Proposal for mandatory SFC licence for all virtual asset trading platforms

Each year we see major developments in Hong Kong’s virtual asset (VA) regulation being revealed at the city’s FinTech Week. This year is no different.

On 3 November 2020, Ashley Alder, CEO of the Securities and Futures Commission (SFC), announced a ground-breaking legislative proposal to introduce a new licensing regime for VA trading platforms (VA platforms) under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615) (AMLO) (the proposed regime).

On the same day, the Financial Services and the Treasury Bureau (FSTB)’s Consultation Paper, explaining the proposed regime in detail, was released.

Why is this significant?

1. A mandatory licensing regime for VA platforms

Under the proposed regime, all VA platforms operating in Hong Kong, or targeting Hong Kong investors, must be licensed, regulated and monitored by the SFC, regardless of whether the virtual assets they trade are “securities” or not. In other words, VA platforms no longer have the ability to stay outside of the SFC’s current “opt in” licensing regime for VA platforms (read more here) by simply avoiding the inclusion of securities on their platform. Importantly, non-compliance is a criminal offence.

2. A mandatory licensing regime for VA platforms with full legal backing

It was the same time last year when we asked in our blog post “if and when” legislative changes would catch up with the fast-moving developments in VA, and that “time” has now arrived, although in a slightly unexpected form (given the proposed regime is to be built into the AMLO, not the Securities and Futures Ordinance (SFO) under which “securities”, “futures”, and the SFC “regulated activities” are defined). In any case, we think the proposed regime is a big leap forward – and if successful, it will be the first time that VAs are officially recognised by and written into a Hong Kong Ordinance.

Trigger for introducing the proposed regime

The use of AMLO to deliver the proposed regime (rather than the SFO) is a result of Hong Kong being a member jurisdiction of the Financial Action Task Force (FATF). Hong Kong has an obligation to align itself with various FATF Standards including Recommendation 15, which calls for member jurisdictions to impose AML/CTF obligations on “virtual asset service providers” (VASP), and to require VASP to be licensed or registered. Therefore, to be consistent and up-to-date with international AML standards and developments, Hong Kong lawmakers and regulators have proposed to take this opportunity to address the “significant limitation” (in Mr. Alder’s words) previously left unsolved with the “opt in” licensing regime.

Who will need to apply for a licence under the proposed regime?

In short, any VASP operating a VA exchange in Hong Kong, or targeting Hong Kong investors, will need to obtain a VASP licence from the SFC under the proposed regime. Firms that are already licensed by the SFC under the existing “opt-in” regime will not be required to seek an additional licence. It is expected that the proposed regime and the existing regime will work in parallel, meaning that VA platforms that only trade non-security tokens would fall under the proposed regime, whereas those that trade security tokens, or a mixture of security and non-security tokens, would continue to be regulated under the existing regime.

Some of the key definitions and carve-outs of the proposed regimes are explained below.

VASP” means “any person seeking to engage in a regulated VA activity under the AMLO”.

Regulated VA activity” only captures the activity of “operating a VA exchange”, at least for now.

Currently, the proposed regime does not intend to regulate VA activities conducted outside VA exchanges (e.g. OTC trade and crypto-ATMs, VA payment systems or VA custodian services operating as a standalone business) given their presence in Hong Kong is “scanty and negligible”, according to the Consultation Paper. However, this definition will be “expanded to cover forms of VA activities other than VA exchanges where the need arises in the future”.

VA exchange” means “any trading platform which is operated for the purpose of allowing an offer or invitation to be made to buy or sell any VA in exchange for any money or any VA (whether of the same or different type), and which comes into custody, control, power or possession of, or over, any money or any VA at any point in time during its course of business”.

Similar to the existing “opt-in” regime, direct peer-to-peer trading platforms will not be covered by this definition, provided the actual transaction is conducted outside the platform and the platform is not involved in the underlying transaction by coming into possession of any money or any VA at any point in time. Specifically, peer-to-peer trading platforms refer to those that only provide a forum where buyers and sellers of VAs can post their bids and offers, for the parties themselves to trade at an outside venue.

VA” means “a digital representation of value that is expressed as a unit of account or a store of economic value; functions (or is intended to function) as a medium of exchange accepted by the public as payment for goods or services or for the discharge of a debt, or for investment purposes; and can be transferred, stored or traded electronically”.

This definition is derived and adapted from the FATF Recommendation. Stablecoins are covered by this definition, but the following are not:

  1. digital representation of fiat currencies (including digital currencies issued by central banks);
  2. financial assets (e.g. securities and authorised structured products) already regulated under the SFO;
  3. closed-loop, limited purpose items that are non-transferable, non-exchangeable and non-fungible (e.g. air miles, credit card rewards, gift cards, customer loyalty programmes, gaming coins etc)

Licensing and regulatory requirements

The proposed regime is based on the existing “opt-in” regime. This was confirmed by Mr Alder at the FinTech week, where he said: “both regimes will impose the same regulatory standards, guaranteeing a level playing field for all operations. And both will benchmark against the well-understood regulatory principles which apply to securities brokers and other trading venues. The overarching principle is ‘same business, same, risks, same rules’.

More details on the licensing and regulatory requirements can be found in the Consultation Paper. Consistent with the existing “opt-in” regime, licensed VASP will be restricted from servicing non-professional (i.e. retail) investors, although the SFC is likely to reconsider this no-retail position “as the market becomes more mature in future”.

So, what’s next?

The Hong Kong regulatory landscape for VA platforms has evolved rapidly over the past year. For the platforms that have so far remained outside of the SFC’s regulatory net, the issue to consider is no longer “should I get an SFC licence?” Instead, the questions to be asked are now “How should I structure my business such that I can secure an SFC licence?” and “Should I ‘opt in’ now for more certainty before the proposed regime is officially introduced?” For those platforms that have a specific retail focus – a more imminent choice will need to be made before considering licensing issues: “Should I change the business to focus on professional investors? Or should I simply exit the Hong Kong market?”

In any case, the proposed regime, if officially introduced, will undoubtedly have a significant impact on many industry players. Views and comments are invited by the Consultation Paper, which must be received by 31 January 2021. Following the consultation phase, the proposed regime is expected to go through the legislative process, so it is likely to take some time before the proposed regime comes into effect.

We think the proposed regime is a big leap forward – and if successful, it will be the first time that virtual assets are officially recognised by and written into a Hong Kong Ordinance.

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