The Financial Services and Treasury Bureau (FSTB) issued a consultation paper on 3 November 2020 seeking comments on its proposal (the New Regs) to amend Hong Kong’s anti-money laundering legislation to bring exchanges that offer virtual assets (VAs) that are not securities within the regulatory remit of Hong Kong’s securities regulator, the Securities and Futures Commission (SFC), in line with recommendations issued in 2019 by the Financial Action Task Force (FATF) in relation to virtual asset service providers (VASPs).
By way of recap, the SFC already has a regulatory framework in place for virtual asset trading platforms (the 2019 Framework – see our blog entry on its launch in November 2019 here). This licensing regime works on an opt-in basis, and is only available to exchanges that offer trading in at least one token that qualifies as a security under the Hong Kong securities regime. As a result, exchanges that offered only payment cryptocurrencies such as bitcoin were not covered.
The New Regs are designed to close this regulatory gap and seek to regulate providers of non-securities virtual asset services for the first time. The aim, as stated by Ashley Alder, Chief Executive of the SFC during Hong Kong Fintech Week, is to ensure that the same regulatory standards as the 2019 Framework apply.
What is covered by the New Regs?
This has thrown the unwary reader. The consultation paper suggests initially that all VASPs are in scope (which, following FATF parlance would include not just crypto-to-crypto and crypto-fiat exchanges, but also business transferring and safekeeping VAs as well as those providing financial services related to an offer or sale of VAs). However, when describing the regulated activity that will be caught, the reference is to businesses operating a VA exchange (defined as 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). Does this mean other service providers (e.g. a free standing VA custody service) which would fall within the FATF definition of VASPs are not caught? They seem to be – the consultation paper expressly refers to seeing “a case to tailor a licensing regime for VA exchanges” and that VA activities conducted outside VA exchanges in Hong Kong are “negligible”. The paper goes to conclude that the Government will consider the need for regulation when the market is ready.
For completeness, note that the New Regs will align the definition of VAs[1] with that in the FATF requirements, and will include stablecoins. Excluded are digital representations of fiat currencies (including CBDCs) and financial assets such as securities and structured products that are already regulated by the SFC. In addition, 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.) will also be carved out.
What are the required standards?
All responsible officers (ROs) and ultimate owners will need to meet the fit & proper test, and only locally incorporated companies can apply. The RO regime will follow that of other SFC-licensed financial services firms – i.e. the licensed VASP will need to appoint at least two ROs, and all executive directors must be made ROs upon approval by the SFC.
In addition to being required to observe the statutory AML/CTF requirements under the anti-money legislation, licensed VASPs will be subject to a robust set of regulatory requirements which will be imposed by way of licensing conditions which include:
- At the initial stage, services can only be offered to professional investors (i.e. institutional investors or those that meet specified asset threshold tests) – this rules out almost all of the retail market other than HNW individuals
- (As yet unspecified) financial resources requirements
- Governance, knowledge and risk management requirements
- Segregation of client assets
- Listing and trading policies
- Financial reporting and disclosure
- Prevention of market manipulation and market abuse
- Prevention of conflicts of interest
The SFC will be granted far-reaching supervisory and intervention powers which we expect to be in line with other financial services firms under its remit. Sanctions for non-compliance are extensive and include criminal penalties.
Important for our friends overseas
The consultation paper proposes that in order to protect local investors from being exposed to risks from unlicensed VA exchanges, the proposal is to prohibit any person from actively marketing, whether in Hong Kong or elsewhere, to the public of Hong Kong a regulated VA activity or a similar activity elsewhere (i.e. services associated with a VA exchange), unless the person is properly licensed and regulated by the SFC for the purpose of conducting the regulated VA activity.
It is not clear what “similar activity elsewhere” means – potentially this would mean that wider services are caught offshore than onshore?
The term “active marketing” will be interpreted in accordance with the equivalent term that is used in relation to offshore to onshore marketing for other financial services firms within the SFC’s remit. We can provide further guidance as needed.
Food for thought
- It makes sense for the new proposal to be rolled into the amendment of the anti-money laundering legislation, as Hong Kong is required to implement the 2019 FATF standards for VASPs. This will make entities regulated under the New Regs criminally liable for failures to implement client due diligence and record-keeping requirements. It will be important to ensure that the new regime matches that for already licensed VA platforms to create a level playing field.
- Any VA adjacent businesses will need to check their business model carefully. As set out above, we don’t think some of these VASP businesses will be caught at the outset.
- The professional investor only requirement will be a big blow to the businesses dealing in “traditional” crypto assets such as BTC.
- Beware active marketing restrictions: even overseas exchanges will need to tread a very fine line when onboarding Hong Kong customers. We will need to see some clarification on what “similar activity elsewhere” means.
- Who are ultimate owners? It is not yet clear whether the ultimate owners will follow the substantial shareholder definition used in the securities legislation for other SFC regulated businesses (broadly > 10% direct and > 35% indirect ownership or control up the chain)?
- Will all the other requirements in the 2019 Framework apply? See also point 1. above.
- No word on derivatives and whether margin will be permitted.
The consultation paper is available here, and responses can be submitted until 31 January 2021. If you want to discuss, please contact Etelka Bogardi (etelka.bogardi@nortonrosefulbright.com) or Amy Chung (amy.chung@nortonrosefulbright.com).
[1] The proposed definition is: [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.
