Hong Kong has taken yet another significant step in the regulation of virtual assets by launching a consultation in late 2020 for the proposed licensing of virtual asset services providers ("VASPs"). It is part of the legislative proposals to enhance anti-money laundering ("AML") and counter-terrorist financing ("CTF") regulation in Hong Kong. This alert highlights the proposed licensing regime and the reception by industry players.
Who will be required to be licensed?
Under the new proposal, any persons operating a virtual asset exchange will be required to apply for a license from the Securities and Futures Commission of Hong Kong (“SFC”), even if the VA Exchange only trades virtual assets that are not securities. The existing voluntary opt-in regime, with the first license being granted on 16 December 2020, only applies to the trading of virtual assets ("VAs") with securities feature.
Clarifying the scope of virtual assets
A virtual asset is defined as a digital representation of value that is expressed as a unit of account or a store of economic value; functions 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. The definition covers virtual assets which are not securities, such as Bitcoin and Ether.
With reference to the definition, the new proposal will include stablecoins (i.e. virtual assets backed by assets) but will exclude digital representations of fiat currencies (including central bank digital currencies), as well as financial assets (e.g. securities and authorised structured products) already regulated under the SFO and 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 and gaming coins).
Defining Virtual Assets Exchanges
VA Exchanges are trading platforms for buying or selling virtual assets and have custody or control of virtual assets during the process. Peer-to-peer platforms where the actual transaction is conducted outside the platform without it coming into possession of any VA at any point in time, are not covered under the above definition of VA Exchange. VA Exchanges that are already regulated as a licensed corporate in the current opt-in regime are also exempted.
It is noteworthy that VA activities conducted outside the VA exchanges such as VA payment systems, VA custodian services, initial coin offerings, over-the-counter trade and crypto-ATMs will not be subject to regulation under the proposed framework, as such VA activities in Hong Kong are currently negligible. The government proposal has indicated that the licensing regime may be expanded to cover other types of VASPs should the need arise in the future.
Key requirements for a VASP license
To ensure local anchorage is available for SFC supervision and enforcement, only locally incorporated companies with a permanent place of business in Hong Kong will be considered for the granting of a VASP license.
II.Appointment of at least 2 Responsible Officers
To ensure proper management of a licensed VASP and for it to be accountable, VA Exchanges applying for a license is required to appoint at least two responsible officers ("ROs") to assume the general responsibility of ensuring compliance with AML/CTF and other regulatory requirements. They will be held personally accountable in case of contravention or noncompliance of SFC requirements. All executive directors of a licensed VA Exchange are required to be ROs.
All ROs and ultimate owners of the VA exchange seeking a license are required to satisfy a fit-and-proper test, for which the SFC will take into account, among other relevant considerations:
- whether the person has been convicted, in any jurisdiction, of a money laundering or terrorist financing offence or other offence in which the person is found to have acted fraudulently, corruptly, or dishonestly;
- whether the person has failed or may fail to observe the AML/CTF, or other regulatory requirements applicable to licensed VA Exchanges;
- the experience and relevant qualifications of the person; and
- whether the person is of good standing and financial integrity (e.g. not being the subject of any bankruptcy or liquidation proceedings).
Obligations for licensed VASPs
The SFC will be able to impose licensing conditions resembling those that apply to virtual assets trading platforms under the current Opt-in Regime, on top of the AML/CTF requirements stipulated in the AML legislation, in order to create a level playing field for all market participants. These conditions include:
- Professional investors only – at the initial stage, licensed VASP should only offer services to professional investors which includes high net-worth individuals with a portfolio of at least HK$8 million, corporations with portfolios of at least HK$8 million or total assets of at least HK$40 million, or institutional investors licensed banks, broker-dealers, and asset managers
- Financial resources - A licensed VASP must have adequate financial resources for operating its virtual asset business, including a paid-up share capital of a specified amount and liquid assets, depending on the nature of its business. However, the minimum financial resources required is not quantified
- Knowledge and experience - A licensed VASP must have a proper corporate governance structure staffed by personnel with the necessary knowledge and experience to enable the effective discharge of responsibility
- Soundness of the business - A licensed VASP must operate its virtual asset business in a prudent and sound manner, and ensure that client and public interests will not be adversely affected
- Risk management - A licensed VASP must have implemented appropriate risk management policies and procedures for managing money laundering/terrorist financing, cybersecurity, and other risks arising from a regulated virtual asset activity that are commensurate with the scale and complexity of the business
- Segregation and management of client assets - A licensed VASP must implement proper segregation of client assets by placing them in an associated entity, with adequate policies and governance procedures to ensure the proper management and custody of client assets including virtual assets
- Virtual asset listing and trading policies - A licensed VASP must implement and enforce robust rules for the listing and trading of virtual assets on its platform. VA Exchanges should also perform all reasonable due diligence on virtual assets before listing them for trading.
- Financial reporting and disclosure - A licensed VASP must observe prescribed auditing and disclosure requirements
- Prevention of conflicts of interest - A licensed VASP must not engage in proprietary trading or market-making activities on a proprietary basis, in order to avoid any conflicts of interests.
The SFC will prepare and publish for consultation of the regulatory requirements, including the codes and guidelines, before the commencement of the new licensing regime.
With the rationale that the penalty level should be high enough to achieve the necessary deterrent effect, criminal liabilities will be imposed for unlicensed VA activities; making false, deceptive or misleading statements in connection to the granting of a license; and non-compliance with the statutory AML/CTF requirements. The sanctions proposed are similar to those applicable to financial institutions already regulated under the anti-money laundering legislation.
Public reception of the new proposals
The new regulatory framework is a move that promises change to the largely unregulated trading of virtual assets. Although VASPs will face stringent requirements and retail investors in Hong Kong may find themselves unable to trade virtual assets on exchange, the new proposal will nonetheless step up constructive oversight in the region by establishing rigorous benchmarks and in turn enhance investors' confidence. The majority of market players are supportive of the licensing regime as it is essential to the development of a robust and dynamic VAs ecosystem and positions Hong Kong to be a hub and market leader for VAs.
Click here to read more on the regulatory approach to virtual assets in Hong Kong.