SFC issues proposed regulatory requirements for licensed virtual asset trading platformsor: How Hong Kong learned to stop worrying and love crypto regulation
The Securities and Futures Commission (SFC) published a Consultation Paper setting out proposed regulatory requirements for virtual asset (VA) exchanges licensed under the bespoke regime for virtual asset service providers (VASPs) in the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615) (the AMLO VASP regime). The Consultation Paper also includes guidance on transitional arrangements applicable to VA exchanges currently operating in Hong Kong.
The implementation of the AMLO VASP regime is a part of Hong Kong’s recent efforts to position itself as a VA hub, as summarised in our previous client update in November 2022.
If there is one key takeaway from this latest development, it is this: the proposed regulatory requirements indicate that the AMLO VASP regime will not contain light touch regulations. Licensed exchanges will be held to similar standards as, if not higher standards than, SFC-licensed entities which conduct regulated activities not involving VAs. Investor protection is clearly front of mind for the SFC. Given the number of seismic events in the VA space which have occurred since the start of 2022, this seems to be a sensible first step in the SFC’s formulation of a regulatory framework covering VA-related financial services.
Overview of the AMLO VASP regime
To set the scene, key aspects of the AMLO VASP regime which were confirmed before the Consultation Paper are set out below.
- What is the AMLO VASP regime? Hong Kong is rolling out a mandatory licensing regime for VA exchanges, which will take effect on 1 June 2023. This is a significant evolution from the SFC’s existing opt-in licensing regime for VA exchanges, in which the only eligible platforms are those that offer trading in one or more tokens which are securities (i.e. VA exchanges which only offer trading in VAs currently do not have to be licensed and regulated by the SFC).
- Who needs a licence? Centralised custodial VA trading platforms (VATPs), which are (i) carrying on their businesses in Hong Kong or (ii) actively marketing their services to Hong Kong investors, must be licensed and regulated by the SFC. VASPs which do not provide exchange services (e.g. those that only provide custody services or VA issuers) are not caught and therefore would not need a licence under the AMLO VASP regime.
- What are VAs under the AMLO VASP regime? VAs are broadly defined and would capture many forms of crypto-assets, including governance tokens of decentralised finance (DeFi) protocols with voting rights and, potentially, a wide variety of non-fungible tokens (NFTs).
Exclusions from the definition of VAs include central bank digital currencies (CBDCs), in-game assets, customer loyalty or reward points, as well as securities under the Securities and Futures Ordinance.
The AMLO VASP regime also includes wide powers for the SFC and the Secretary for Financial Services and the Treasury to, in effect, prescribe specific crypto-assets as VAs.
What’s new in the Consultation Paper?
In addition to proposed regulatory requirements which would apply to licensed VATPs, the Consultation Paper sheds light on the SFC’s thinking on various issues related to those requirements.
We have highlighted several key points and relevant implications which should be of interest to the industry.
Not all types of VA exchange platforms are meant to be caught.
The AMLO VASP regime will only cover VATPs which are centralised and operate in a manner similar to traditional automated trading venues (i.e. exchanges which provide automated trading services for securities).
The SFC goes on to state that, by way of illustration, these VATPs typically provide VA trading services using an automated trading engine and provide custody services as an ancillary service.
Specifically, the regime does not aim to capture platforms which provide VA trading services
- without using automated trading engines (e.g. a platform which operates as an order routing facility); or
- which are peer-to-peer (P2P) in nature and do not involve a centralised party providing intermediation services (e.g. decentralised exchanges which are not “decentralised in name only” (DINO) and utilise automated market maker (AMM) protocols).
In terms of services, licensed VATPs can only offer spot trading – that’s (generally) it.
Two of the most popular types of products currently provided by VA platforms, namely VA derivatives and “earn” products which pay out yield (or interest, as some platforms call it) denominated in VAs, are out.
On VA derivatives, although the SFC did acknowledge their importance in hedging strategies for institutional investors, the proposed approach is that VATPs may not offer, trade or deal in VA derivatives.
The proposed language of the prohibition on “earn” products appears to be straightforward. In gist, licensed VATPs should not make any arrangements with its clients on using client VAs for the purpose of generating returns for the clients or any other parties. This raises the question of whether staking-related services which are truly on-chain and pay out staking rewards generated from proof-of-stake protocols – as opposed to services in which pay-outs are generated by the service platform via investments or other yield-generating activities (e.g. both traditional and DeFi lending) – would be caught. As the nature of staking activities come under increased scrutiny due to recent regulatory developments globally, the industry would benefit from clear guidance from the SFC on this point.
Other popular forms of service offerings, such as margin trading and algorithmic trading services (i.e. computer generated trading activities created by a predetermined set of rules aimed at delivering specific execution outcomes) are also generally restricted, unless exempted and/or approved by the SFC.
In terms of other business activities, licensed VATPs are generally not allowed to conduct proprietary trading or market making activities.
Crucially, these restrictions apply to the licensed entity and its affiliates – this clearly addresses various risks related to the close relationship between FTX (a VA exchange) and Alameda Research (a proprietary trading firm within the same group).
The SFC does state there may be limited circumstances in which proprietary trading may be allowed, but these would be assessed on a case-by-case basis.
Retail ban is removed, but significant restrictions on scope of accessible VAs still remain – stablecoins in particular may not be accessible by retail.
The SFC’s latest proposal that retail investors can trade on licensed VATPs is a significant shift from its earlier position that licensed VATPs can only serve professional investors. Notably, the SFC acknowledged public feedback that its previous position may drive retail investors to trade on unregulated VA exchanges based offshore, which would not be conducive to the SFC’s aim of protecting investors.
The devil is in the detail, however, as VAs accessible by retail investors will be limited to an extremely small pool based on the SFC’s proposals.
First, in line with various regulatory proposals seen globally, licensed VATPs must ensure all VAs available for trading satisfy a non-exhaustive set of general token admission criteria set out by the SFC. These include assessments relating to, among other things, a VA’s management or development team, regulatory status, maturity and liquidity, technical specifications and accuracy of marketing materials. VAs passing this test can be traded by professional investors.
Retail investors are only permitted to trade VAs which satisfy the specific token admission criteria, which only comprise “eligible large-cap” VAs included in at least two acceptable indices issued by at least two independent index providers. In effect, this may mean that retail investors will not be able to purchase stablecoins on licensed VATPs, as many indexes which may satisfy SFC requirements exclude crypto-assets which are pegged to fiat currencies from their constituent selection. This may be intentional as the Hong Kong Monetary Authority (HKMA) confirmed earlier this year that it is aiming to implement a stablecoin licensing regime by 2024 – it may therefore be the case that retail investors will be able to purchase stablecoins approved by the HKMA as and when this licensing regime takes effect.
Given the potentially small pool of assets accessible by retail, the question therefore remains whether these proposed retail-specific restrictions would go against the desired effect of incentivizing retail investors to trade on VATPs regulated by the SFC.
No “proof of reserves” requirements, but compensation arrangement needed.
Although many VA exchanges have provided publicly accessible “proof of reserves” following the FTX collapse, the SFC has not made this mandatory.
Instead, licensed VATPs are required to have a compensation arrangement approved by the SFC to provide an appropriate level of coverage for risks associated with the custody of client VAs (i.e. the amount under this arrangement should exceed the total value of client VAs held in custody). This compensation arrangement may be any or a combination of third-party insurance and funds of a licensed VATP or any corporation within the VATP’s group which are set aside on trust and designated for such a purpose.
The SFC suggests obtaining licences for both “TradFi” regulated activities and VA exchange at the same time - we think this reasoning may have significant implications applicable across the VA industry, not just exchanges.
The reason cited by the SFC for this suggestion is that a VA’s classification may change from a non-security token to a security token (or vice versa), therefore VA exchanges would be prudent to obtain licences under both regimes to avoid contravening relevant regulations and ensure business continuity.
While the industry would likely agree that the legal classification of crypto-assets may be highly fluid, the SFC’s confirmation of this view may affect how issuers and VA businesses monitor compliance with applicable laws:
- Issuers may have to carefully formulate distribution mechanisms, even if the initial legal assessment suggests that a particular crypto-asset is not a security. For example, many crypto-assets have ongoing distribution models whereby existing holders and/or new investors can receive crypto-assets after the initial offering. If the VA has “morphed” into a security token at any point in time, the ongoing distribution may be subject to registration / approval requirements under securities laws.
- VA businesses will have to continuously assess the legal classification of crypto-assets that they deal with, in order to ensure they are not conducting any regulated activities involving securities without a licence. In practice, this may mean seeking legal advice when a crypto-asset’s tokenomics undergo significant updates (e.g. moving towards a proof-of-stake consensus mechanism, implementing buyback schemes, paying out any form of returns (including staking rewards) to holders) to assess whether a crypto-asset may now be a security token.
It also remains to be seen whether this is an indirect reference to the concept of “sufficient decentralization” as made popular by William Hinman, former director of the U.S. Securities and Exchange Commission, who suggested that “[i]f the network on which a token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract.”1 The open question here is therefore how the potential change in a crypto-asset’s legal classification may affect the application of the regulated investments regime and/or prospectus regime in existing securities laws.
Transitional arrangements – how do you get “grandfathered” in?
There will be a 12-month transitional period from 1 June 2023 to 31 May 2024 for existing VATPs operating in Hong Kong to comply with the AMLO VASP regime.
- Existing VATPs must submit their licensing application by 29 February 2024 or cease operations by 31 May 2024.
- VATPs operating in Hong Kong before 1 June 2023 and with “meaningful and substantial presence” may continue their operation during this transition period (e. up to 31 May 2024). The SFC will consider the following factors in determining whether a firm has been operating a VATP in Hong Kong prior to 1 June 2023:
- whether it is incorporated in Hong Kong;
- whether it has a physical office in Hong Kong;
- whether its Hong Kong staff have central management and control over the VATP;
- whether its key personnel (g., those responsible for the operation of the trading system) are based in Hong Kong; and
- whether the centralised trading platform’s operation is live with considerable number of clients and volume of trading activities in Hong Kong.
VATPs not in operation in Hong Kong before 1 June 2023 will not be able to commence business until they are formally licensed.
The amount of detail in the Consultation Paper clearly demonstrates that there has been significant consideration (and reconsideration) by the SFC on many issues. The proposed regulatory requirements would provide some much-needed clarity for the industry and investors alike, and, perhaps more importantly, a clear pathway for currently unregulated VA exchanges to be licensed in Hong Kong. Besides benefits relating to regulatory compliance, being a licensed entity may also present a potential practical benefit of being viewed more favourably by banking partners and therefore lower the risk of being de-banked, which has been a pain point for many VA businesses especially in recent months.
A new licensing regime would also come with new challenges relating to licensing strategy. For example, many VA exchanges have issued native crypto-assets which are meant to provide utility for their users (e.g. discounted trading fees, airdrops), but the issuance and legal classification of these types of crypto-assets have been subject to increasing regulatory scrutiny – mostly due to the various issues which surfaced when FTX’s uses of its native exchange token, FTX Token (FTT), was found to be a major contributor of industry-wide misconceptions regarding its balance sheet. VA exchanges with native tokens should therefore carefully consider whether the issuance of such crypto-assets may adversely affect their licensing application.
Other market participants, such as SFC-licensed corporations and registered financial institutions, will also need to consider the impacts of the new regime on their relationships with VA exchanges and onboarding procedures.
About DLA Piper’s Blockchain and Digital Assets practice
DLA Piper worked with the Dubai Virtual Assets Regulatory Authority (VARA), as its exclusive global legal advisor, on the creation of the world’s first virtual assets specific regulatory framework.
The Hong Kong Fintech team regularly advises on regulatory compliance and licensing matters involving virtual assets and have a strong track record of obtaining licences for fintech clients in various regulatory frameworks, including the first SFC-regulated roboadvisory app and equity crowdfunding platform.
For further information regarding the AMLO VASP regime and inquiries on how DLA Piper can assist with your licensing application, please contact Kristi Swartz (Partner).
1 See William Hinman’s “Digital Asset Transactions: When Howey Met Gary (Plastic)” speech dated 14 June 2018: https://www.sec.gov/news/speech/speech-hinman-061418