- The new regime will replace the opt-in regime for virtual asset trading platforms (VATPs), which has been in place since 2019.
- It is mandatory, requiring all VATPs (including currently licensed VATPs) to be licensed.
- The proposals envisage sales to retail investors, which licensees were not permitted under the earlier regime.
- The proposals envisage detailed requirements with respect to custody of client assets, KYC, anti-money laundering and counter-financing of terrorism (AML/CFT), conflicts, cybersecurity, admission of assets for trading, and others.
- Currently licensed VATPs will be given a 12-month transitional period to comply.
- Whether VATPs will be permitted to offer virtual asset (VA) derivatives remains under review.
Introduction
On 20 February 2023, the Hong Kong Securities and Futures Commission (SFC) published a Consultation Paper (the Paper) setting out its proposals for regulating VATPs under the forthcoming VATP licensing regime and seeking comments on the same.
This client alert summarises the key proposals set out in the Paper.
Background
VATPs active in Hong Kong need to be aware of:
(a) The existing licensing regime administered by the SFC under which platforms dealing in securities tokens will need to be licensed under the Securities and Futures Ordinance (SFO).
(b) The existing SFC opt-in regime for VATPs under terms and conditions published in 2019.
(c) Changes to the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO), which, when they come into effect in June 2023, will introduce a new licensing regime for VATPs that carry on the business of trading non-security tokens in Hong Kong and/or actively market such services to Hong Kong investors.
(d) Proposals by the Hong Kong Monetary Authority (HKMA) to regulate stablecoins.
Mandatory licensing for all centralised VATPs operating in Hong Kong
Upon commencement of the new VATP licensing regime on 1 June 2023, all centralised VATPs carrying on business in Hong Kong or actively marketing their services to Hong Kong investors will need to be licensed by the SFC, even if they do not provide security token trading services.
From 1 June 2023, any VATP operating in Hong Kong without a valid licence will be in breach of the new VATP licensing regime unless it is eligible to operate under the transitional arrangements (see below).
Dual licensing
The Paper effectively proposes to align the regulatory requirements for VATPs trading non-security tokens under the AML licensing regime with those for platforms trading security tokens, which will continue to be licensed under the SFO. This will be done by rolling out a single consolidated application procedure. This is sensible for VATPs planning to offer trading in a number of tokens, given uncertainty as to whether some will be classified as securities.
Transitional arrangements
The Paper envisages that unlicensed VATPs may make use of transitional arrangements. Provided they have been operating with a “meaningful and substantial presence” in Hong Kong prior to 1 June 2023, such existing VATPs will have until 31 May 2024 to become licensed and may continue operating in the meantime.
Importantly, platforms which do not have such meaningful and substantive presence in Hong Kong immediately before 1 June 2023 will not be able to take advantage of this transitional arrangement and should wait until they are SFC-licensed before commencing any VATP businesses.
Factors going to whether a platform has such a meaningful presence include whether they are incorporated in Hong Kong, have a physical presence in Hong Kong, or have key personnel in Hong Kong.
There will also be a 12-month transitional period for currently licensed VATPs.
Retail access and protections
Currently, SFO-licensed platform operators can only serve professional investors and are restricted from providing services to retail investors. The Paper envisages that retail investors will be allowed to access trading services.
However, to better protect such retail investors, licensed VATPs will need to implement the following measures:
(a) Onboarding: VATPs will need to assess the client’s risk profile to determine if the client is suitable to trade VAs. VATPs must also limit each client’s exposure to VAs based on that client’s financial situation and personal circumstances. This requirement only applies to clients who are retail investors.
(b) Governance: VATPs will need to establish a token admission and review committee comprising members of the VATP’s senior management. The committee must, among others, establish and enforce criteria for VAs to be admitted, suspended or withdrawn from trading.
(c) Token due diligence and admission criteria: VATPs should consider the following non-exhaustive criteria in determining if a VA should be admitted for trading:
- The background of the VA’s management or development team.
- The VA’s regulatory status in the jurisdictions that the VATP operates in.
- The supply, demand, maturity, liquidity and other financial information about the VA.
- The market risks of the VA, including the VA’s susceptibility to price manipulation and fraud.
- The legal risks of the VA, including any pending or potential civil, regulatory, criminal or enforcement action related to the VA.
- The technical aspects of the VA, including the security infrastructure of its blockchain protocol.
- Whether the marketing materials issued by the VA’s issuer are accurate and not misleading.
- Previous major incidents associated with the VA during its development.
- Whether the VA’s touted utility or use case is fraudulent or scandalous.
VATPs should also ensure that the VA in question is an eligible large-cap VA (i.e., the VA is included in at least two “acceptable indices” issued by at least two independent index providers). VATPs should also provide the SFC with a written legal opinion to confirm that the VAs to be admitted do not fall within the definition of “securities” under the SFO.
VATPs must also conduct reasonable token due diligence, including an audit for VAs based on blockchains with a smart contract layer. Where reasonable, VATPs may rely on an independent smart contract audit.
(d) Disclosure: VATPs will need to disclose sufficient information about the VA to allow retail investors to reach an informed investment decision. Relevant information to provide includes, but is not limited to:
- Price and trading volume of the VA on the VATP in the last 24 hours.
- Issuance date of the VA.
- A brief description of the terms and features of the VA.
- Links to the VA’s website and smart contract audit report (if any).
- For VAs with voting rights, how those rights will be handled by the VATP.
(e) Prohibition on VAs amounting to securities: VATPs licensed under the new VATP licensing regime are prohibited from offering VA securities that may breach the “offers of investments regime” or the “prospectus regime” under the SFO.
Guidelines for VATP operators
All VATPs licensed under the new VATP licensing regime will need to comply with the guidelines for VATP operators (VATP Guidelines), which will supersede the existing VATP terms and conditions (T&Cs) currently imposed on SFC-licensed VATPs.
While the VATP Guidelines are largely similar to the T&Cs, they contain the following modifications:
(a) Insurance/compensation arrangements: The SFC proposes that:
- VATPs must implement a compensation arrangement approved by the SFC. This arrangement must cover risks associated with custody of VAs and may comprise insurance, the VATP’s funds, the funds of a group company or any combination thereof.
- Where the total value of client VAs under its custody exceeds the amount covered under the compensation arrangement and the VATP expects this to persist, the VATP must take prompt measures to rectify the situation.
- Funds set aside by the VATP or group companies under the compensation arrangement should be segregated and held on trust.
(b) VA derivatives trading: The SFC has signalled its intent to consider lifting the prohibition on VA derivatives trading. The SFC will issue further guidance on this proposal after conducting a separate review exercise.
(c) Legal opinion on VA and SFC approval: VATPs no longer need to submit a written legal opinion on VAs to be traded unless those VAs will be made available to retail investors. VATP operators also need not seek SFC approval to admit VAs that will only be available to professional investors.
(d) Handling of VA voting rights: Unlike in the T&Cs, VATPs will only be required to disclose how they will handle voting rights and need not facilitate the exercise of those rights.
Guideline on AML/CFT
VATPs licensed under the new VATP licensing regime will have to comply with the AML/CFT guidelines set out in (the newly inserted) Chapter 12 of the existing Guideline on AML/CFT (For Licensed Corporations).
In particular, VATPs will have to comply with a modified form of the Financial Action Task Force (FATF) Travel Rule:
(a) When acting as an ordering institution of VA transfers, a licensed VATP must obtain, record and submit the required information of the originator and recipient to the beneficiary institution immediately and securely.
(b) When acting as a beneficiary institution, a licensed VATP must obtain and record the required information submitted by the ordering institution or intermediary institution.
(c) A licensed VATP should conduct due diligence on a VA transfer counterparty to identify and assess the associated AML/CTF risks.
(d) When conducting VA transfers to or from unhosted wallets, a licensed VATP should obtain and record the required information from its customer, who may be the originator or recipient, and should take reasonable measures to mitigate and manage the ML/TF risks associated with the transfers.
Comments
The comprehensive guidelines and regulations set out in the Paper once again showcase the Hong Kong authorities’ efforts to position Hong Kong as a VA-friendly financial hub. In particular, currently licensed VATPs will likely welcome the generous transitional and deeming arrangements which help to ensure business continuity. VATPs with plans to begin operations in Hong Kong should also take note of the commencement date of the new VATP licensing regime and structure their plans in accordance.