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Authored by: Simon Deane and Chris Wong
The Securities and Futures Commission (“SFC”) launched a consultation on the regulatory requirements for virtual asset trading platforms (“VATPs”) in Hong Kong. As most would now know, a licensing regime for virtual asset service providers that operate centralised virtual asset trading platforms will come into operation on 1 June 2023, and the SFC is now preparing the relevant regulatory guidelines and requirements for VATPs so that they are in place once the regulatory regime comes into effect. The SFC has issued a consultation document relating to (i) the proposed regulatory requirements for VATPs, and (ii) whether retail investors should be allowed access to VATPs.
The SFC will base the requirements on the existing requirements for centralised VATPs which have “opted-in” to be regulated, and expand the requirements to take into account the changes to the industry since the implementation of the opt-in regime in 2019. The proposed guidelines have requirements in relation to (i) custody of client money and virtual assets, (ii) AML/CFT and KYC checks, (iii) conflicts of interest in relation to trading or market-making activities, (iv) criteria and procedures for admitting virtual assets for trading on the VATP, (v) policies on prevention of market manipulation and other similar activities, and (vi) standard requirements for systems of control and management, in particular accounting, auditing and risk management.
Of somewhat greater interest is the consultation in relation to whether retail investors should be permitted to access licensed VATPs. Although the SFC has in the past taken a more reserved view on the participation of retail investors in virtual assets, it has allowed limited and indirect access to retail investors to virtual assets exposures through limited regulated products. Given the changes and growing maturity in the virtual asset industry over the last few years, as well as the intentions of the HKSAR Government to develop Hong Kong into a virtual asset hub, the SFC now sees an opportunity to permit all investors to access trading services provided by licensed VATPs within limited circumstances and under proper investor protection measures. Such measures will include (i) requiring VATPs to have onboarding requirements for its clients, including the client’s risk tolerance, financial situation, etc., and (ii) requiring VATPs to establish and implement criteria in relation to what virtual assets can be admitted for trading by retail investors, taking into account factors such as the virtual asset’s background, development and management, regulatory status, supply, demand, maturity and liquidity of the virtual asset, technical aspects, market and legal risks of the virtual asset, etc.
Specifically in relation to trading by retail investors, the SFC intends only to allow “eligible large-cap virtual assets” to be traded by them. An eligible large-cap virtual asset refers to a virtual assets that is included in at least two acceptable indices (an index that has a clearly defined objective to measure the performance of the largest virtual assets and is investible, objective, possessing necessary expertise and well documented methodology) issued by at least two independent index providers (independent meaning not within the same group or belonging to the same entity as the VATP). The SFC is also proposing to introduce additional due diligence requirements for VATPs on virtual assets proposed to be traded by retail investors, including (i) ensuring that the VATP’s own systems of control are sufficient, (ii) conducting a smart contract audit for virtual assets based on blockchains with a smart contract layer, and (iii) obtaining a legal opinion to be provided to the SFC to the effect that the virtual asset in question does not fall within the definition of securities under the Securities and Futures Ordinance (Cap. 571).
Other matters subject to the consultation include requirements on disclosure of information relating to the virtual assets to be traded on the VATP, insurance and compensation arrangements, whether virtual asset derivatives should be permitted in the future (noting that they are not currently allowed), and requirements on AML/CTF measures. Transitional arrangements are also outlined in the consultation paper.
The willingness of the SFC to consider opening the possibility of investing and trading in virtual assets to retail investors is a welcome move, and the tumult in the virtual asset industry in 2022 (including the collapse of the Terra stablecoin, several large players in the industry, and the then-second largest virtual asset exchange in FTX) emphasises the need for stringent and robust regulatory requirements to protect all investors, and in particular the ordinary retail investor. The proposals strike a balance between these necessary protections and the aim to encourage the growth of the virtual asset industry in Hong Kong.
The deadline for submission of comments to the consultation closes on 31 March 2023. For more details, please see the link to the consultation paper, and the link to the press release announcing the consultation.
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