Digital Assets: Safety,
Security and Regulation

At HashKey Group, we understand that safety, security and regulation are major concerns for investors. Today we look at some of the risks associated with digital asset investment, and share how HashKey safeguards investors’ assets. We also delve into how regulation will further enhance investor protection and help drive the development of this novel asset class.

Security concerns
Ensuring that your digital assets are protected from cyber threats and malicious attacks is an important aspect of digital asset investment. Whilst the digital assets themselves are highly secure due to their underlying decentralised ledger technology, every year there are still cases where the platforms and exchanges that “store” these assets have been hacked or investors have been defrauded by bad actors. Since then, there have been major advances with reputable firms investing heavily in improving operational and technological security, audits and compliance. That said it remains important for investors to take additional precautions to protect their digital assets.

Digital asset wallet
Digital assets such as Bitcoin and Ethereum exist on the blockchain, a public and decentralised ledger that records and authenticates digital asset transactions. One’s assets can only be accessed using their private keys, a sophisticated form of cryptography that proves ownership and allows one to make transactions. If a user loses their private keys, they lose access to their assets.

 A digital asset wallet is an application that stores the private keys needed to access your digital assets. The security of your digital assets is only as good as the operational and technological controls that govern access to your wallet. The choice of wallet requires some trade-offs between security and convenience – there are two primary forms of digital asset wallets: a hot wallet (those connected to the internet), and a cold wallet (those disconnected). 

In theory, it is possible to have a non-digital wallet. Private keys could be written down on a paper and kept in a safe place. However, this would make it significantly more difficult to access and trade digital assets. A digital alternative to this is a cold storage hardware wallet in which keys are stored on a hard drive or USB device that is only connected to a computer when you wish to access your digital assets. This eliminates the ability of hackers to remotely access your wallet, but this does come at the cost of convenience. Another alternative is an online (warm) wallet. As this is connected to the internet it makes accessing and trading your digital assets more straightforward; however, it is only as secure as the security and authentication protocols that control user access.

Regulation
Against a heightened level of regulatory scrutiny around digital assets, the subject of regulation has become increasingly important for the industry. Existing regulatory frameworks designed for traditional financial markets do not provide clear guidance on the legal foundations required for digital assets to gain mainstream adoption. The rapid development of the industry in recent years has prompted regulators around the world to develop regulatory regimes that can put digital assets on an equal footing with other asset classes. Clearly there is a balance to be struck between facilitating innovation and safeguarding the integrity of the financial system.

At HashKey, we support the implementation of a coherent regulatory framework and robust licensing requirements for the digital asset industry. We believe that regulation is necessary for digital assets to achieve mass adoption and for decentralised financial technologies to become a part of the mainstream global economy.

“Regulation is a key point in the development of digital assets. It is recognition that what started out in 2008 as an experiment has developed into a fully fledged new asset class.”

Angelina Kwan, Senior Advisor to the Board, HashKey Group

In May 2021, the Hong Kong Financial Services and Treasury Bureau (FSTB) published its proposals for the regulation of “virtual asset service providers”. Having provided input into the public consultation earlier in the year, HashKey Group broadly welcomes the proposals and believes that they will enhance investor protections, allowing professional and institutional investors, particularly those with fiduciary responsibilities, to invest with greater confidence.

The call for regulation
In its early days, digital assets, unfortunately, were usually labelled as an environment for illegal activities due to the actions of a few bad actors;  the comparative lack of regulation and the anonymous nature of cryptocurrency transactions didn’t help their case. Increased regulatory action will no doubt allow digital assets to be taken more seriously by institutions and professional investors alike.

The traditional financial sector has rigorous anti-money laundering (AML) and counter-terrorist financing (CTF) requirements. Licensed financial institutions are required to verify and authenticate the identity and suitability of their clients. Whilst many digital asset exchanges and service providers would normally conduct comprehensive KYC checks on prospective clients, this has not always been the case. At HashKey, we welcome the introduction of more stringent and robust requirements around due diligence and record keeping in order to address the risk to financial integrity posed by such unlawful activities, eventually bringing digital assets into line with the broader financial system.

Licensing Requirements
The same principle applies to licensing requirements. Without regulatory oversight and proper operatational licenses, investors would find it hard to adequately assess the credibility and trustworthiness of firms operating in the sector, making it all the more mandatory for the introduction of a licensing regime for all digital asset exchanges and service providers.

Licensed firms are required to meet specific standards around financial stability, risk management, the segregation and management of client assets, financial reporting and disclosures, and the prevention of conflicts of interest. Digital asset brokerages and exchanges provide the financial architecture that underpins the development and mass adoption of digital assets. Regulation and licensing will ensure that the systems and processes that make up that financial architecture are scalable and resilient.

“Regulation is an enormous opportunity for the industry. It’s going to shine a light on how firms are operating, their technology and their processes. And this might come as a shock for some, especially those that maybe don’t have the experience of operating in regulated financial markets. But this is also an opportunity to demonstrate and prove that the industry takes security, resilience and transparency seriously. And I think regulation is how we can win over some of those of investors who at the moment may have some doubts.”

Angelina Kwan, Senior Advisor to the Board, HashKey Group

While regulation is beneficial, there are potential downsides to it. For instance, overly prescriptive regulation may stifle innovation. The underlying technology is developing rapidly, and new use cases are being constantly developed, as epitomised by the rapid rise of tokenising digital art in the form of non-fungible tokens (NFTs). This tokenisation technology has a potentially transformative effect on how financial services are delivered, but that will only be realised if regulatory and legal regimes are aligned to the capabilities of the technology. It is important that regulators and firms such as HashKey work in close partnership to ensure that regulation evolves and adapts, especially given the rapid rate of change.

Conclusion
The pace of how the digital assets industry have evolved since its inception has been remarkable and is a testament to the long-term potential of digital assets and blockchain technology. HashKey’s investment and trading solutions help bring life to the premise that digital assets will become an integral part of any well-diversified investment portfolio. However, for this to be realised, a robust financial architecture for digital assets that can coexist with the traditional financial ecosystem needs to be established. Whilst these asset classes may have different value drivers, there is nothing fundamentally different about trading a digital asset like Bitcoin and trading a security. It is for this reason that HashKey welcomes the transparency and legitimacy that comes with regulation.