Impending Changes: Understanding the “Licensed System for Virtual Currency Exchanges in Hong Kong”

Author | Gu Jiening Senior Legal Advisor, Shanghai Man Kun Law Firm

Starting June 1, 2023, Hong Kong will implement a virtual asset service provider (VASP) licensing regime. This will mark a major industry change in Hong Kong and the greater China region.

I. Voluntary Licensing Regime

For virtual asset trading platforms, the Securities and Futures Commission (SFC) introduced a regulatory framework for virtual asset trading platforms in 2019 and made detailed provisions in its “Position Paper – Regulation of Virtual Asset Trading Platforms”.

“The SFC has no power to issue licenses to or supervise platforms that only trade non-securities virtual assets or tokens,” as these virtual assets do not fall under the “securities” or “futures contracts” under the Securities and Futures Ordinance, and the businesses operated by these platforms do not constitute “regulated activities” under the Ordinance. Therefore, non-security token virtual asset trading platforms are not required to be licensed under the “voluntary licensing regime”.

In fact, the “Position Paper” is consistent with the SFC’s “Circular on the Publication of the SFC Regulatory Sandbox” issued in 2017, which takes a sandbox approach to innovation in the “fintech” field and is a specific measure in the cryptocurrency finance field. In 2018, the SFC further formulated a “Statement on the Framework for Supervision of Management Companies, Fund Distributors and Trading Platform Operators for Virtual Asset Portfolios”.

According to the “Position Paper”, a central platform that provides virtual asset trading services can apply to the SFC for a license to engage in regulated activities of Type 1 (dealing in securities) and Type 7 (automated trading services) if they intend to offer trading services for at least one securities-type token. The regulatory framework includes strict standards for asset custody, network security, anti-money laundering, market supervision, accounting and auditing, product due diligence review, and risk management.

SFC also specifically states that it only regulates virtual asset trading platforms (i.e. centralized virtual asset exchanges) that provide virtual asset trading, settlement and delivery services and have control over investor assets. If a platform only provides trading services for direct peer-to-peer markets, and its investors usually retain control of their own assets (whether fiat or virtual), SFC will not accept license applications from these platforms (i.e. decentralized virtual asset exchanges are not regulated by SFC). In addition, if the platform conducts virtual asset transactions for customers (including transmitting buy and sell instructions), but does not provide automated trading services itself, SFC will not accept their license applications.

So far, only two exchanges have obtained the above two licenses. At the end of 2020, OSL Digital Securities Limied, a subsidiary of BC Technology Group, obtained licenses No. 1 and No. 7, becoming Hong Kong’s first compliant licensed virtual asset exchange. In April 2022, Hash Blockchain Limited, a subsidiary of HashKey Group, became the second virtual asset exchange to obtain licenses No. 1 and No. 7. Although there are a few more asset management companies that have obtained license No. 9, there are only six institutions such as Huobi Asset Management, LionRock Global Asset Management, MaiCapital, and Fore Elite Capital.

However, under the “voluntary licensing system”, licensed entities can only provide services to professional investors. For most virtual asset exchanges that focus on the “retail” market, licenses No. 1 and No. 7 are not very attractive due to their lack of practicality. This further highlights the “rarity” of the VASP license, which will be introduced in June this year.

II. VASP Licensing System

On December 7, 2022, the “2022 Anti-Money Laundering and Counter-Terrorist Financing (Amendment) Bill” (hereinafter referred to as the “AML Bill”) was passed by the Legislative Council of Hong Kong to implement the VASP licensing system, which will begin on June 1, 2023.

The following table summarizes the simple comparison of the new and old licensing systems in Hong Kong:

3. Dual Licensing

Depending on the regulatory authorization, SFC will regulate the trading of security-type tokens conducted by virtual asset trading platforms under the current regime of the Securities and Futures Ordinance, and will also regulate the trading of non-security-type tokens conducted by virtual asset trading platforms under the virtual asset service provider regime under the Anti-Money Laundering Ordinance.

Given that the terms and characteristics of virtual assets may evolve over time, the classification of a certain virtual asset may change from a non-security-type token to a security-type token (or vice versa). In accordance with the above regulatory logic, in order to avoid violating any issuance regulations and ensure that business operations can continue, virtual asset trading platforms should apply for approval under the current regime of the Securities and Futures Ordinance and the virtual asset service provider regime under the Anti-Money Laundering Ordinance (i.e. apply for VASP license and Type 1 and Type 7 licenses) in parallel to obtain dual licensing and approval.

To simplify the application procedure for dual licensing, if the applicant wishes to apply for licenses under the current regime of the Securities and Futures Ordinance and the virtual asset service provider regime under the Anti-Money Laundering Ordinance at the same time, the applicant only needs to submit a comprehensive application form online and indicate that both licenses are applied for at the same time.

It is expected by the SFC that platform operators with dual licensing will only need to make one submission to comply with the issuance or notification requirements under the current regime of the Securities and Futures Ordinance and the virtual asset service provider regime under the Anti-Money Laundering Ordinance.

4. Compliance Requirements for Exchanges

According to the “Guidelines Applicable to Virtual Asset Trading Platform Operators” and the “Terms and Conditions Applicable to Virtual Asset Trading Platform Operators” published by the SFC, centralized virtual asset exchanges need to meet the following compliance requirements when operating.

1. Safeguard client assets

Platform operators should hold client funds and virtual assets in trust through a wholly-owned subsidiary (“connected entity”). Platform operators should ensure that no more than 2% of the virtual assets stored in the online wallet are client virtual assets.

Furthermore, since accessing virtual assets requires the use of private keys, the safe management of private keys is essential. Platform operators should establish and implement written internal policies and governance procedures for private key management to ensure the secure generation, storage, and backup of all encryption seeds and keys.

In addition, platform operators should not deposit, transfer, lend, pledge, re-pledge, or buy and sell customer virtual assets in any way, or create any ownership burden on customer virtual assets. They must also have insurance, and their coverage should cover the risks involved in storing customer virtual assets.

2. Know Your Customer (KYC)

Platform operators should take all reasonable steps to establish the true and complete identity, financial status, investment experience, and investment objectives of each customer.

In addition, platform operators must ensure that customers have sufficient knowledge of virtual assets (including awareness of the risks involved) before providing any services to them.

3. Combating Money Laundering/Terrorist Financing

Platform operators should establish and implement adequate and appropriate policies, procedures, and monitoring measures to combat money laundering/terrorist financing. Platform operators can use virtual asset tracking tools to trace the records of specific virtual assets on the blockchain.

4. Conflict of Interest

Platform operators should not engage in proprietary trading or proprietary banking activities, and should have policies in place to manage internal employee transactions in virtual assets to eliminate, avoid, manage or disclose actual or potential conflicts of interest.

5. Inclusion of Virtual Assets for Trading

Platform operators should establish a function responsible for formulating, implementing, and enforcing guidelines for the inclusion of virtual assets, guidelines for suspending, temporarily suspending, and revoking virtual asset trading, and customer options.

In addition, platform operators should conduct a reasonable due diligence review of any virtual assets before including them for trading and ensure that they continue to meet all criteria.

6. Prevention of market manipulation and misconduct

Platform operators should establish and implement written policies and monitoring measures to identify, prevent, and report any market manipulation or misconduct that occurs on their platform. The monitoring measures should include restrictions or suspensions on trading upon discovery of manipulation or misconduct. Platform operators should adopt effective market surveillance systems provided by reputable independent vendors to identify, monitor, detect, and prevent such manipulation or misconduct and provide the SFC with access to these systems.

7. Accounting and auditing

Platform operators should select auditors with appropriate skills, care, and diligence, taking into account their experience, track record, and ability to audit virtual asset-related businesses and platform operators.

In addition, platform operators should submit auditors’ reports annually, which should include a statement on whether there have been any breaches of applicable regulatory requirements.

Furthermore, we impose a licensing condition requiring platform operators to submit reports to the SFC on a monthly basis, after the end of each calendar month and upon request by the SFC, on their business activities.

8. Risk management

Platform operators should establish robust risk management frameworks that enable them to identify, measure, monitor, and manage all risks arising from their business and operations.

Platform operators should also require customers to pre-fund their accounts and not provide any financial accommodation to customers to purchase virtual assets.

Section 5 – Transitional arrangements

For “pre-existing virtual asset trading platforms”, the AMLO provides for a transitional period until 1 June 2024.

If the operator applies to the SFC within 9 months after 1 June 2023 and confirms that it will comply with the regulatory requirements formulated by the SFC, the operator may be regarded as having been licensed until the SFC makes a decision on its licensing application. During this period, the operator will be able to continue to provide services until (i) the end of the first 12 months, (ii) the withdrawal of the application, (iii) the SFC’s refusal of the application, or (iv) the SFC’s grant of the licence, whichever is the earlier.

If its application for a virtual asset service provider license is rejected by the SFC, the operator must terminate its virtual asset service within three months of receiving the rejection notice or by June 1, 2024, whichever is later. During this period, the operator may only take actions that are purely for the purpose of closing its services. The operator may apply to the SFC for an extension of the closure period, which shall be for such period as the SFC considers appropriate having regard to the operator’s business and activities.

For “non-existing virtual asset trading platforms” planning to provide virtual asset services in Hong Kong after June 1, 2023, they should apply to the SFC in advance and obtain a virtual asset service provider license.

VI. Regulatory arbitrage is gradually disappearing

Under the Anti-Money Laundering Ordinance, sanctions will be imposed on illegal and non-compliant activities, including the provision of virtual asset services without a license and non-compliance with AML/CTF requirements. In addition, any act of actively promoting services to the Hong Kong public will be considered as providing virtual asset services, regardless of the location or service provider of the service.

Operating and providing virtual asset services without a VASP license after June 1, 2023 is a criminal offense. If convicted through a public prosecution procedure, a fine of HKD 5 million and imprisonment for 7 years may be imposed. If it is a continuing offense, a fine of HKD 100,000 may be imposed for each day during the period of the offense. If convicted through a summary conviction procedure, a fine of HKD 5 million and imprisonment for 2 years may be imposed. If it is a continuing offense, a fine of HKD 10,000 may be imposed for each day during the period of the offense.

Failure to comply with statutory AML/CTF requirements will result in criminal liability for licensed service providers and their responsible persons. Upon conviction, each person may be fined HKD 1 million and imprisoned for 2 years. In addition to criminal liability, they will also be subject to disciplinary action by the SFC, including suspension or revocation of the license, reprimand, direction to take remedial action, and fines.

In addition, various “misconduct” during the operation of virtual asset exchanges may also face disciplinary fines from the SFC.


Note: All Bitpush News articles only represent the views of the author and do not constitute investment advice.
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