Hong Kong's virtual assets regulatory regime – beginning of a new chapter

Article 31 October 2022 Experience: Banking and finance
Corporate

At the beginning of the Hong Kong FinTech Week this year, the government announced a policy statement (” 2022 Policy Statement “) to outline its vision, strategies and regulatory system for opening up investment opportunities related to virtual assets (” VA “) and developing the city into an international centre for VA.

In essence, the government affirms its “same activity, same risks, same regulation” principle, but decides it is now the time to launch a mandatory licensing regime for all VA service providers, and to facilitate retail investors to increasing their exposure to VA.

While more exciting developments are in the works, this article first traces the city’s major regulatory developments since early 2020 (please click here ) and highlights the major initiatives outlined in the 2022 Policy Statement.

1. Joint circular by HKMA and SFC on intermediaries’ VA-related activities

Earlier this year, the Securities and Futures Commission (” SFC “) and the Hong Kong Monetary Authority (” HKMA “) issued a joint circular providing guidance to intermediaries on the distribution of VA-related products and provision of VA dealing and advisory services (the “ Joint Circular “), superseding an earlier circular issued on 1 November 2018.

Distribution of VA-related products

The SFC and HKMA find that VA service providers (” VASPs “) and spot markets may be unlicensed and unregulated, which will lead to investor protection issues including lack of pricing transparency, counterparty risks and market manipulation.

As such, the SFC and HKMA suggest that investor protection measures and other requirements under the complex product regime should be imposed to cover the above risks. In particular, complex products (e.g. overseas VA non-derivative exchange-traded funds) should only be offered to professional investors.

In addition, intermediaries need to assess whether specified clients (those that are neither institutional professional investors nor qualified corporate professional investors) have knowledge of investing in VA or VA-related products. Intermediaries should only distribute VA to clients if doing so would be acting in the client’s best interests and proper training on the nature and risks of VA to the clients has been provided. Intermediaries must also ensure their clients have sufficient net worth to be able to assume the risks and bear the potential losses.

Provision of VA dealing and advisory services

The Joint Circular requires intermediaries to partner only with SFC-licensed VASPs when providing VA dealing and advisory services to ensure adequate investor protection.

Intermediaries are also expected to comply with the SFC and HKMA’s regulatory requirements when providing VA dealing and advisory services, regardless of the nature of the VA. Such dealing and advisory services can only be provided to professional investor clients of the intermediary’s Type 1 (dealing in securities) and 4 (advising on securities) regulated activities when such clients have sufficient knowledge of investing in VA or VA-related products.

When providing VA dealing services, the Joint Circular further highlights those intermediaries should only permit clients to deposit or withdraw fiat currencies from their accounts. Depositing or withdrawing the client’s VA is not allowed to minimise the risks associated with the transfer of VA.

2. Bill for Mandatory Licensing of VA Service Providers

Following the public consultations in late 2020 (click here for our preceding update), the government introduced the proposed amendments – the Anti-Money Laundering and Counter-Terrorist Financing (Amendment) Bill 2022 (the “ Bill “) – to the Legislative Council on 6 July 2022. It introduces a licensing regime for VASPs where the SFC’s regulatory powers will be extended to all VA trading platforms in Hong Kong.

The new licensing and regulatory regime for VASPs and the transitional arrangements for pre-existing VASPs will come into effect on 1 March 2023.

Detailed definition of virtual assets

Under the Bill, VA are defined as “a cryptographically secured digital representation of value” that satisfies three essential criteria:

1) It is expressed as a unit of account or a store of economic value;
2) It either (a) is used or intended to be used as a medium of exchange accepted by the public for payment for goods or services or discharge of a debt or investment purposes; or (b) provides the right to vote on the management and administration or change of terms of any arrangement in connection with the VA; and
3) It can be transferred, stored, or traded electronically.

This definition would be wide enough to include Bitcoins, Altcoins, Ether and stablecoins. On the other hand, the definition expressly excludes:

  • digital representations of fiat currencies including central bank or government issued digital currencies;
  • limited purpose digital tokens that are non-transferable, non-exchangeable and non-fungible (e.g. air miles, credit card rewards, gift cards, customer loyalty programmes and gaming coins);
  • financial assets regulated under the Securities and Futures Ordinance (Cap. 571) (e.g. securities or futures contracts); and
  • float or stored value facilities deposit of stored value facilities regulated under the Payment Systems and Stored Value Facilities Ordinance (Cap. 584).

How about NFTs?

According to a press release from the SFC issued on 6 June 2022, NFTs are especially risky to uninformed investors due to their illiquid secondary markets, volatility, opaque pricing and risks of hacking and fraud. But will they be counted as VA under the new licensing regime?

Under the current definition, whether or not an NFT will qualify as a VA will depend on the structure and features of the NFT. If an NFT merely represents a genuine digital representation of a collectible (e.g. digital image, artwork, music or video), it will not fall within the definition of a VA under the Bill.

However, where the characteristics of a specific NFT go beyond the boundary of a collectible and towards that of a financial asset (e.g. fractionalised or fungible NFTs structured in a form similar to securities or interests in a collective investment scheme; or NFTs that contain fungible elements or allow holders to vote on its arrangement), it may meet the qualification of a VA and falls within the regulatory ambit of the Bill and the SFC.

Compared to the licensing scheme outlined in the 2020 consultations, the Bill contains the following key changes:

a) ‘VA service’ is defined as the operation of a VA exchange providing services through means of electronic facilities where:

  • offers to sell or purchase VA are regularly made or accepted in a way that forms or results in a binding transaction;
  • persons are regularly introduced or identified to other persons so they can negotiate or conclude sales or purchases of VA in a way that forms or results in a binding transaction; and
  • where client money or client VA comes into direct or indirect possession of the person providing such services.

b) Eligible applicants for VASP licenses under the new regime would include both locally incorporated companies as well as companies that have a registered presence in Hong Kong.

c) Apart from ultimate owners and responsible officers, licensed representatives of a VASP (i.e. agents who provide VA services on behalf of a VASP) are also subject to licensing requirements and the fit-and-proper test under the Bill.

For licensing requirements, apart from those stipulated in our preceding update, there are other conditions such as the following:

  • prevention of market manipulation and abusive activities;
  • keeping of accounts and records by licensed providers and their associated entities;
  • provision of contract notes, receipts, statements of account and notifications by licensed providers and their associated entities;
  • financial statements and other documents, and the auditor’s report;
  • business conduct of licensed providers and their licensed representatives;
  • notification of changes; and
  • cybersecurity.

What should existing VASPs do now?

Under the Bill, where a pre-existing VASP files an application for licensing with the SFC within the first 9 months after the commencement (i.e. 1 March 2023) of the new regime and confirms that it will comply with SFC’s regulatory requirements, the VASP would be deemed to be licensed until the SFC and has made a decision on its licence application.

Existing VASPs may wish to review whether a VASP licence is required for their business operations in Hong Kong. If so, they will have to assess: (i) whether structural changes are required as only companies incorporated or registered in Hong Kong are eligible applicants, (ii) whether their existing internal policies and procedures are sufficient to meet the licensing standards in relation to anti-money laundering and counter-terrorist financing (“AML/CTF”), risk management and prevention of market manipulation and abusive activities, VA listing and trading policies, etc. and (iii) when and how to offboard all retail customers (as VASPs may only provide services to professional investors) and customers in jurisdictions where cryptocurrency activities are prohibited to avoid cross-border regulatory issues.

3. New Initiatives under the 2022 Policy Statement

The 2022 Policy Statement makes it clear that Hong Kong is “ready to calibrate” its legal and regulatory regime to provide a facilitating environment for promoting sustainable and responsible development of the VA sector.

Launching the above-mentioned mandatory licensing regime for VASPs will align requirements for VASPs in terms of AML/CTF compliance and investor protection to those applicable to financial institutions. It will also invigorate financial intermediaries’ and banks’ VA dealing and advisory services, which under the Joint Circular must be operated by partnering with SFC-licensed VASPs.

Another major regulatory leap is SFC’s announcement, on the same date of and as contemplated in the 2022 Policy Statement, that it is prepared to authorize exchange traded funds that obtain exposure to VAs primarily through futures contracts, i.e. VA Futures ETFs. Concurrently the 2022 Policy Statement also indicates that the SFC will conduct public consultations on how retail investors may be given further access to VA under the new licensing regime. Once implemented, these will substantially increase retail investors’ options to invest in VAs, and further enhance the VA ecosystem in Hong Kong.

In addition, the government also indicates it is open to review on the property rights for tokenised assets and the legality of smart contracts. These key questions have been looming for some time and are due for clarifications and/or statutory reform in order to provide a solid legal foundation for the VA sector in Hong Kong.

Finally, the 2022 Policy Statement confirms that consultation outcome and next steps will be shortly announced as a follow up from the HKMA’s discussion paper for the regulation of payment-related stablecoins issued in January 2022.

4. Observations

These positive developments arguably represent the silver lining of the recent crisis in the VA market, as regulators all over the world have been given a good deal of foods for thoughts in venturing into the new digital economy. If pursued and implemented properly in earnest, these new initiatives may very well lead us out of the Crypto Winter!