The Government of Hong Kong has released a consultation to implement a new regulatory system enabling the SFC to control virtual asset exchanges. A year after the Hong Kong SFC introduced a new Virtual Asset Exchanges (VA Exchanges) regulatory structure to allow trade of security tokens, the SFC turned its focus to regulating non-security virtual assets, outlining a proposed regulatory system to formalize and explicitly control virtual asset trading, such as Bitcoin.
In the keynote speech on the second day of Hong Kong Fintech Week 2020, SFC Chief Executive Ashley Alder discussed plans to govern virtual asset service providers (VASPs), and later on the same day, the FSTB published a consultation report (Consultation Paper) presenting more specifics of the proposals.
After the consultation (open until 31 January 2021), it is proposed that a bill will be submitted to the Legislative Council in 2021. There will be a transitional period of 180 days, after the new framework becomes law, to encourage market participants to apply for and receive the requisite SFC license or withdraw from the market.
Limitations of the current opt-in regulatory regime
Nothing completely surprising about the current regulatory system. The legislative perimeter of the SFC applies only to products qualifying under the Securities and Futures Ordinance (SFO) (including conventional securities such as stocks and shares, futures contracts, and funds) and to intermediaries offering services related to such products. Many virtual currencies, such as Bitcoin, other stable cryptocurrencies, or alt-coins, fall beyond the regulatory perimeter of the SFO and hence the SFC.
A virtual asset trading platform (VATP) offering to trade of at least one virtual asset that is security may ‘opt-in’ to be licensed and governed by the SFC under the current regulatory regime (Opt-In Regime). All of the VATP sector (including the exchange of non-security virtual properties, such as Bitcoin) will be under the control of the SFC if authorized. However, the SFC has recognized the drawbacks of the opt-in regime, stating that VA Markets, which merely allow the trading of non-security virtual products, will not have to be approved by the SFC and will continue to function as non-regulated undertakings.
The new regulatory system
The updated regulatory regime outlined in the Consultation Paper marks a major shift in the way Hong Kong governs virtual assets and also incorporates the current criteria of the Consultation Paper. Financial Action Task Force (FATF) concerning operators of virtual asset providers (VASPs) (VASPs).
The net effect of the current regulatory structure is that any VA Exchange located in Hong Kong (or overseas VA Exchanges targeting Hong Kong customers) will need to be authorized by the SFC and will initially only be able to deal with ‘qualified investors’ customers, meaning that Hong Kong retail customers will not be given access to trade virtual assets on licensed VA Exchange. This is the first time the licensing and supervisory functions of the SFC have been vastly altered outside the SFO and its relevant derivative rules.
Scope of the new regulatory system
Definition of “virtual assets”
‘Virtual assets’ are known as a digital representation of value represented as a unit of account or as a store of economic value; that acts (or is intended to function) as a means of exchange accepted by the public as a payment for goods or services or debt relief or investment purposes; and that may be digitally transferred, deposited or exchanged.
Different forms of digital currencies, like Bitcoin, Ether, and other alt-coins, will be covered by the standard. The Consultation Paper also explicitly mentions that to sustain their valuation, virtual assets are allegedly assisted by some type of asset.
Definition of a VA Exchange
A VA Exchange is defined by the Consultation Paper as any trading platform that is controlled to make an offer or invitation to buy or sell any virtual asset in exchange for any money or any virtual asset (whether of the same or different type) and that comes into custody, control, authority or ownership of, or over, any money or any virtual asset at any time.
The term will include centralized VATPs that offer virtual asset trading services. Moreover, since the concept is very broad, it would be appropriate for OTC virtual asset trading service providers to examine whether their activities might unintentionally come under the definition of a VA Exchange.
Specifically, the Consultation Paper excludes peer-to-peer trading platforms (i.e., platforms that only have a venue for virtual commodity buyers and sellers to post their bids and deals, with or without automated matching systems, for the parties themselves to exchange outside the platform), to the fact that the actual transaction takes place outside the platform and the deal takes place outside the platform.
Exemptions from the new regulatory framework
VA Exchanges currently governed by the SFC under the current VATP opt-in regime are removed from the new regulatory structure to prevent redundant control.
However, the Consultation Paper did not say whether VA Exchange licensees in Hong Kong would be exempted from other regulatory regimes. For example, it is unknown if licensed VA Exchanges will automatically be exempted under AMLO from the Money Services Operator Licensing Regime (which applies to remittance and money-changing services) and the Trust or Business Service Provider Licensing Regime (which applies to trust undertakings) to the extent that any of these services are rendered by the VA Exchange as ancillary to its duties as a trust undertaking
Proposed licensing requirements under the new regulatory structure
The Consultation Paper further outlines VA Exchanges’ general licensing requirements. Pretty much by definition, the SFC would need to be assured by a VA Exchange that the exchange is ‘fit and proper’ and will meet with the AML/CTF provisions under Schedule 2 to the AMLO and other regulatory requirements for investor security purposes (e.g., having to contend only with professional investors).
Local establishment requirement
Only businesses registered in Hong Kong that have a permanent place of operation in Hong Kong will be classified as VA Exchanges for licensing by the SFC.
Responsible officer requirement
At least two Accountable Officers (ROs) shall be chosen by the VA Exchange to assume general liability for ensuring compliance with AML/CTF and other regulatory requirements and shall be kept directly liable in the event of a violation or non-compliance with such requirements.
Fit and proper requirement
To meet the fit and proper test, all ROs and final owners of a VA Exchange are necessary. The SFC will take into account different considerations when determining whether an individual is a fit and proper person, including:
- Whether the AML/CTF or other regulatory requirements applicable to licensed VA Exchanges have failed or may not be followed by the individual.
- Whether the person is found to have behaved fraudulently, corruptly, or dishonestly in any jurisdiction for a money-laundering or terrorist funding crime or other offense.
The concept of an “ultimate owner” is well-entrenched under AMLO.
‘Ultimate owner’ of a corporation means a person who (i) owns or controls, directly or indirectly, whether, through a trust or bearer shareholding, more than 25% of the issued share capital of the corporation; (ii) is entitled to exercise, directly or indirectly, of the issued share capital of the corporation, concerning the money services operator licensing regime and the trustor company services provider licensing regime; However, the SFC imposes a different threshold in respect to VATPs and other approved
financial institutions. The SFC assesses, as described in the SFO, the fitness, and propriety of
“substantial shareholders” which, in some respects, is wider than the concept of “ultimate
Hong Kong Gives Out First Crypto License
The SFC website explains that on Dec. 15, OSL Digital Securities Ltd. was permitted. A part of the Hong Kong stock exchange-listed BC Technology Group, the Asian digital asset platform is authorized for regulated Type 1 (dealing in securities) and Type 7 (providing automated trading services) operations. The platform will only “serve professional investors under the close supervision of the SFC” and “will be subject to customized requirements similar to those applicable to securities brokers and automated trading venues,” stated the regulator.
Under Hong Kong’s current crypto guidelines, registration of crypto exchanges is optional, but the government introduced a new crypto regulatory system in a consultation conducted in November (which we mentioned above) that enables the SFC to oversee all centralized crypto exchanges. The SFC clarified that its approach to the control of cryptocurrencies is compatible with international standard-setting bodies’ guidelines.
The company now describes itself as “the world’s first SFC-licensed, listed, digital asset walletinsured, Big-4 audited digital asset trading platform for institutions and professional investors.” OSL clarified that while registration was possible, it preferred to be licensed and “underwent the rigorous vetting requirements of the SFC.”
Matt Long, OSL Head of Distribution and Prime, said, ‘Registered companies are the future of digital assets and capital markets in the digital era and institutional investors, hedge funds and family offices are now increasingly growing portfolio exposures to digital assets such as bitcoin.’
Licensing conditions to which VA Exchanges must comply
The Consultation Paper recommends that the SFC be empowered to enforce licensing
requirements on VA Exchanges that are approved.
The overriding assumption is that, under the Opt-In Regime for VA Exchanges, the current regulatory structure would enforce the same regulatory requirements that apply to VATPs, thereby ensuring a fair playing field for all market players, be they VATPs or VA Exchanges.
The Consultation Paper states that the new licensing requirements are based on the licensing conditions available to the Opt-In Regime for VATPs.
The current requirements for the regulation of VA Exchanges include the following:
- Financial reporting and disclosure
- Prevention of market manipulative and abusive activities
- Segregation and management of client assets
- Virtual asset listing and trading policies
- Financial resources
- The soundness of the business
- Risk management
- Professional investors only
Penalties and sanctions
The Consultation Paper proposes to enforce criminal liability with a fine of HK$5 million (US$645,000) (plus some additional fines for prolonging breaches) and imprisonment of seven years for any person operating a VA Exchange without a license.
Also, several supervisory and intervention powers for controlling VA Exchanges are issued to the SFC. In specific, the SFC may be empowered to perform regular checks at the business premises of the approved VA Exchange, to order the production of paperwork and other information, to enforce certain limits, to prosecute non-compliance, and to impose administrative penalties.
Suspension or revocation of a license, reprimands, remedial instructions, and money orders are included in the range of regulatory punishments. Also, non-compliance with AMLO’s formal AML/CTF provisions is a criminal act, whereby registered VA Exchanges and their ROs are liable for a fine of HK$1 million (about US$129,000) and two years in prison.
The new regulatory system represents a major advancement for VA Exchanges currently headquartered in Hong Kong or VA Exchanges abroad that offer services to Hong Kong citizens and other regulatory authorities.
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