On 23 May 2023, the Securities and Futures Commission (the “SFC”) issued the consultation conclusions on the proposed regulatory requirements for virtual asset trading platform operators licensed by the SFC (the “Consultation Conclusions”) setting out the finalised changes on the regulatory requirements and proposed transitional arrangements under the new licensing regime (the “AMLO VASP regime”) for centralised virtual asset trading platforms (the “VA Trading Platforms”). The Consultation Conclusions were issued in response to the consultation paper (the “Consultation Paper”) published on 20 February 2023 (see our news update here).
Implementation of the Guidelines
The SFC will implement the Guidelines for Virtual Asset Trading Platform Operators (the “VATP Guidelines”), the Guideline on Anti-Money Laundering and Counter-Financing of Terrorism (For Licensed Corporations and SFC-licensed Virtual Asset Service Providers) and Prevention of Money Laundering and Terrorist Financing Guideline for Associated Entities of Licensed Corporations and SFC-licensed Virtual Asset Service Providers (the “AML Guidelines”, together with the VATP Guidelines, the “Guidelines”)) with some modifications and clarifications as set out and discussed in the Consultation Paper. The Guidelines will be published in the Gazette and become effective on 1 June 2023. The Guidelines set out, among others, safe custody of assets, segregation of client assets, avoidance of conflicts of interest and cybersecurity standards and requirements expected of licensed trading platforms. The SFC will provide additional guidance on the new regulatory requirements, other implementation details including licence application procedures, as well as more information about the transitional arrangements.
Part I: Amendments to the proposed regulatory requirements for licensed VA trading platform operators
A: Allow retail access to licensed VA Trading Platforms
Most of the respondents showed their strong support for allowing licensed VA Trading Platforms to provide their services to retail investors. Apart from permitting retail access, the SFC agreed that the licensed VA Trading Platforms should comply with a range of robust investor protection measures covering onboarding, governance, disclosure and token due diligence and admission, before providing trading services to retail investors. The SFC expressed that it will continue its efforts with the Investor and Financial Education Council to educate investors about all aspects of virtual assets and their trading, including risks of trading on unregulated platforms to ensure investor protection.
Many of the respondents agreed to the imposition of onboarding requirements for retail clients, but they also indicated their concerns on whether retail clients have sufficient knowledge of virtual assets before trading. A few of the respondents also requested that individual professional investors be exempt from the onboarding requirements entirely.
In response, the SFC considered that the terms, features and risks of virtual assets are generally not likely to be understood by a retail investor, and the implementation of the full scope of proposed onboarding requirements is necessary. The SFC is also of the view individual professional investors should be subject to similar protections as retail investors.
The SFC indicated that platform operators should conduct a holistic assessment of an investor’s understanding of the nature and risks of virtual assets, which could include an assessment of virtual asset training or courses that the investor has previously attended, the investor’s current or previous work experience related to virtual assets and the investor’s prior trading experience in virtual assets.
The respondents showed strong support for requiring a licensed VA Trading Platform to establish a token admission and review committee to enhance its governance. The SFC is of the view that the members “principally responsible for” different areas of the platform will at least include the corresponding managers-in-charge of the platform operator and it would not be necessary to require platform operators to appoint independent external members to the committee.
The majority of the respondents agreed that the imposition of disclosure obligations for each admitted virtual asset is important for the protection of investors. To address the concern of some respondents on the difficulty to obtain and verify information from an issuer of an admitted virtual asset, the SFC proposed requiring licensed VA Trading Platforms to act with due skill, care and diligence when disclosing information. The disclosure obligations in the VATP Guidelines are also further refined to require platform operators to take all reasonable steps to ensure the product specific information they disclose is not false, biased, misleading or deceptive.
General token admission criteria
The majority of respondents agreed that licensed VA Trading Platforms should have regard to general token admission criteria prior to admitting any virtual asset for trading, while some asked for exemptions for virtual assets with large market capitalisations, for virtual assets which have already been admitted for trading on a licensed VA Trading Platform or for unsolicited execution-only transactions. In response, the SFC believed that it is not appropriate to provide any exemption from conducting due diligence. Also, regarding the issue on token’s regulatory status in each jurisdiction, the SFC expressed that it will only require the platform operator to consider the regulatory status of the virtual asset in Hong Kong. Nevertheless, platform operations are reminded to ensure their operations are in compliance with local laws and regulations in all jurisdictions where they operate.
Specific token admission criteria for “eligible large-cap virtual assets”
The SFC clarified that the tokens must be eligible large-cap virtual assets included in at least two acceptable indices issued by two independent index providers. It further requires that the index provider with experience in publishing indices for the conventional securities market to comply with the IOSCO Principles for Financial Benchmarks such that it has proper internal arrangements in place to protect the integrity and ensure the quality of its indices. In addition to being independent of each other, the SFC will also require that the two index providers should be independent of the issuer of the virtual asset and also of the VA Trading Platform operator.
The SFC also expressed that as the admissibility and continued eligibility of a token for trading depends on the due diligence conducted by a platform operator, it would not be appropriate for the SFC to publish lists of virtual assets eligible for retail trading, acceptable indices or index providers.
Stablecoins will be of no avail prior to implementation of stablecoin regulatory regime
The possible inability to maintain its peg, and susceptibility to run, are reasons the SFC considered that stablecoins should not be admitted for retail trading at this stage prior to being subject to regulation in Hong Kong. It is noted that the Hong Kong Monetary Authority published the conclusion on its discussion paper on crypto-assets and stablecoins in January 2023 (see our news update here) and the regulatory arrangements for stablecoins are expected to be implemented in 2023/24.
B. Maintain an insurance or compensation arrangement
Lowered coverage ratio from 95% to 50% for cold storage of client virtual assets
With regard to the comments provided by the respondents, the SFC is of the view that as risks to client virtual asset held in hot and other storages are not typically associated with the custody of client assets in the traditional financial markets, these client virtual assets should be fully covered by the compensation arrangement of a licensed VA Trading Platform. On the other hand, for client virtual assets held in cold storage, the SFC is prepared to lower the coverage threshold to 50%, on the basis that 98% of client virtual assets will be required to be held in cold storage.
Regarding the types of assets that could form part of a compensation arrangement, the SFC accepts (a) bank guarantees; (b) funds held in the form of demand deposits or fixed deposits with a maturity of six months or less; and (c) virtual assets which are of the same type of the client virtual assets being covered.
Other than an escrow arrangement put in place for the compensation arrangement, VA Trading Platforms are allowed to hold the funds set aside, provided that such funds are segregated from the assets of the VA Trading Platform operator and its group companies, and are set aside on trust and designated for such purpose. Funds held by the platform operator or its associated entity should be held in a segregated account with an authorised financial institution.
C. Trading in virtual asset derivatives
The respondents generally support the idea of allowing licensed VA Trading Platforms to provide trading services in virtual asset derivatives. The SFC will take the comments into consideration and conduct a separate review in due course.
D. Other adaptations to existing requirements
After considering the comments of the respondents, the SFC remains its view that the cold to hot storage ratio should not be lowered and the bulk of client virtual assets should be held in cold storage, so as to ensure the safe custody of client assets. Regarding proprietary trading, the SFC has revised the requirements in the VATP Guidelines to allow trading by affiliates other than trading through the licensed VA Trading Platform. However, licensed VA Trading Platforms are not allowed to provide services commonly seen in the virtual asset market such as earning, deposit-taking, lending and borrowing.
E. AML/CFT matters
Virtual asset transfers
The SFC considers that any delay in the implementation of the Travel Rule in Hong Kong would affect the competitiveness of the Hong Kong-licensed VA Trading Platforms. Where the required information cannot be submitted to the beneficiary institution immediately, the SFC considers the submission of the required information as soon as practicable after the virtual asset transfer to be acceptable as an interim measure until 1 January 2024.
Virtual asset transfer counterparty due diligence
To address the concern of the respondents, the SFC believed the relevant guidance, including the factors that should be considered and the measures to be taken, are in line with the Financial Action Task Force (FATF)’s standards and guidance and should be applied using a risk-based approach. The due diligence measures should be applied to the entity which a licensed VA Trading Platform conducts virtual asset transfers with.
Risk-based policies and procedures for handling incoming virtual asset transfers lacking the required information
The SFC clarified that a licensed VA Trading Platform should only return virtual assets where appropriate and when there is no suspicion of money laundering or terrorist financing (“ML/TF”), and the returns should be made to the account of the ordering institution rather than the originator’s account.
Virtual asset transfers to or from unhosted wallets
Many respondents supported the requirements imposed for virtual asset transfers to or from unhosted wallets. The SFC indicated that it is mandatory for licensed VA Trading Platforms to take reasonable measures on a risk-sensitive basis to mitigate and manage the ML/TF risks associated with virtual asset transfers to or from an unhosted wallet.
Other virtual asset-specific AML/CFT requirements
The SFC clarified that the licensed VA Trading Platforms should not carry out occasional transactions as they are required to establish a business relationship with all customers pursuant to the VATP Guidelines.
Cross-border correspondent relationships
Some respondents had asked the SFC to clarify the scope of application of cross-border correspondent relationships in the context of virtual assets. The SFC stated that the requirements for cross-border correspondent relationships apply to a licensed VA Trading Platform when it provides services in the course of providing a virtual asset service to a virtual asset service provider or financial institution located in a place outside Hong Kong.
Screening of virtual asset transactions and the associated wallet addresses
The SFC has clarified that screening of virtual asset transactions and their associated wallet addresses should be performed before conducting a virtual asset transfer, or before making the transferred virtual assets available to the customer; and after conducting a virtual asset transfer on a risk-sensitive basis.
F. Disciplinary Fining Guidelines
Responding to the concerns regarding the fining criteria, the SFC agreed that the same set of fining criteria should be applied to both Securities and Futures Ordinance (“SFO”)-licensed and Anti-Money Laundering Ordinance and Counter-Terrorist Financing Ordinance (“AMLO”)-licensed VA Trading Platforms, where both of them will be subject to the same fining criteria irrespective of the ordinance under which they are licensed.
The SFC believed the proposed Disciplinary Fining Guidelines already provide sufficient information regarding the factors being considered in determining whether to impose a fine as well as the appropriate fine. The SFC stipulated that it will not follow a rigid framework in applying a specific amount or numerical value to any of the factors.
In deciding whether disciplinary action should be taken against individuals, corporations or both, the SFC will take a holistic approach, in which it will consider all the circumstances including the conduct of the corporation and individual in question. And for those involved in the management of a corporation, the SFC will consider whether there is any consent, connivance or negligence on their part, any failure in supervision, or the management of business.
Part II: Key measures of the transitional arrangements and implementation details of the new regulatory regime
License application related matters
The SFC clarified the scope of “providing a virtual asset service”, where the AMLO regime will cover VA Trading Platforms which are centralised and operate in a manner similar to traditional automated trading venues licensed under the SFO. The provision of virtual asset services without an automated trading engine and ancillary custody services would not fall under the scope of the AMLO regime.
Regarding the dual-licensing issue, the SFC suggested that it would be prudent for VA Trading Platforms to apply for approvals under both the existing SFO and AMLO regime to avoid contravention of the licensing regimes, given the ever-changing nature and classification of tokens. It also acknowledged that withdrawing a token previously admitted for trading when the token evolved into a security token may not be in the best interests of clients and should be a measure of last resort. The dual-licenses application process will be streamlined to allow applicants to submit only one single consolidated application.
The SFC also emphasised that the Phase 1 external assessment report shall be submitted together with the license application, given that an external assessor is expected to be involved in the early preparation stages of applying for a license.
Transitional arrangement-related matters
The SFC explained that the VATP Guidelines will supersede the Terms and Conditions for VA Trading Platform Operators previously issued by the SFC and be imposed as a licensing condition. For existing SFO-licensed VA Trading Platforms, the SFC will not remove the corresponding licensing conditions on compliance with the Terms and Conditions for VA Trading Platforms from their licenses until the VA Trading Platform can fully comply with the VATP Guidelines or by the deadline of the 12-month transitional period, whichever is earlier.
Analysis and Takeaways
We believe that the clarifications and amendments proposed by the SFC are mostly sensible, as they represent the collective wisdom and practitioners’ experience accumulated over the years. The discussion on gathering of irrevocable commitments, the closing of “offer period” and partial offers are indeed helpful and timely. The proposal to include green initiatives is also commendable, especially when bulk-printing of documents for compliance with the despatch requirements may in practice hinder actions where time is of essence.
It is expected that the SFC would continue to review the rules to provide better guidance and efficiency to the market participants while balancing the core value to maintain market order and defend the market integrity of Hong Kong.
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.