28 Feb 2023

THE SFC PUBLISHED CONSULTATION PAPER ON THE PROPOSED REGULATORY REQUIREMENTS FOR VIRTUAL ASSET TRADING PLATFORM OPERATORS

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Introduction

On 20 February 2023, the Securities and Futures Commission (the “SFC”) issued a consultation paper on proposed regulatory requirements for virtual asset trading platform operators licensed by the SFC (the “Consultation Paper”). The Consultation Paper is a follow-up consultation of the Anti-Money Laundering and Counter-Terrorist Financing (Amendment) Bill 2022 (the “Bill”) which was gazetted in June 2022 and passed in December on the same year, introducing a new licensing regime for virtual asset service providers (the “AMLO VASP regime”) (see our news update on the Bill). The Consultation Paper further explains and sets out the proposed changes in regulatory requirements and proposed transitional arrangements under the regime for centralised virtual asset trading platforms (the “VA Trading Platforms”) trading non-security tokens coming into effect on 1 June 2023. Industry and public proposals are invited on the applicable regulatory approach. The public comment period ends on 31 March 2023.

Key Regulatory requirements

A. Key proposed regulatory requirements for licensed VA Trading Platforms

Upon the commencement of the AMLO VASP regime, it is proposed that VA Trading Platforms licensed by the SFC shall comply with the Guidelines for Virtual Asset Trading Platform Operators (“VATP Guidelines”). Such VATP Guidelines will be based on the existing regulatory requirements applicable to SFO-licensed platform operators (“LPOs”), and particularly, the Terms and Conditions for VA Trading Platform Operators (VATP Terms and Conditions).

The proposed regulatory requirements under VATP Guidelines cover various aspects and areas, such as fit and proper requirement, compliance with the general principles, financial soundness, operations, prevention of market manipulative and abusive activities, dealing with clients, custody of client assets, management, supervision and internal control, cybersecurity, conflict of interests, record keeping, auditors, ongoing report obligations.¹ The SFC also emphasise the “same business, same risks, same rules” approach, which requires VA providers of the same risk level to be subjected to the same obligations but adapted to address the specific risks of virtual assets (“VA(s)”), aiming to provide investors with more protection under the backdrop of the collapse of the Luna token and Terra stablecoin.² After the AMLO VASP regime comes into effect, the VATP Terms and Conditions will be superseded. All platform operators, whether licensed under the SFO and/or the Anti-money Laundering Ordinance (“AMLO”), will be subject to the VATP Guidelines.

B. Dual Licences

Upon the commencement of the AMLO VASP regime, the SFC will regulate the trading of security tokens by VA Trading Platforms under the existing SFO regime and regulate the trading of non-security tokens by VA Trading Platforms under the AMLO VASP regime.

Given that a VA may evolve from a non-security token to a security token (or vice versa), VA Trading Platforms (together with their proposed responsible officers and licensed representatives) should apply for approvals under both the existing SFO regime and the AMLO VASP regime and become dually licensed and approved.

C. Proposal to allow retail access to licensed VA Trading Platforms³

When the existing SFO regime was introduced in 2018, it was more prudent to restrict SFO-licensed VA Trading Platforms to serve professional investors only. In this regard, the SFC notes the public’s diverse views on whether retail investors should be allowed access to the services of licensed VA Trading Platforms.

In January 2022, the SFC allowed for the first-time retail investors to access a limited suite of regulated virtual asset-related derivative products traded on conventional exchanges. Later in October 2022, the SFC put in place a regime for authorising virtual asset futures exchange-traded funds. Retail investors, thus, since then have indirect access to Vas through regulated products in Hong Kong (see our news update for details).

Since more global financial institutions and service providers have entered the market, the SFC proposes to allow all types of investors, including retail investors, to access trading services of “Eligible large-cap VAs” offered by LPOs, provided that the VAs are included in at least two “acceptable indices” issued by at least two independent index providers. LPOs should also take into account other general token admission criteria including the market capitalization, trading volume, security of protocols, and internal compliance of the VAs before admitting them for trading.⁴

D. Consultations Questions⁵

Some of the key questions set out by the SFC for industry and public feedback, together with their corresponding views, are extracted as follows:

No.	Key Consultations Questions	Views of the SFC
1.	Do you agree that LPOs should be allowed to provide their services to retail investors, subject to the robust investor protection measures proposed?	Propose to implement robust measures to provide additional safeguards for retail investors including requiring the LPOs to (a) assess the client’s risk tolerance level and risk profile; and (b) set a limit for each client to ensure the individual client’s exposure to VAs is reasonable when providing services. Propose that LPOs should set up a token admission and review committee which should be mainly responsible for (a) establishing and enforcing the criteria for a VA to be admitted for trading and for halting, suspending and withdrawing the same; and (b) regularly reviewing the criteria abovementioned to ensure they remain appropriate as well as the VAs admitted so that they continue to satisfy the token admission criteria
2.	Do you have any comments on the proposals regarding the general token admission criteria and specific token admission criteria?	General non-exhaustive token admission criteria include, such as, (a) the background of a VA; (b) the regulatory status of a VA in each jurisdiction in which the LPO provides services and whether its regulatory status would affect the obligations of the LPO; and (c) the technical aspects of a VA, including the security infrastructure of its blockchain protocol, the size of the blockchain and network and how resistant it is to common attacks.⁶ Specific token admission criteria which are necessary but not sufficient conditions include (a) “Eligible large-cap virtual assets” referring to VAs which are included in at least two independent index providers and (b) an “acceptable index” which is an index clearly defined to measure the performance of the largest VAs.⁷ LPOs, whether licensed under the existing SFO regime or the AMLO VASP regime, should not offer a virtual asset that falls within the definition of “securities” under the SFO to the Hong Kong public if such an offer may breach the offers of investments regime or the prospectus regime under the securities laws of Hong Kong.
3.	What other requirements do you think should be implemented from an investor protection perspective if the SFC is minded to allow retail access to license VA trading platforms?	Reasonable due diligence to be carried out before admitting any VAs for trading.⁸ Disclosure obligations to be imposed on the LPOs as in the following non-exhaustive matters: (a) price and trading volume of the VAs; (b) background information about the VAs; and (c) brief description of the terms and features of the VAs.⁹
4.	Do you have any comments on the proposals to allow a combination of third-party insurance and funds set aside by the LPO or a corporation within its same group of companies? Do you propose other options?	Proposed requirements for insurance/compensation arrangement including (a) LPOs should have in place compensation arrangements approved by the SFC to provide appropriate levels of coverage for risks; (b) LPOs should monitor on a daily basis the total value of client VAs under their custody; and (c) where a LPO sets aside its own funds or the funds of a corporation within its same group of companies to satisfy the requirements, it should ensure that the funds are held on trust for specific purpose.

Key measures of the transitional arrangements and implementation details for the AMLO VASP regime

E. Eligibility for the transitional arrangements

To be eligible for the transitional arrangements, a VA Trading Platform must be pre-existing, i.e., in operation in Hong Kong prior to 1 June 2023 and with meaningful and substantial presence. To determine the same, the SFC will take to account the following non-exhaustive factors including (a) whether it is incorporated in Hong Kong; (b) whether it has a physical office in Hong Kong; and (c) whether its Hong Kong staffs have central management and control over the VA Trading Platform.¹⁰

F. Key dates and implementation details of the transitional arrangements

For pre-existing VA Trading Platform which intends to apply for a licence, it must submit a fully completed licence applicable online under the AMLO VASP regime between 1 June 2023 and 29 February 2024. It will be asked to confirm and demonstrate that it has been operating a VA Trading Platform in Hong Kong immediately before 1 June 2023 and it will comply with the applicable regulatory requirements.

For pre-existing VA Trading Platform that does not intend to apply for a licence, it should start preparing to close down its business in Hong Kong in an orderly manner. While the strict deadline for these platforms to close down is 31 May 2024, the SFC expects them to cease any active marketing of their services in Hong Kong.

By 1 June 2024, all VA Trading Platforms in Hong Kong must have been either deemed to be licensed or granted a licence by the SFC. The SFC will take immediate action against any unlicensed VA Trading Platforms.

Analysis and takeaways

Subsequent to the Government’s Policy Statement on its plan and approach for the VASP regime (see our news update), this Consultation Paper is a timely attempt to translate visions into practices and denotes a significant milestone in the global regulatory regime over VAs. SFC is committed to taking the forefront role in expanding the retail market for VAs in Hong Kong by implementing legal safeguards for different stakeholders. It helps retail investors acclimate to the volatile market and enables retail investors’ access to regulated trading platform under a protective and effective system. This Consultation Paper, together with the previously unveiled regulations, foster a new wave of market opportunities and capital investments while modernising Hong Kong’s financial market, which aligns with the global trajectory of further utilising VAs.

As such, we welcome the SFC’s proposals and would be happy our perspectives on the Consultation Paper for facilitating local VA services. We would also like to take the opportunity to encourage you to have discussion with us and share your views on this topic.

Please contact our Partner Mr. Rodney Teoh for any enquiries or further information.

This news update is for information purposes only. Its content does not constitute legal advice and should not be treated as such. Stevenson, Wong & Co. will not be liable to you in respect of any special, indirect or consequential loss or damage arising from or in connection with any decision made, action or inaction taken in reliance on the information set out herein.

¹ Please see p.10-11 of the Consultation Paper for the full list and corresponding explanation of the existing regulatory requirements.
² P.7 of the Consultation Paper.
³ P.12 of the Consultation Paper.
⁴ P.16 of the Consultation Paper.
⁵ P.12-23 of the Consultation Paper.
⁶ Please see p.15 of the Consultation Paper for the full list of general non-exhaustive token admission criteria suggested by the SFC.
⁷ Please see p.16 of the Consultation Paper for the specific token admission criteria, particularly on requirements for an “acceptable index”.
⁸ Please see p.17 of the Consultation Paper for the specific areas of due diligence required.
⁹ Please see p.17-18 of the Consultation Paper for the non-exhaustive list of disclosure obligations.
¹⁰ Please see p.24 of the Consultation Paper for full list of non-exhaustive factors in determining whether the firm has a meaningful and substantial presence.