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Hong Kong consults on detailed requirements for virtual asset exchanges

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Authored by: Scott Carnachan

The Securities and Futures Commission (SFC) is consulting on the detailed requirements that will apply to virtual asset exchanges licensed under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO). The same requirements will also apply to virtual asset exchanges that list securities tokens and so are required to be licensed under the Securities and Futures Ordinance (SFO). The consultation paper is available here. The deadline to submit comments to the SFC is 31 March 2023. Our article on the licensing regime under the AMLO is available here.

The licence regime comes into effect on 1 June 2023. Given the limited time between the end of the consultation and the commencement of the licensing regime, it would be prudent for virtual asset exchanges operating or considering operating in Hong Kong to assume virtual asset exchanges licensed under the AMLO will be subject to requirements in substantially the form set out in the consultation paper.

Securities regulation plus

Virtual asset exchanges operating in Hong Kong will move from a largely unregulated environment (now) to a highly regulated environment (from 1 June 2023).

The detailed requirements in the consultation paper indicate that the regulatory environment for licensed virtual asset exchanges will be equivalent to the requirements that currently apply to licensed corporations under the SFO, with modifications, additional requirements and additional restrictions specific to virtual assets. The SFC has indicated in the consultation paper that, in designing the regulatory requirements, it has sought to strike a balance between investor protection and market development.

Steps that existing virtual asset exchanges operating in Hong Kong should consider are set out below under “What existing operators should do next”.

Overview of regulatory requirements

The detailed requirements set out in the consultation paper consist of:

1. Guidelines for Virtual Asset Trading Platform Operators (VATP Guidelines) – the VATP Guidelines set out the requirements for establishment and ongoing operation of licensed virtual asset exchanges, including in relation to:

    (a) Minimum requirements to be considered “fit and proper”, competency requirements and continuous professional training requirements;

    (b) Financial resources;

    (c) Corporate governance and operations, including processes for admitting tokens for listing and processes to prevent market manipulative and abusive activities;

    (d) Client take-on procedures and ongoing disclosures to clients;

    (e) Custody of client assets;

    (f) Cybersecurity;

    (g) Conflicts of interest;

    (h) Recordkeeping;

    (i) Audits; and

    (j) Ongoing reporting and notification obligations;

2. Guideline on Anti-Money Laundering and Counter-Financing of Terrorism (For Licensed Corporations and SFC-licensed Virtual Asset Service Providers) (AML Guideline for LCs and SFC-licensed VASPs) – the AML Guideline for LCs and SFC-licensed VASPs apply the existing anti-money laundering requirements for licensed corporations under the SFO to virtual asset exchanges licensed under the AMLO and include a new chapter 12 specifically relating to the anti-money laundering risks of virtual assets and the steps that need to be taken when assessing and managing such risks;

3. Prevention of Money Laundering and Terrorist Financing Guideline issued by the Securities and Futures Commission for Associated Entities of Licensed Corporations and SFC-licensed Virtual Asset Service Providers (Associated Entity AML Guideline) – the Associated Entity AML Guideline applies the AML Guideline for LCs and SFC-licensed VASPs to associated entities as if they were licensed as a virtual asset exchange under the AMLO (see “Custody requirements – need for a TCSP” below for more detail on associated entities and their role);

4. Disciplinary Fining Guidelines – these Guidelines set out the basis on which the SFC intends to exercise its power to impose fines under section 53ZSP(3)(c) of the AMLO and are consistent with how the SFC exercises its existing power to impose fines under the SFO.

Various requirements of the VATP Guidelines are discussed in more detail below.

Requirement for dual licences under both the SFO and the AMLO

The SFC proposes that virtual asset exchanges must be licensed under both the AMLO and the SFO, even if the intention of a virtual asset exchange is only to list tokens that are not “securities” under the SFO. This proposal is a change from the longstanding approach that a licence will only be granted under the SFO where an applicant will engage in “regulated activities”, as defined under the SFO.

The SFC rationale for proposing a dual licence requirement is that the terms and features of virtual assets may evolve over time and a virtual asset’s classification may change from a non-security token to a security token (or vice versa). The SFC notes that, by obtaining licences under both the AMLO and the SFO, any change in the nature of a token listed on a virtual asset exchange would not result in the exchange breaching either licensing regime.

To the extent that there are differences in the requirements under the SFO and the AMLO, a dual-licensed virtual asset exchange would need to comply with the more stringent requirement.

Custody requirements – need for a TCSP

Licensed virtual asset exchanges will need to establish an “associated entity” to hold client assets. The associated entity must:

1. Be a company incorporated in Hong Kong;

2. Be a wholly-owned subsidiary of the exchange;

3. Be licensed by the Registrar of Companies as a trust or company services provider (TCSP) under the AMLO;

4. Hold client assets on trust; and

5. Not conduct any business other than that of receiving or holding client assets on behalf of the exchange.

Requirement for external assessment reports to support licence applications

The SFC proposes to require that a licence applicant engages an external assessor to assess its business going forward, and submit the assessor’s reports to the SFC (i) when submitting the licence application (Phase 1 Report) and (ii) after the SFC has granted approval-in-principle of the application (but before final approval) (Phase 2 Report). Separate external assessors may be appointed to review different areas of the applicant’s business. The assessor(s) must be independent and should have the necessary expertise and technical knowledge to conduct the required assessment. The SFC reserves the right to oppose the appointment of any external assessor.

The Phase 1 Report should cover the design effectiveness of the virtual asset exchange’s proposed structure, governance, operations, systems and controls, with a focus on key areas such as governance and staffing, token admission, custody of virtual assets, know your client, anti-money laundering, market surveillance, risk management and cybersecurity. The assessor should review and assess whether the platform operator’s policies and procedures are clearly written and in compliance with the applicable legal and regulatory requirements. The Phase 2 Report should be the assessor’s assessment of the implementation and effectiveness of the actual adoption of the planned policies, procedures, systems and controls.

The SFC will grant final approval of a licence application only if it is satisfied with the findings of the Phase 2 Report.

The purpose of the requirement for external assessment reports is to streamline the SFC application process. It will mean an additional up-front commitment of time and costs for licence applicants, both in identifying and appointing an external assessor and in liaising with the external assessor on review of the virtual asset exchange’s proposed structure, governance, operations, systems and controls and the external assessor’s final reports.

Permitted scope of activities

A licensed virtual asset exchange will be able to offer trading in virtual assets to “professional investors” (as defined in the SFO). The SFC also proposes that virtual asset exchanges be permitted to offer trading in certain virtual assets to retail investors.

Prohibited activities

Licensed virtual asset exchanges will not be permitted to:

  • provide financial accommodation for their clients to acquire virtual assets (i.e. margin trading is not permitted);
  • offer, trade or deal in virtual asset futures contracts or related derivatives;
  • provide algorithmic trading services for their clients; or
  • make any arrangements with their clients to use client virtual assets held by the exchange for the purpose of generating returns for the clients or any other parties (i.e. lending, staking etc.).

Ability to offer virtual assets to retail investors

The SFC proposes that a licensed virtual asset exchange be permitted to offer trading in eligible large-cap virtual assets to retail investors.

“Eligible large-cap virtual assets” refer to virtual assets which are included in at least two “acceptable indices” issued by at least two independent index providers. An index provider may only be considered independent if it does not belong to the same entity or is not within the same group of companies as the licensed virtual asset exchange.

An “acceptable index” is an index which has a clearly defined objective to measure the performance of the largest virtual assets in the market and fulfils the following criteria:

a) The index should be investible, meaning the constituent virtual assets should be sufficiently liquid;

b) The index should be objectively calculated and rules-based;

c) The index provider should possess the necessary expertise and technical resources to construct, maintain and review the methodology and rules of the index; and

d) The methodology and rules of the index should be well documented, consistent and transparent.

At least one of the indices must be issued by an index provider which has experience in publishing indices for the traditional non-virtual asset financial market. An example of such an index provider is one which has issued an index tracked by an SFC-authorised index fund.

What existing operators should do next

If you are a virtual asset exchange that is currently operating in Hong Kong, you should:

1. Review the detailed regulatory requirements and decide whether you wish to apply for a licence under the AMLO transitional provisions;

2. If you wish to apply for a licence under the AMLO transitional provisions:

    (a) Confirm you are eligible to apply (see “Eligibility for AMLO transitional provisions” below);

    (b) Conduct a gap analysis of your existing structure, governance, operations, systems and controls to identify areas that need enhancement to comply with the detailed regulatory requirements;

    (c) Implement any necessary enhancements, including any changes required to financial resources, custody arrangements, personnel, policies, documentation etc.;

    (d) Incorporate a wholly-owned subsidiary to act as the exchange’s associated entity and apply to the Registrar of Companies to licence such associated entity as a TCSP;

    (e) Engage an external assessor to prepare a Phase 1 Report;

    (f) Submit an application to the SFC for a licence no later than 29 February 2024.

    Note: At the time a virtual asset exchange submits its application, it is required to give the SFC a confirmation that it complies with and has arrangements to ensure compliance with the regulatory requirements applicable to licensed virtual asset exchanges. As a result, the virtual asset exchange needs to be in full compliance with the detailed regulatory requirements no later than 29 February 2024.

3. If you do not wish to apply for a licence under the AMLO transitional provisions, you should put in place a plan to either:

    (a) So far as possible, restructure your operations so that the services you provide do not trigger a licence obligation under the AMLO; or

    (b) Wind down your business in Hong Kong on or before 31 May 2024.

Eligibility for AMLO transitional provisions

The AMLO contains transitional provisions for existing virtual asset exchanges that have been carrying on business of providing VA services (as defined in the AMLO) in Hong Kong immediately before 1 June 2023. The SFC has indicated it will apply a high threshold for this purpose and will only accept virtual asset exchanges that have been in operation in Hong Kong prior to 1 June 2023 and with meaningful and substantial presence as eligible for the transitional provisions.

In determining whether an existing virtual asset exchange has a meaningful and substantial presence, the SFC has indicated that it will take into account the following factors, amongst others:

a) whether the exchange is incorporated in Hong Kong;

b) whether the exchange has a physical office in Hong Kong;

c) whether the exchange’s Hong Kong staff have central management and control over the exchange;

d) whether the exchange’s key personnel (for example, those responsible for the operation of the trading system) are based in Hong Kong; and

e)  whether the exchange’s operation is live with a considerable number of clients and volume of trading activities in Hong Kong.

Key Contacts

Scott Carnachan

Consultant | Financial Services

Email or call +852 2825 9265

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