After lengthy discussions and consultations, the new licensing regime for Virtual Asset Trading Platforms (VATPs) finally took effect on 1 June 2023, representing the collective efforts of the government, regulators, the industry, and other interested stakeholders in fostering the orderly and sustainable growth of the crypto community in Hong Kong. Under the new regime, all centralised VATP exchanges which carry on business in Hong Kong or actively market to Hong Kong investors must be licensed by the Securities and Futures Commission (the SFC).

The new licensing regime is a two-tier framework that comprises:

1. The Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615) (the AMLO) as amended by the Anti-Money Laundering and Counter-Terrorist Financing (Amendment) Ordinance 2022, being Hong Kong’s first virtual asset specific legislation that provides a broad VATP regulatory framework to be overseen by the SFC; and
2. The Guidelines for Virtual Asset Trading Platform Operators (the VATP Guidelines) appended in the Consultation Conclusions on the Proposed Regulatory Requirements for Virtual Asset Trading Platform Operators Licensed by the Securities and Futures Commission dated 23 May 2023, which provide detailed implementing details of the VATP regulatory framework in Hong Kong.

The object of the new licensing regime is to fill in the regulatory lacuna in the regulation of crypto trading. Formerly, only centralised VATPs which provided trading services in security tokens were regulated by the SFC under the Securities and Futures Ordinance (Cap. 571) (the SFO), as a result of which trading of crypto assets that were non-security tokens was out of the SFC’s scrutiny. Upon commencement of the new licensing regime, trading of non-security tokens would be subject to regulation. The VATP regime will operate in parallel with the SFO regime, i.e. VATPs engaging in the trading of security tokens will be regulated under the SFO, and those in the trading of non-security tokens under the VATP regime. Notwithstanding the differentiation between security tokens and non-security tokens, the SFC encourages VATP operators to apply for dual licences under the SFO and the VATP regimes, so as to facilitate business continuity and avoid the risks of contravening the licensing requirements under either regime.

Coverage

Only licensed providers may carry on the business of providing virtual assets services. The only virtual assets service currently regulated under the AMLO is the operation of a VATP, whereby (i) binding sales and purchases of virtual assets are, or are reasonably expected to be, made, negotiated or concluded; and (ii) client money comes or client virtual assets come into the possession of the VATP. The new licensing regime therefore captures centralised VATPs and arrangements that trade or support the trading of virtual assets, excluding peer-to-peer platforms which merely provide a forum for bid and offer and do not trade or support the trading of virtual assets on the platforms.

“Virtual assets” are defined as a cryptographically secured digital representation of value that:

• is expressed as a unit of account or a store of economic value;
• either
  • is used, or is intended to be used, as a medium of exchange accepted by the public for payment for goods or services, the discharge of a debt, or for investment; or
  • provides rights, eligibility or access to vote on the management, administration or governance of the affairs in connection with, or to vote on any change of the terms of any arrangement applicable to, any cryptographically secured digital representation of value; and
• can be transferred, stored or traded electronically.

This definition is wide, covering most forms of cryptocurrencies in the market. Nevertheless, under the AMLO, it excludes (i) central bank digital currencies; (ii) securities or futures contracts; (iii) stored value facilities; (iv) limited purpose digital tokens; and (v) any other form which the SFC declares as not being a virtual asset. It also likely precludes non-fungible tokens (NFTs), being non-interchangeable and non-fractional representation of rights over arts and collectibles that do not constitute “a unit of account” or “a store of economic value”.

Key regulatory requirements

• Retail access: in addition to professional investors, licensed VATPs may provide services to retail investors, insofar as robust investor protection measures, as summarised below, are in place.
  • Onboarding requirements: VATPs should (i) conduct holistic knowledge and suitability assessments on an investor’s understanding of the nature and risk of virtual assets before providing trading services; and (ii) impose an exposure limit such that the client’s exposure to virtual assets is reasonable having regard to the client’s financial situation and personal circumstances.
  • Governance: VATPs must establish a token admission and review committee responsible for the following functions:
    • establishing, implementing and enforcing (i) the criteria for admitting a virtual asset for, and halting, suspending and withdrawing a virtual asset from, trading and (ii) the rules setting out the obligations of and restrictions on virtual asset issuers;
    • reviewing regularly the criteria and rules to ensure they remain appropriate, as well as the virtual assets admitted for trading to ensure they continue to satisfy the token admission criteria; and
    • making the final decision as to whether to admit, halt, suspend and withdraw a virtual asset for clients to trade based on the criteria.
  • Disclosure obligations: VATPs shall disclose sufficient product information to enable clients to consider their investment position. When disclosing information, VATPs shall act with due skill, care and diligence and take all reasonable steps to ensure the specific product information is not false, biased, misleading or deceptive.
  • General token admission criteria: in line with the fundamental principle that an intermediary shall know the products offered, VATPs shall exercise reasonable care and conduct product due diligence in (i) admitting virtual assets for trading; and (ii) monitoring the status of the admitted virtual assets, based on a list of general non-exhaustive factors published in the VATP Guidelines. In conducting product due diligence, however, VATPs are only required to consider the regulatory status of the virtual assets in Hong Kong, and not in other jurisdictions.
  • Specific token admission criteria: on top of the general token admission criteria above, VATPs shall meet additional minimum criteria if the virtual assets are open for trading by retail investors. These criteria include, amongst others, the tokens being eligible large cap virtual assets that are included in at least two acceptable indices issued by at least two independent index providers. Each of the independent index providers shall (i) have experience in publishing indices for the conventional securities market that complies with the International Organization of Securities Commission (IOSCO) for Financial Benchmarks; and (ii) be independent of each other, the issuer of the virtual asset and the platform operator.
• Insurance / compensation requirements: VATPs must have in place insurance / compensation arrangements approved by the SFC to cover for the risks associated with the custody of clients’ virtual assets. The compensation arrangements can be made in the form of bank guarantees, along with funds held in the form of demand deposits or fixed deposits with a maturity of six months or less, and virtual assets are an acceptable form of assets that can form part of the compensation arrangements. The SFC has made it clear that insofar as 98% of the client’s assets are held in cold storage (which is generally free from hacking and other cybersecurity risks), the coverage threshold for the clients’ virtual assets held in cold ratio can be not less than 50%.
• Proprietary trading: to avoid conflict of interests, VATPs must not engage in any proprietary trading activities in virtual assets for its own account or any account in which it is interested, except for (i) proprietary trading by affiliates which is not conducted through the licensed VATPs; and (ii) off-platform back-to-back transactions entered into with a third party for the purposes of effecting purchase / sell orders from clients.
• Trading in virtual assets derivatives: currently, the prohibition against offering, trading or dealing in virtual asset future contracts or related derivatives are preserved in the VATP Guidelines. However, with the importance of virtual asset derivatives to institutional investors in mind, the SFC will conduct a separate review in due course.
• Trading in stablecoins: stablecoins are more volatile and unstable. At present, stablecoins are not subject to regulation in Hong Kong (arrangements are expected to be implemented in 2023/24) and therefore should not be admitted for retail trading.
• Anti-money laundering and counter-financing of terrorism requirements (AML-CFT requirements): under the Guideline on Anti-Money Laundering and Counter-Financing of Terrorism (For Licensed Corporations and SFC-licensed Virtual Asset Service Providers), VATPs will be required to observe additional AML-CFT requirements.
  • In particular, VATPs are required to comply with the Travel Rule which provides fundamental information for carrying out sanctions screening and transaction monitoring, as well as other risk mitigation measures.
  • Under the Travel Rule, VATPs shall (i), when acting as an ordering institution, obtain, record and submit the required information of the originator and recipient to the beneficiary institution; and (ii) when acting as a beneficiary institution, obtain and record the required information submitted by the ordering institution or intermediary institution.
• Disciplinary Fining Guidelines: under section 53ZSP(3) of the AMLO, where the regulated person is guilty of misconduct, the SFC may impose a fine of up to HK$10 million or three times the profit gained or loss avoided by the regulated person, whichever is higher. The Disciplinary Fining Guidelines provide further guidance on the manner in which the SFC will exercise its disciplinary powers in the event of misconduct by VATPs and the regulated persons. In considering whether to take disciplinary actions and, if taken, the appropriate penalty, the SFC will take into account all the circumstances, including the conduct of the VATPs and their management, and whether there is any consent, connivance, negligence or failure in supervision or management of business.

Transitional arrangements

Pre-existing VATP operators which are in operation in Hong Kong before 1 June 2023 with a “meaningful and substantial presence” will be eligible for the transitional arrangement. They will be provided with a one-year transitional period (i.e. until 31 May 2024) to either apply for a licence or close down their virtual assets trading operations in an orderly manner. To determine what constitutes “meaningful and substantial presence”, the SFC will consider a range of factors including the place of incorporation, physical office space, location of central management and key personnel, and the platform’s active user base and trading volume in Hong Kong.

VATP operators shall make an application within the first nine months of the commencement of the regime (i.e. between 1 June 2023 and 29 February 2024). Under the deeming arrangements, upon making the licensing application, they will be deemed to be licensed from 1 June 2024 until their applications are approved, withdrawn or refused. If the SFC formally rejects the application, VATP operators will be required to close down the business with respect to Hong Kong within a specified time period.

Application for VATP licence

As a matter of prudence, VATPs should consider applying for dual-licence, i.e. seeking approval under both the existing licensing regime under the SFO and the new VATP licensing regime under the AMLO. A streamlined application process will be adopted so that VATP applicants will only be required to submit one single consolidated application to the SFC for a dual-licence application.

Apart from the obligations discussed above relating to various standards and requirements established under the AMLO or VATP Guidelines, VATP applicants must prove to the SFC that they can also satisfy similar licensing criteria considered under the existing licensing regime under the SFO, including (i) the fit and proper criteria, (ii) competence requirements, (iii) requirements on responsible officers (ROs), and (iv) financial resources and soundness.

• Fit and proper criteria: the SFC will assess whether licensed individuals, directors, substantial shareholders, ultimate owners, or controllers of the VATP applicants are fit and proper to carry on the regulated activities and/or be associated with the licensed entity. Factors which will be taken into account include (i) an applicant's financial status or solvency; (ii) the applicant or its senior management’s educational or other qualifications or experience; (iii) an applicant's ability to carry on the relevant activities competently, honestly and fairly; and (iv) the reputation, character, reliability and financial integrity of the applicant, including whether they have been found to be dishonest or engaged in fraudulent or criminal activity, and (v) an applicant's financial resources and soundness.
• Competence requirements: when assessing whether an applicant satisfies the competence requirement, the applicant must demonstrate to the SFC that it possesses the necessary technical skills and professional expertise to be “fit” and is aware of the relevant ethical standards and regulatory knowledge to be “proper” in carrying on any relevant activities.
  • When considering the competence level of corporate applicants, the SFC shall consider factors including, but not limited to, business, corporate governance, staff competence, internal controls, operation, risk management and compliance.
  • When considering the competence level of individual applicants, the SFC shall consider factors including, but not limited to, whether the applicant has (i) the necessary academic, professional or industry qualifications; (ii) knowledge about virtual assets and the virtual asset market; (iii) sufficient relevant industry and management experience (where applicable); (iv) a good understanding of the regulatory framework, including the laws, regulations and associated codes governing the virtual asset sector; and (v) familiarity with the ethical standards expected of a financial practitioner.
• Requirements on RO: VATPs are required to have two SFC-approved ROs, and at least one RO as their executive director. Notably, the SFC has confirmed that an individual can be concurrently approved under both the SFO and the AMLO so that dual-licensed VATPs are not required to maintain duplicated sets of ROs.
• Financial resources and soundness: VATPs are subject to the requirement of maintaining, at all times, (i) a minimum paid-up share capital of HK$5 million and (ii) a minimum liquid capital of HK$3 million. In addition, VATPs are further required to also maintain, at all times, assets in Hong Kong, that are (i) beneficially owned by the VATP and (ii) sufficiently liquid (e.g. cash, deposits, treasury bills, and certificates of deposit, but not in the form of virtual assets) and equivalent to at least 12 months of their actual operating expenses calculated on a rolling basis.

Last but not least, VATP applicants are required to engage external assessor(s) to assess their businesses and in particular their policies and procedures, to ensure they meet the requisite standards. VATP applicants are required to submit such external assessment reports (EARs) to the SFC (i) when submitting their licence application (Phase 1 Report) and (ii) after approval-in-principle is granted (Phase 2 Report), covering the following scope:

• Phase 1 EAR: the external assessor will be required to review the design effectiveness of the operator’s proposed structure, governance, operations, systems, and controls and assess if they comply with the applicable legal and regulatory requirements.
• Phase 2 EAR: the external assessor will be required to review and assess the implementation and effectiveness of the actual adoption of the planned policies, procedures, systems, and controls. The SFC will grant final approval only if it is satisfied with the findings therein.

In light of the wide-ranging questions received during the public consultation, such as the qualifications and suitability of such external assessor and scope of the EARs, the SFC intends to publish further guidance in the form of circulars, FAQs, and a licensing handbook for common questions relating to the new AMLO regime.

Commentary

The new licensing regime for VATPs is a welcome move and a significant milestone in Hong Kong’s regulatory regime, representing the government’s resolve to provide a workable framework for the virtual assets trading industry. The SFC will be at the forefront in regulating the conduct and licensing of these VATPs. Legal safeguards seek to ensure the stability, certainty and integrity of the trading of virtual assets by and through VATPs. The expansion of the trading of virtual assets to retail investors is a big step in enhancing retail access to the rapidly evolving crypto market, while at the same time harnessing retail investors’ confidence. Active retail involvement could unlock a new wave of capital investments and market opportunities, and reinforce Hong Kong’s position as an international financial hub.

A corporate team trainee, Ronald Wan is one of the authors.

Acknowledgements to interns Bruce Lee, Geoffrey Tang and Winnie Lui (all of Dentons Hong Kong) for research and contribution to this article.