The most common questions about virtual assets, and their answers

With its price volatility and hectic pace of innovation, one can often hear people chat about virtual assets, in the news as well as in life. But how much do you personally know about the space? In this article, we've compiled some of the most frequently asked questions about virtual assets — with their answers. Mastering these questions will make sure you're equipped to talk about the topic knowledgeably and, maybe, start dipping your toes!

We've broken down the questions into four parts, covering:

• Questions about the very basics of virtual assets

• Questions about the risks virtual assets involve

• Questions about how virtual assets are regulated

• More advanced questions about how virtual assets and the blockchain works

Virtual assets: the very basics

What are virtual assets?

Virtual assets — or virtual currency — use cryptography to secure transactions and control the creation of additional units of the currency. They typically operate independently of central authorities like banks or governments. Most virtual assets are decentralized, meaning no single entity controls or administers the network.

What's Bitcoin (BTC)?

The most well-known virtual asset is Bitcoin, which was created in 2009 as an open-source project by an unknown individual or group of individuals under the pseudonym Satoshi Nakamoto.

Bitcoin operates on a peer-to-peer network and transactions are verified and recorded on a decentralized ledger called a blockchain. Cryptographic keys secure transactions, and the supply of Bitcoins is limited and controlled through a process called mining.

The smallest unit of a dollar is called a cent. What's the smallest unit of Bitcoin called?

Bitcoin (BTC) was the first virtual asset to ever be created, and is now the largest by market cap. You can find it on almost any digital currency exchange. One challenge with Bitcoin is that 1 BTC costs a lot of money, therefore very few people can afford to buy a whole Bitcoin.

Luckily, they don’t have to, as Bitcoin can be broken down into smaller units. Similar to how the U.S. dollar has a cent, Bitcoin has a satoshi — its smallest unit.

What is a satoshi?

A satoshi is the smallest unit of Bitcoin. It represents one-hundred-millionth of 1 BTC, and it was named after the mysterious creator of the Bitcoin protocol, Satoshi Nakamoto. Obviously, when Bitcoin first appeared, it didn’t need a smaller denomination of its currency. In the early days of Bitcoin, the price of BTC was measured in cents. However, these days, when each BTC costs thousands of dollars, it's very useful to divide it into satoshis.

Fortunately, even with Bitcoin’s massive price appreciation, satoshis are still very affordable for virtual asset users. In fact, even if the BTC price reached $1 million per coin, 1 satoshi would still only cost $0.01.

However, a whole Bitcoin is still too expensive for most traders. Because of that, satoshis come in quite handy, as they allow everyone to still use portions of BTC. Otherwise, Bitcoin would simply not be affordable for anyone other than wealthy and institutional investors.

How does the satoshi work?

Given that a satoshi is just a small amount of Bitcoin, it behaves exactly like BTC. It runs on Bitcoin’s decentralized network, and can be used for Bitcoin transactions, payments, trading, and alike. Sometimes, people don’t even use the name satoshi, but instead they say the amount in BTC.

For example, if you were to buy $250 worth of BTC, you can say that in two ways. You can refer to it as 0.00347089 BTC (based on the price at the time of writing). Alternatively, you can just say 347,089 satoshis. It means the same thing, and it's entirely up to the user to choose how to explain this amount. On exchanges, you'll have to type it as the value of Bitcoin, since satoshi isn't officially supported.

What are some other virtual assets?

There are many other virtual assets in addition to Bitcoin, each with its own unique features and use cases. Some popular examples include Ethereum (ETH), which uses smart contracts to build decentralized applications, Uniswap (UNI), and more.

What are the benefits of virtual assets?

Most virtual assets are decentralized, meaning they're usually not controlled by a central authority. This decentralization can provide a level of freedom that's not always possible with traditional currencies.

What are the risks of virtual assets?

It's important to note that virtual assets carry risks. The market can be highly volatile, and the value of virtual assets can fluctuate significantly over short periods of time. There's also the risk of potential fraud and legal uncertainty in certain jurisdictions.

What is a stablecoin?

Stablecoins are virtual assets that are intended to hold their value over time. They're often linked to the value of major currencies like the U.S. dollar, a combination of currencies (called a basket), or a real-life commodity. Stablecoins aim to offer a substitute for the high volatility of most widely used virtual assets, such as Bitcoin.

Stablecoin advantages

Stablecoins offer several advantages compared to conventional fiat currencies and virtual assets like Bitcoin. These advantages include:

• Price stability: Price stability is essential for traders. Virtual assets like Bitcoin and Ethereum experience significant volatility, sometimes minute-by-minute. A more stable asset assures traders that the value of their tokens won't rise or crash sharply in the near future.

• Cheap and fast transfer: Blockchain-based currencies cross boundaries with more speed than payments made through commercial bank networks. Stablecoins can be a fantastic option for sending money worldwide because of their quick processing times and low transaction costs.

• Hedge against inflation: Stablecoins are considered by some to be suitable for fighting inflation due to their unchanging, unconstrained nature. For people who want to keep their money's worth while still being able to transact regularly, stablecoins may be the solution.

How stablecoins are used

Stablecoins are intended to solve the volatility problem that plagues many mainstream virtual assets. The coins therefore have a variety of uses.

• Medium of exchange: The main benefit of stablecoin technology is its use as a medium of exchange. This efficiently bridges the gap between fiat and virtual assets. Many retailers will accept stablecoins in return for goods and services, just like they do with fiat currency.

• Store of value: Stablecoins are intrinsically stable assets, making them an ideal store of value. As a result, they're often used to complete regular transactions. Stablecoins also increase the mobility of virtual assets across the network.

• Used with smart contracts: Stablecoins can be used with smart contracts — an electronic contract that automatically executes when all of its conditions are met. The currency's stability also aids in avoiding disputes that could develop when dealing with more volatile assets.

Stablecoins: integral to the virtual asset markets

As Bitcoin becomes more known and accepted by individuals and institutions, there's an increasing demand for simpler, less volatile, and easily understood currencies. Despite not being perfect solutions, stablecoins have been embraced and backed by some of the biggest institutions in the world. And, they can offer a haven for virtual asset traders.

Stablecoins may appear to be low-risk, but they're not. A stablecoin may experience a run-on-the-bank kind of experience and lose the peg to its target currency — if it isn't sufficiently supported by hard assets — particularly cash.

That's what happened to the algorithmic stablecoin TerraUSD in 2022, since it wasn't backed by cash but rather by other virtual assets. As users lost faith in the stablecoin's capacity to uphold the peg, its price collapsed.

Stablecoins still make up less than 10% of the whole market for virtual assets. Despite their market cap rising from just under $23 billion in early 2021 to about $129 billion in late 2023. However, they've become an important part of the ecosystem due to their regular use in virtual asset trading.

What is a blockchain?

A blockchain is a database structure consisting of one "block" after another. Each block stores a specific amount of data. The blocks are connected to form a chain structure according to the generation order, which creates a "chain of blocks" — hence the name blockchain.

Unlike traditional databases, blockchains generally have the following core features: decentralization, difficulty to corrupt, and transparency.

Why are blockchains decentralized?

The blockchain system is maintained by many servers together. Each server involved in maintenance stores a copy of all the data on a blockchain. Data on the blockchain won't be lost as long as one server is still operating. These servers are called "nodes" in the blockchain system, providing storage space and computing support for the whole system.

If someone wants to record some new data in the blockchain system, all nodes must agree on it. If more than half of them agree, they'll record it together. In contrast, the nodes of a blockchain are usually run by different entities not connected outside the blockchain system. We can therefore assume that a blockchain isn't run by a single individual or entity but is maintained by multiple parties, often referred to as the core feature of the blockchain: decentralization.

Why is data on a blockchain difficult to corrupt?

An encryption algorithm connects two adjacent blocks in the blockchain system. Specifically, the data in the previous block will be encrypted into a cryptographic digest and recorded in the next block. Each block is generated by relying on the data recorded in the last block, forming a chain. Therefore, once data is recorded in a block, it's continuously encrypted and passed on to each subsequent block as a digest.

If someone wants to corrupt the data in a historical block, it'll cause the data in all subsequent blocks to be changed. However, since all nodes have recorded all subsequent blocks, all nodes would need to modify it, which would require the consent of more than half of all nodes. Nodes in the network will consider the act of data corruption evil and won't agree to it.

Why is the blockchain system open and transparent?

The technical foundation of blockchain is open source, and the data in a blockchain is available to anyone. Everyone can query the data in a blockchain through the open interface and develop related applications, so the whole blockchain system is open and transparent.

What are the components of a wallet?

Understanding the relationship and functionality of seed phrases, private keys, and public keys is essential for effectively managing and securing virtual assets within a wallet. But what exactly are the components of a wallet, and what function do they hold?

Seed phrase

The seed phrase, also known as a mnemonic, recovery phrase, or backup phrase, serves as a master key to the wallet's private keys. Typically consisting of 12 to 24 words, the seed phrase enables the recovery of a virtual asset wallet's private keys. This recovery is possible if the initial generation of private keys was done using the same seed phrase. The seed phrase allows for the generation of an unlimited number of virtual asset accounts with the same set of seed words.

Private keys

You may have heard the phrase “not your keys, not your coins” uttered in the industry before. The keys being referred to here are private keys. These keys act as variables within algorithms, enabling the encryption and decryption of data. Typically, private keys are represented as strings of alphanumeric characters. By successfully signing a specific message with the private key, individuals can demonstrate their ownership of a particular blockchain address, verifying their control over the associated account.

In the simplest terms, private keys are like your virtual asset passwords — and anyone in control of them may control your coins or tokens. Because of this, you must always keep your private keys as confidential as possible.

Public addresses allow anyone to deposit coins or tokens to the very same public address, but withdrawals can only be made using a single unique private key. To draw an analogy, addresses are like locked mailboxes. Anyone can drop a letter into the mailbox, but only a unique private key can be used to unlock the same mailbox.

Public key

The public key plays a crucial role, functioning as an address where anyone can send virtual asset transactions, much like a bank account number used for routing deposits. Public keys are derived from private keys through asymmetric algorithms, which create a matching pair of keys.

The public key is employed for the encryption of messages, while the private key is used for its decryption. This makes sure that only the intended recipient, holding the corresponding private key, can decipher and access the contents of the message. This maintains secure communication within the virtual asset ecosystem.

The connection between seed phrase, private key, and public key:

• Private keys, similar to passwords or access keys, provide access to specific public keys, much like email addresses associated with different accounts.

• The seed phrase acts as a means of retrieving multiple private keys/passwords, akin to secret questions/answers used to recover access to a wallet.

What are custodial and non-custodial wallets?

Custodial wallets and non-custodial wallets represent two distinct approaches to wallet management. A wallet is used by traders to store and transfer their virtual assets.

Custodial wallets: convenience at the cost of control

Custodial wallets involve a third-party controlling the private keys for users. These wallets are often provided by centralized exchanges, offering users a convenient and user-friendly experience. While custodial wallets simplify the management and trading of virtual assets through password-based access, users must trust the custodian with the security and integrity of their assets.

Non-custodial wallets: taking control of your virtual assets

Non-custodial wallets, on the other hand, grant users complete control over their private keys. Private key signing is performed offline within hardware wallets, providing enhanced security. Non-custodial wallets are governed by smart contracts and enable individuals to maintain full ownership and sovereignty over their virtual assets.

What are hot and cold wallets?

Any wallet to which the private key has been previously entered or generated on an online device is considered a hot wallet. It's “hot” because these wallets are typically much more actively used due to internet connectivity. While they're convenient, access to the web also means that sophisticated malware such as a keylogger or simply the theft of the device could compromise the private key.

By contrast, the key pair of a cold wallet is generated entirely offline, and as soon as you enter it into an online device, the wallet can no longer be considered cold. For these reasons, cold wallets — when created properly — offer a much higher degree of security than hot wallets. If the private key has never been on a device that’s connected to the internet, it’s safe from the kind of online attacks that threaten hot wallets.

That said, a cold wallet is generally less convenient for day-to-day spending than a hot wallet. Authorizing any transaction requires a digital signature constructed using the private key to be submitted to the network. Therefore, to remain cold, the wallet must have some secure environment that's always offline to sign transactions. Alternatively, to maintain the security benefits of cold storage, the user must send the wallet’s remaining contents to a new offline key pair after making their initial spend.

Importantly, any cold wallet can become a hot wallet by entering the private key into an online device. However, no hot wallet can ever become a cold wallet, as its private key has already been on an online device.

What are software and hardware wallets?

Software wallets

Software wallets are cryptographic key management programs that you can install on a mobile phone or computer. The software itself will generate a private and public key on your behalf, and you can start using them within minutes. Because software wallets usually generate keys on an online device, they're almost always considered hot wallets. This means they're ill-suited for long-term storage of high-value virtual assets. That said, a software wallet on your mobile phone or computer is much more convenient for making regular, smaller transactions than a completely cold storage solution.

Hardware wallets

Hardware wallets are small devices that feature a secure offline environment in which private keys are generated and transactions are signed. Because using a hardware wallet means you never need to enter the private key on an online device, it's recommended for virtual asset users who want to protect sizable funds as well as for long-term holders. Such devices provide user-friendly, secure cold storage and often support multiple virtual assets.

What is a centralized exchange?

A centralized virtual asset exchange, or CEX, is an online trading platform. As the name suggests, a trading platform of this kind is centralized. This means it's operated and managed by a centralized authority — usually by the company that created it.

How does a centralized exchange work?

A CEX is fairly simple to use and applies similar sign-up practices as used within traditional finance. These platforms require you to open an account, verify your identity, and deposit some funds. Once this process is complete, you're free to trade.

What services can a centralized exchange offer?

A CEX plays several primary roles regarding virtual asset trading. This includes order matching, custody, and acting as a clearing counterparty.

When you want to buy virtual assets, you submit a buy order. If you want to sell virtual assets, you submit a sell order. The orders get stored in the order book, where they wait for a match. If someone offers to sell the same amount that you are buying, the system will match your orders.

Next, we have the exchange’s role as a clearing counterparty. This role helps protect a user's privacy and identity by matching orders against the exchange. Users are technically purchasing virtual assets from other users. However, to protect user identity, the transaction is marked against the exchange, as opposed to the user.

Lastly, CEXs also play the role of a custodian for both cash and virtual assets. Once you deposit money into your account, it's being kept safe by the exchange. Therefore, the money is in its custody. After you buy virtual assets, they're stored in your portion of the exchange’s wallet. Until you withdraw it to a private wallet, these coins and tokens are also in the exchange’s custody.

How can I effectively protect my assets?

Two-factor authentication (2FA)

You might not have realized but most of us regularly use two-factor authentication (2FA) online. It's widely used to protect the data of your online accounts. The most common form of two-factor authentication is when you log into your account and you receive a one-time security code via SMS on your registered phone. This better protects your account because you need both a password and your phone to log in.

Google Authenticator

A more secure way to protect your assets is by using the Google Authenticator. The tool scans barcodes on participating websites to create 2FA codes that serve as a second level of protection when users log in, keeping their account safer. The benefits of Google Authenticator, besides not requiring an SMS message that can be hijacked, are that you have all the codes you need in a central location, and they’re available all of the time, even when your phone is offline.

Remember: there's no such thing as being too vigilant. Although no security product can claim to be perfectly safe, it’s good to be extra vigilant (especially when dealing with virtual assets), so your assets are kept out of reach of scammers.

Understanding the risks of virtual assets

What does custody mean in the context of virtual assets?

Custody in the context of virtual assets refers to a virtual asset management solution that supports the safe storage and security of sizable holdings. Like financial institutions that secure your traditional monetary assets, virtual asset custodial services protect your holdings from theft and unauthorized access.

Virtual asset custody involves the secure storage and management of coins or tokens while safeguarding private keys — the indispensable components of virtual asset wallets. These intricate alphanumeric combinations serve as cryptographic passwords, granting access to an individual’s virtual asset holdings.

Public keys, meanwhile, are alphanumeric codes designed to streamline the process of receiving funds from others. They can be likened to a bank account number, email address, or username, as they can be shared with anyone.

Unlike their traditional counterparts, virtual asset custodians don’t technically store the assets themselves. Instead, they serve as guardians of users’ private keys. This evolution underscores a profound shift from securing physical assets to prioritizing the protection of cryptographic keys on a blockchain’s transparent ledger.

What are the different types of virtual asset custody storage solutions?

Self-custody

Self-custody, often termed “non-custodial,” grants individuals absolute control over their virtual assets by allowing them to manage their private keys personally. This method's primary advantage is the unparalleled level of control provided, which removes the reliance on a third party.

However, this autonomy comes with a critical caveat — if you lose your private keys, you lose access to your assets without the possibility of recovery. Misplacing private keys, akin to losing a physical wallet, means no recovery option, and funds become irretrievable.

Partial custody

Partial custody, often called “shared custody,” bridges the gap between independent self-custody and complete reliance on third-party custodians. Within this framework, users are responsible for securing their assets with a trusted third-party, typically a virtual asset custody service provider.

This collaborative setup grants the user and the custodian access to private keys, providing a safety net for potential key loss by enabling asset recovery through the custodian. However, this arrangement also introduces a potential risk factor. If the custodian’s security measures are compromised, it threatens the safety of the user’s assets.

Third-party custody

Third-party custodians involve service providers that assume the responsibility of storing virtual assets on behalf of users. Ideal for institutional virtual asset custody, this approach offers institutional-grade security, insurance, and flexibility.

However, entrusting private keys to a third party brings with it some key considerations. Users enjoy ease of access but relinquish control, facing potential transaction limitations. In certain instances, third-party custodians may limit transactions, freeze funds, or block access to virtual asset wallets — actions that international regulators may influence. Additionally, there's the risk of losing funds if the custodian goes bankrupt.

What are the common risks associated with virtual assets?

There are several risks associated with buying or holding virtual assets. Some of the most significant risks are:

Liquidity risk

Virtual asset markets can be illiquid, meaning it can be difficult to buy or sell large amounts of a particular asset quickly. Because pairs can be created arbitrarily and their liquidity doesn't have a minimum limit, this can make it hard to exit a position or realize gains.

Regulatory risk

Virtual assets are still a relatively new asset class. Governments around the world are beginning to develop regulations, but the rules are still evolving, and it's unclear how they'll affect the market in the long term.

Volatility risk (specific risk / alpha risk)

Due to the lack of liquidity (small market size), regulation, trading hours (24x7), and price limits (no limit up or down), the price volatility of virtual assets can be extremely high. This volatility can lead to rapid depreciation of holdings, especially for some memecoins, whose lifespan may end in just a few hours (from skyrocketing prices hundreds of times over to zero) due to severe illiquidity.

Market risk (systematic risk / beta risk)

The overall market sentiment can affect the price of virtual assets. Bitcoin and Ethereum are the benchmarks of the market for now, holding the number one and two positions respectively for total market cap. Global financial policies, regulatory news, and negative reports may lead to a decline in demand, which can then cause a drop in virtual asset prices.

Wallet security risk

Virtual assets are stored in digital wallets, which can be vulnerable to hacking, theft, and other forms of cybercrime. If your wallet is compromised, you could lose all your funds.

It's important to understand these risks and do your own research (DYOR) before trading virtual assets. Additionally, you should always use secure digital wallets and employ good security practices to minimize the risk of loss due to hacking or theft.

What's the risk associated with trading on a virtual asset exchange that isn't regulated in Hong Kong by SFC?

Starting from June 1, 2023, all centralized virtual asset trading platforms operating in Hong Kong or actively marketing their services to Hong Kong traders must be licensed and regulated by the Securities and Futures Commission (SFC). Traders can refer to the SFC's "list of licensed virtual asset trading platforms" to identify platforms that have been officially licensed by the SFC. However, it's important to note that most virtual asset trading platforms currently available to the public aren't regulated by the SFC. Traders should exercise caution and be aware of the risks associated with unlicensed and overseas virtual asset trading platforms.

Unprotected when trading on unregulated platforms

Trading on unregulated platforms exposes users to potential high risks. These platforms may lack transparency and have less-established operations, leaving users with little or no protection. For instance, many platforms may include disclaimers to absolve themselves of responsibility in the event of losses to traders' virtual assets. In the case of disputes between users and such platforms, there may be no proper channels to address complaints, and the SFC may not be able to provide assistance. If these platforms wind up, cease operations, or experience instances of fraud, breaches, or theft, users may face complete loss of their virtual assets held on these platforms.

Meanwhile, some platforms may claim to have submitted license applications to the SFC. It's crucial to understand that applicants without a valid SFC license may not comply with the SFC's regulatory requirements, and their applications don't guarantee approval from the SFC.

Risks of overseas platforms

Users should also be aware of the risks associated with overseas platforms. While some platforms may be licensed or registered with regulators in other jurisdictions, it's important to note that certain jurisdictions may have a lenient regulatory approach, lacking user protection measures. Additionally, due to the cross-border nature of these platforms, lodging complaints or seeking assistance overseas can be challenging when disputes arise. If trading platforms close down or cease operations, users may face difficulties in submitting claims and seeking legal remedies. If these trading platforms have no connection to Hong Kong, the Hong Kong Police and SFC may be unable to provide assistance. Users should remain vigilant as fraudulent platforms may falsely claim to hold overseas licenses to gain trust.

What is market volatility?

One of the biggest risks associated with virtual asset trading is market volatility. Virtual asset prices can fluctuate wildly and rapidly, making it difficult to predict the future value of your positions. This can lead to significant losses if the market takes a turn for the worse.

For example, in December 2017, Bitcoin reached an all-time high of nearly $20,000, only to drop to around $3,000 just one year later. This level of volatility can be a major challenge for traders. It's important to understand that virtual asset markets could be speculative and influenced by a variety of factors, such as regulatory changes, news events, and market sentiment. These factors can make it difficult to predict the future value of your funds and increase the risk of losses.

Strategies to manage market volatility

Despite the risks associated with market volatility, there are tactics you can use to manage risk and potentially minimize losses. Some of these tactics include:

• Educating yourself

Before you start trading, it's important to educate yourself on the virtual asset market and the different coins and tokens available. This will help you to understand market trends and signals and make more informed trading decisions.

• Diversifying your portfolio

Diversifying your portfolio by trading a variety of coins and tokens can help to reduce the risk of losses. This way, if one coin performs poorly, your overall portfolio may still be protected.

• Using take profit and stop-loss (TP/SL) orders

TP/SL orders can help to limit your losses or take profit by automatically selling your positions when they reach a certain price.

• Don't chase quick gains

Don't let the potential for quick gains cloud your judgment. It's important to stick to your trading strategy and not to make impulsive decisions based on the potential for short-term earnings.

What's the best way to approach virtual asset trading to minimize the risk of losing your money?

While different individuals may opt for various trading products, the fundamental principle remains the same: consider your objectives, time horizon, and risk tolerance, and then proceed with asset allocation and the selection of suitable trading products.

Evaluate your risk appetite carefully

It's crucial to thoroughly evaluate your risk tolerance, particularly when it comes to virtual assets. Looking at the historical price volatility of virtual assets, it's no surprise that they're considered high-risk. For instance, Bitcoin encountered two significant downturns between 2017 and 2022, experiencing drops of over 80% from December 2017 to December 2018, and 70% from November 2021 to November 2022, respectively. Other virtual assets exhibit even higher volatility than Bitcoin, with some recording total losses.

Virtual assets generally lack physical asset backing, making them highly speculative and sensitive to market news and rumors. A single social media post can trigger significant price fluctuations within a short period. Therefore, traders should carefully consider whether they can tolerate potential substantial losses before venturing into virtual asset exposure.

Avoid YOLO and FOMO

YOLO, "you only live once", implies that individuals dedicate themselves to pursuing the greatest returns since everybody only lives once. Meanwhile, FOMO, or "fear of missing out", manifests when people speculate on virtual assets out of fear of missing opportunities. Virtual assets are innovative products that have experienced substantial price increases in the past.

Coupled with market sentiment, many become overly fixated on the upside potential, disregarding the true nature and risks associated with virtual assets. If traders blindly follow the crowd without comprehending the products before committing their funds, it's akin to gambling.

The importance of DYOR

Herd mentality and trading something you don't understand are common financial pitfalls. That's why it's crucial to DYOR — "do your own research". The term holds two meanings.

Firstly, before trading any virtual asset, you should thoroughly comprehend its nature, operations, and risks. Virtual assets come in different forms, each with distinct features and risks. So, it's important to have a comprehensive understanding of the product before making financial decisions.

Secondly, in the era of social media, numerous sources offer trading advice, analysis, and news about virtual assets. DYOR also entails not blindly succumbing to hype. Always conduct your own research, think independently, and exercise critical judgment.

What's the potential impact of an exchange becoming insolvent?

One of the main drawbacks of virtual assets is the risk of loss, especially when your coins are held by a virtual asset company. This risk became even more apparent in November 2022 when FTX, a prominent centralized exchange, experienced a significant liquidity crisis and filed for Chapter 11 bankruptcy. Similarly, in July 2022, two major virtual asset trading platforms, Voyager and Celsius, also declared bankruptcy.

Bankruptcies leave traders unable to withdraw

The bankruptcies of these companies left virtual asset traders unable to withdraw their funds. Voyager filed for Chapter 11 bankruptcy protection on July 1, 2022. While the company stated that users should expect to have their U.S. dollar deposits returned, it couldn't provide clarity on the portion of virtual asset holdings that would be returned. On the other hand, Celsius Network, a large virtual asset lending platform, filed for bankruptcy protection on July 13, 2022, following a month-long suspension of all withdrawals, swaps, and transfers between customer accounts.

Virtual assets aren't insured

It's crucial for traders to understand that virtual assets aren't insured by any government agency. Unlike traditional banks, where funds are insured up to certain limits, if a virtual asset exchange goes out of business, users aren't guaranteed any reimbursement from the government.

Who gets priority during a bankruptcy?

During a bankruptcy proceeding, priority is typically given to secured creditors for initial payments. Once these obligations are fulfilled, remaining funds are used to repay debts owed to unsecured creditors. Unfortunately, traders are often among the last in line when it comes to recovering their assets.

When the pool of assets available for distribution to individual traders is determined, everyone is notified of their pro-rata share. For instance, if a company owes $100 million to customers and has $90 million remaining after paying off debts, customers would receive approximately 90% of their deposits as a proportionate share.

How can users reduce their risk when doing business with a centralized exchange?

Read on for tips for trading through a centralized exchange:

Verify the licensing of trading platforms

Make sure the trading platforms you use are licensed by the Securities and Futures Commission (SFC). Unlicensed or overseas platforms may lack transparency and stability, leaving users vulnerable. In the event of platform closures, fraud, breaches, or theft, users could face complete loss of their virtual assets. Some platforms may claim to have submitted a license application to the SFC, but until they're officially licensed, their compliance with regulations can't be guaranteed. To protect your interests, it's advisable to choose licensed platforms. The SFC provides a "list of licensed virtual asset trading platforms" containing the names and relevant information of licensed platforms.

Assess your risk tolerance

Virtual assets are highly volatile and carry various risks. They lack intrinsic value and aren't backed by governments, banks, or physical assets. As high-risk products, virtual assets may not be suitable for everyone. Although retail traders can now trade virtual assets on licensed platforms under new regulations, this doesn't imply an endorsement or encouragement for retail traders to do so. While licensed platforms must guarantee product suitability for clients, users should evaluate their own risk tolerance and gain a comprehensive understanding of the product's features and risks. If you lack a true understanding of virtual assets and can't bear potential losses, it may be wise to refrain from trading in this asset class.

Conduct independent research

Before trading virtual assets, it's crucial to comprehend their nature, operations, and risks. Different virtual assets have distinct characteristics and risks. Currently, social media is flooded with advice, analysis, news, and endorsements from self-proclaimed experts, celebrities, or influencers promoting virtual asset products or services. It's important not to blindly follow the hype. Always conduct your own research, think independently, and assess critically.

Beware of virtual asset-related scams

Scams involving virtual assets have seen a significant increase in recent years. These include fraudulent trading apps or platforms and romance scams, where scammers exploit victims' trust to request virtual assets under various pretenses. It's essential to remain vigilant and exercise caution when encountering financial opportunities that promise high returns with low risks. The SFC provides a list of suspicious virtual asset trading platforms (VATPs) that can help you to identify potentially fraudulent entities operating in Hong Kong more easily.

What kinds of scams are out there?

Phishing scams

• Seed-phrase scams and fake websites: Like deceptive doppelgangers, some scammers create fake websites that mimic popular platforms or applications. Always double-check URLs before clicking on them, and never give a website your seed phrase.

• Email and social media phishing: Beware of scammers posing as well-known figures like Elon Musk on X, offering "too good to be true" deals. If it feels wrong, it probably is. Remember: never give out any personal information or passwords and seed phrases.

• Fraudulent mobile apps: Scammers can disguise themselves as popular wallet apps like Trezor, waiting to snatch your hard-earned virtual assets. Always download apps from official sources and check reviews to make sure the app is legitimate.

Virtual asset project scams

• Imitation/fake projects: Some scams involve projects imitating well-known virtual assets. They may appear genuine, but their sole purpose is to deceive you and capture your funds. Always verify the project's authenticity before committing your funds.

• Pump-and-dump schemes: Groups artificially inflate a coin's value, only to dump it later by selling at a higher price, leaving unsuspecting traders in the dust. You can avoid this scam by being cautious of hype surrounding a new project.

Exchange and wallet scams

• Fraudulent exchanges: Unscrupulous individuals might set up fake exchanges to lure users. Stick to well-known, reputable exchanges that transparently communicate their Proof of Reserves to protect your assets.

• Initial Coin Offering (ICO) scams: ICOs can be an exciting and rewarding opportunity, as with any new project, but they also carry big risks. Be mindful of the pitfalls associated with them and make sure you do your due diligence on what these ICOs are promising.

What is best practice advice to help avoid getting scammed?

Secure or self-custody your virtual assets

• Use reputable wallets and exchanges: Trustlessness is crucial in the virtual asset world. Stick to well-established wallets and exchanges with strong security measures in place that transparently communicate their Proof of Reserves or open-source their security models.

• Enable two-factor authentication: Add an extra layer of security to your accounts (including everything from social to email) by enabling two-factor authentication (2FA). It's a small step that can make a massive difference.

Research projects thoroughly

• Check team credentials and project history: Investigate the background of the project's team members and their past accomplishments. A solid team is the backbone of any successful project.

• Examine the project's white paper: A white paper is like a project's blueprint. Make sure it's well-written, comprehensive, and outlines a clear vision and plan.

• Analyze tokenomics and use cases: Dive deep into the project's tokenomics and use case. A strong project should have a practical purpose and a clear plan for token distribution.

Be cautious with communication

• Verify the source of emails and messages: Scammers often pose as official representatives from big companies. Verify the sender's authenticity before engaging or sharing any sensitive information, and always reach out to the customer support team if you receive any phishing attempts.

• Avoid sharing sensitive information online: Keep your private keys and seed phrases to yourself, and try and store your passwords offline. Treat them like your most valuable secrets.

Monitor your assets

• Keep track of your assets: Regularly review your portfolio and stay informed about the projects you're involved in. Better yet, take your virtual assets off exchanges and into a self-custody wallet for higher security.

• Stay informed about the market: The virtual asset landscape evolves rapidly. Keep yourself updated on the latest news and developments to make informed decisions.

About regulation

What is anti-money laundering (AML) in the context of virtual assets?

Virtual asset anti-money laundering (AML) refers to the set of laws, regulations, and practices aimed at preventing criminals from converting illegally acquired virtual assets into traditional fiat currencies.

How does virtual asset AML work?

The Financial Action Task Force (FATF) establishes global standards for AML regulations. Starting in 2014, FATF began providing guidance specifically related to virtual asset AML, prompting policymakers in FATF member jurisdictions to act swiftly. Today, regulatory bodies have incorporated most of FATF's virtual asset AML recommendations into law.

Subsequently, the responsibility falls on virtual asset service providers (VASPs) — a category that FATF defines as including exchanges, stablecoin issuers, and NFT marketplaces. These entities play a crucial role in combatting money laundering by employing AML compliance officers, implementing know-your-customer (KYC) checks, and continuously monitoring transactions for suspicious patterns.

When suspicious activity is identified, VASPs report this information to relevant regulators and agencies, who then investigate the flow of funds and link illicit activities to real-world identities.

What is know-your-customer (KYC) for virtual assets?

Virtual asset KYC refers to the set of identity verification procedures mandated by law for VASPs. KYC processes are essential as they allow criminal investigators to link pseudonymous virtual asset addresses to real-world entities in case these addresses are associated with illicit activities.

How does virtual asset KYC work?

KYC programs generally have three components: customer identification, due diligence, and continuous monitoring.

Customer identification program (CIP)

A customer identification program verifies the customer's identity using reliable and independent data. For individuals, this may include their legal name, date of birth, address, and supporting documents like an identity card or passport. For corporate customers, business licenses and articles of incorporation are commonly required.

Customer due diligence (CDD)

Customer due diligence involves assessing the risks associated with a new client or business relationship. Financial service providers conduct background checks, customer surveys, and reviews of transaction history to assign risk ratings that determine the level of monitoring applied to an account.

Continuous monitoring

Continuous monitoring involves the ongoing scrutiny of transactions to detect potential criminal activity. When suspicious activities are identified, VASPs are obligated to submit suspicious transaction reports (STRs) to relevant law enforcement agencies.

What's the role of regulatory authorities such as the SFC in the virtual asset industry?

New regulatory regime to protect traders’ interests

A new regulatory framework has been implemented to safeguard the interests of traders. In December 2022, the Legislative Council passed the Anti-Money Laundering and Counter-Terrorist Financing (Amendment) Bill 2022, aiming to protect traders and mitigate risks that could impact the traditional financial system. Effective from June 1, 2023, the new licensing regime for virtual asset trading platforms requires all centralized virtual asset trading platforms carrying on their business in Hong Kong or actively marketing their services to Hong Kong residents to obtain licensing and adhere to regulations set by the Securities and Futures Commission (SFC).

The SFC has developed this regulatory regime for virtual asset trading platforms based on the principle of 'same business, same risks, same rules.' Under this new framework, virtual asset trading platforms are subjected to the same regulatory requirements as traditional financial institutions, such as securities brokers and automated trading venues.

However, certain adaptations have been made to address the unique characteristics and risks associated with virtual assets. These adaptations include provisions for the safe custody of client assets, know-your-client processes, anti-money laundering, and counter-financing of terrorism measures, prevention of market manipulation and abusive activities, accounting and auditing standards, risk management protocols, conflict of interest avoidance, and cybersecurity protocols.

Protection measures for retail traders

The new regulatory regime incorporates several measures to protect retail traders. These measures enable retail traders to access licensed virtual asset trading platforms while making sure of suitability. User protection measures include assessing the client's understanding of virtual assets, their tolerance for risk, and their risk profile. Additionally, exposure limits are set based on the client's financial situation and personal circumstances. Reasonable due diligence is conducted on the virtual assets available for trading to meet token admission criteria. Sufficient product information is disclosed to assist clients in evaluating their positions.

Traders can refer to the SFC’s "list of licensed virtual asset trading platforms" which sets out the names of virtual asset trading platform operators that are formally licensed by the SFC, and click on the relevant link for further information on the platform operator.

Advanced topics

What gives virtual assets their value?

In the modern financial world, the concept of value is commonly understood and categorized as market value and intrinsic value. Market value refers to the price at which assets are traded on the open market. Intrinsic value, on the other hand, represents the underlying worth of an asset as estimated by buyers and sellers. Various asset classes have distinct valuation approaches, for example:

• Stocks: Discounted cash flow (DCF) model summarizes the discounted present value of future cash flows a company can generate.

• Commodities: Analyzes and projects the demand and supply of a commodity to derive its intrinsic value.

• Currencies: Purchasing power parity (PPP) and interest rate differentials (IRD) models derive the intrinsic value of foreign exchange currencies based on factors like purchasing power and interest rates.

Bitcoin's characteristics as commodities and currencies

Bitcoin demonstrates characteristics of both commodities and currencies, positioning itself as a unique hybrid asset in the financial landscape.

As a virtual commodity, Bitcoin shares similarities with more traditional commodities like gold or oil. It has a limited supply, with a predetermined maximum number of coins that can ever be mined. Bitcoin's scarcity creates a sense of value and can be seen as a store of wealth. Additionally, Bitcoin's decentralized nature and the energy-intensive mining process contribute to its commodity-like attributes. Meanwhile, the Commodity Futures Trading Commission (CFTC) in the U.S. defined Bitcoin as a commodity in 2015.

At the same time, Bitcoin also demonstrates clear currency-like features. It can be used as a medium of exchange for goods and services, enabling peer-to-peer transactions globally. Bitcoin transactions are borderless, quick, and potentially more cost-effective compared to traditional payment systems with fewer intermediaries. What's more, Bitcoin's decentralized nature provides users with a high degree of financial autonomy and privacy.

Considering the points discussed above, it's important to explore how Bitcoin's intrinsic value is affected by its dual nature as both a commodity and a currency. It's also key to understand the dynamics of demand and supply for Bitcoin.

The utility and demand for Bitcoin

• Store of value: Bitcoin is often called "digital gold". It's decentralized and operates on a blockchain, which provides security and immutability. The limited supply of Bitcoin, capped at 21 million coins, creates scarcity and can offer protection against inflation.

• The role of portfolio and institutional adoption: Bitcoin has emerged as a potential asset class for portfolio diversification. Institutions, including hedge funds, asset management firms, and corporations, increasingly recognize Bitcoin's potential to provide uncorrelated returns and improve the risk-adjusted return in traditional portfolios.

• Digital currency and network effect: Bitcoin's utility as a digital currency allows for seamless and global P2P transactions. Through the use of cryptography and mining, transactions are securely recorded on a decentralized public ledger, empowering users with control over their funds and instilling trust in the system. The network effect plays a pivotal role in enhancing Bitcoin's utility.

• As a legal tender for less stable economies: Bitcoin has gained attention as a potential reserve currency or legal tender in economies with unstable fiat currencies. Unlike traditional currencies tied to specific governments or central banks, Bitcoin offers a diversified and stable store of value, which can help mitigate the impact of economic fluctuations.

The limited and fixed supply of Bitcoin

Bitcoin's creator, Satoshi Nakamoto, designed the asset with a hard cap on supply to increase its scarcity over time. This unique feature sets Bitcoin apart as its supply is limited to 21 million coins — a fixed upper limit encoded into the network's code that can never be altered. This distinguishes Bitcoin from commodities like gold, where the exact unmined amount remains uncertain. The finite supply of Bitcoin reduces uncertainty and positions it as a scarce commodity, bringing the asset distinct advantages.