operators can only allow investors to trade digital assets hosted on its platform in ringgit or a foreign currency that is recognised as legal tender. That means only fiat-to-digital-asset pairs are allowed, eliminating the option to start a cryptocurrency-to-cryptocurrency exchange out of Malaysia, says Affendi.

To safeguard investor interests, the SC requires DAX operators to establish and maintain one or more trust accounts in a licensed Malaysian financial institution. Affendi points out that this may not be as easy as it sounds. He gives a personal example of he opened a local bank account after Vardiz officially became one of the Reporting Institutions dealing with digital currencies declared to Bank Negara Malaysia.

He says the account lasted only 20 days before it was terminated for what he describes as a small offence. “If we cannot get a bank account for payroll, how will we — or any other operator for that matter — get a trust account?

“Back then, we submitted a complaint to Bank Negara, the Association of Banks in Malaysia and the Ministry of Finance. We did not receive a single response. When we visited the central bank, we were informed that it does not interfere with the decisions of individual banks regarding whether or not they want to maintain a relationship with us.

“We understood and moved on. But think about it. There are more than 6,000 banks in the US and only a handful are cryptocurrency-friendly. In Malaysia, there are 27 banks. What is the hit rate? We need at least one to spur the growth of the ecosystem. We need a banking partner.”

Affendi says the guidelines are currently missing the requirement for DAX operators to operate on full reserve, which disallows clients’ digital assets to be repurposed for other business objectives. In fact, he has heard of operators in China and Hong Kong repurposing their clients’ assets for other purposes.

“Let’s look at how Bursa Malaysia functions. Investors have a fiat account that holds their ringgit and a Central Depository System account that holds their stocks. At no point in time can Bursa take the clients’ assets for its other business objectives,” says Affendi.

“While it is mentioned that DAX operators need a trust account with a bank, which solves the custody problem for fiat, the custody for full reserve of the digital assets is not mentioned anywhere.”

Having said that, the SC does require DAX operators to establish and maintain a sufficiently and verifiably secure storage medium designated to hold the digital assets of investors and make arrangements for or implement processes to protect against the risk of loss, theft or hacking.

The regulator also requires DAX operators to have adequate arrangements and processes to manage excessive market volatility, which may include circuit breakers, price limits and trading halts. Affendi does not think this is a good idea.

“Bitcoin-to-fiat pairs, for example, exist in many markets, not just Malaysia. We should depend on intra-exchange arbitrage by market makers to manage volatility, not artificial intervention. If the spread between our DAX operators and foreign markets becomes too high, it will affect our credibility and isolate us,” he says.

As RMOs, DAX operators have to adhere to the same know-your-customer (KYC) requirements as equity crowdfunding and peer-to-peer financing platform operators. This means they will need to have processes to monitor any potential money laundering or terrorism financing, including adequate investor onboarding arrangements and procedures.

While this has led to positive outcomes — for example, the arrest of Alexander Vinnik, the operator of BTC-e, an exchange that allegedly laundered more than US$4 billion for criminals involved in activities such as computer hacking and drug trafficking — Affendi suggests implementing KYC thresholds that are currently used by Coinbase and other exchanges.  

“Although it does not sound like it, sign-up friction [when the sign-up process is tedious] is a real hurdle. That is why I think there should be levels of verification — the more activity you want to do, the more information you have to give,” he says.

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