Hong Kong SFC Consults on Proposals to Regulate Virtual Asset Trading Platforms

The Securities and Futures Commission of Hong Kong (the “SFC”) issued a consultation paper recently on the proposed regulatory requirements for virtual asset (“VA”) trading platform operators licensed by the SFC on February 20, 2023 (the “Consultation”).

1. Background

Under the existing Securities and Futures Ordinance (Cap. 571) (the “SFO”), only VA trading platforms (“VATP”) that enable clients to trade security tokens fall under the current SFC regulatory regime. Under the current SFO, the SFC does not have the power to grant a license to or regulate VATPs that only provide trading services in non-security tokens.

The Hong Kong Legislative Council approved the new Virtual Asset Service Provider (“VASP”) regime in December 2022, which will take effect on June 1, 2023. The new regime will regulate all centralized custodial VA exchanges, whether they operate in Hong Kong or are directly marketed to Hong Kong investors, and they must be licensed by the SFC. On the condition that VATP comply with various investor protection measures, they will be accessible to all types of investors, including retail investors.

The SFC is conducting a market consultation on the proposed regulatory requirements to be imposed on licensed VATPs to prepare for the commencement of the licensing regime, as well as to review the requirements under the existing SFO regime, consider potential modifications, and provide more details on transitional arrangements and implementation.

2. Guidelines for Virtual Asset Trading Platform Operators

The Consultation proposed that all VATPs with business operations in Hong Kong or actively marketing their services to Hong Kong investors will need to be licensed by the SFC unless they are pre-existing VATPs that are eligible for transitional arrangements (which will be further discussed below).

VATPs licensed by the SFC must comply with the Guidelines for Virtual Asset Trading Platform Operators (the “VATP Guidelines”). The VATP Guidelines are based on and will supersede existing regulatory requirements applicable to SFO-licensed platform operators, primarily the Terms and Conditions for VA Trading Platform Operations.

The VATP Guidelines broadly cover areas on safe custody of client money and VA (including secure generation of cryptographic seeds and keys), know-your-client (“KYC”) obligations, anti-money laundering/counter-financing of terrorism (“AML/CFT”) policies, conflicts management, admission criteria for VA, prevention of market manipulation and abusive activities, risk management and accounting and audit functions.

3. Proposal to allow retail access to licensed VA trading platforms

The Consultation proposes to allow all types of investors, including retail investors and purchasers, to access trading services provided by licensed VATP operators, provided that the platforms comply with a range of investor protection measures, including those set out below.

3.1. Onboarding requirements

• A licensed platform operator should conduct a knowledge assessment on investors and purchasers and provide training to them.
• A licensed platform operator should ensure that the provision of its services is suitable for the client by assessing a client’s risk tolerance level and risk profile; assessing whether it is suitable for the client to participate in the trading of VA; and setting a limit (to be reviewed regularly) for each client to ensure that the client’s exposure to VA is reasonable.

3.2. Governance

• A licensed platform operator should set up a token admission and review committee which should be responsible for:
• establishing, implementing and enforcing (i) the criteria for a VA to be admitted for trading, taking into account the token admission criteria in the VATP Guidelines, and (ii) the criteria for halting, suspending, and withdrawing a VA from trading and the options available to clients holding that VA;
• making the final decision as to whether to admit, halt, suspend, or withdraw a VA for clients to trade based on the criteria;
• establishing, implementing and enforcing the rules which set out the obligations of and restrictions on VA issuers, if applicable; and
• reviewing regularly the criteria and rules mentioned above.
• A licensed platform operator should conduct ongoing monitoring of each VA admitted for trading and consider whether to continue to allow it for trading.

3.3. General token due diligence and admission criteria

• The licensed VATP operators should have the ultimate responsibility to perform reasonable due diligence on the VA and ensure they satisfy the token admission criteria before admitting them for trading and continue to monitor the admitted VA on an ongoing basis.

3.4. Specific token due diligence and admission criteria

• Where a licensed platform operator intends to make VA available to retail clients, it should also ensure that the selected VA will satisfy the specific token admission criteria below as an “eligible large-cap virtual asset”.
• “Eligible large-cap virtual assets” refer to VAs that are included in at least two “acceptable indices” issued by at least two independent index providers.
• An “acceptable index” is an index that has a clearly defined objective to measure the performance of the largest VA in the market and fulfils the following criteria:
• The index should be investible, meaning the constituent VA should be sufficiently liquid;
• The index should be objectively calculated and rules-based;
• The index provider should possess the necessary expertise and technical resources to construct, maintain and review the methodology and rules of the index; and
• The methodology and rules of the index should be well documented, consistent and transparent.
• Among the two indices, a licensed platform operator should ensure that at least one of them is issued by an index provider that has experience publishing indices for the traditional non-VA financial market. An example is one which has issued an index tracked by an SFC-authorized index fund.

3.5. Other token due diligence to be performed

• A licensed platform operator should also perform reasonable due diligence in the following areas before admitting any VA for trading:
• Ensure that its own internal controls, systems, technology and infrastructure could support and manage any risk specific to that VA.
• Conduct a smart contract audit for VA based on blockchains with a smart contract layer unless the platform operator demonstrates that it would be reasonable to rely on a smart contract audit conducted by an independent auditor.
• Except for VA only made available to professional investors, obtain and submit to the SFC written legal advice in the form of a legal opinion or memorandum confirming that the VA does not fall within the definition of “securities” under the SFO.

3.6. Disclosure obligations

• A licensed platform operator is expected to disclose sufficient product information to enable clients to appraise the position of their investments.

4. Other adaptations to existing requirements to be incorporated into the VATP Guidelines

1. The SFC will not incorporate the requirement relating to “security tokens” into the VATP Guidelines. Going forward, licensed platform operators should comply with the general token admission criteria under the VATP Guidelines and guidance on the distribution of security tokens, which will be published by the SFC in due course.
2. A licensed platform operator will only be required to disclose to its clients how it will handle the voting rights arising out of a client’s ownership of a VA.
3. Licensed platform operators are no longer required to submit written legal advice in the form of a legal opinion or memorandum for the VA to be traded unless they are made available to retail clients.
4. The Consultation proposes to include exceptions to the proprietary trading requirement whereby licensed platform operators will be allowed to conduct off-platform back-to-back transactions or in limited circumstances permitted by the SFC on a case-by-case basis.
5. Where the VA are made available to professional investors only, the licensed platform operators will only be required to notify the SFC in advance of any plan to add or remove such products to or from its trading platform without the need to seek approval from the SFC. Where the VA are made available to retail clients, the position will remain the same as before, meaning the licensed platform operators should seek the SFC’s advance approval on such a plan before admitting them for trading.

5. Guideline on Anti-Money Laundering and Counter-Financing of Terrorism

Under the proposed new regime, licensed VATP operators will be required to follow additional AML/CFT requirements that are specific to VA (to be included as Chapter 12 of the AML Guidelines as a standalone chapter), along with other AML/CFT requirements that are generally applicable to SFC licensed entities, currently set out in “Guideline on Anti-Money Laundering and Counter-Financing of Terrorism (For Licensed Corporations)” (the “AML Guidelines”) .

VASPs are required to conduct due diligence and obtain, record, and submit VA transfer information, such as ordering, intermediary and beneficiary institutions; to identify and report suspicious activities; and to comply with VA transfer requirements (i.e., the Travel Rule). VASPs should track VA transactions and utilize block chain analysis software. Additional measures include conducting VA-specific KYC due diligence such as collecting IP addresses, location data, and device identifiers to identify and verify customers. Enhanced monitoring will also be required when a VA transaction is conducted with non-custodial wallets. Third-party deposits and withdrawals will also not be allowed.

6. Transitional arrangements

The Consultation provided a one-year transitional period for existing VATP operators in Hong Kong to either apply for a licence or close down their VA trading operations in an orderly manner. In order to be eligible for the transitional arrangements, a VATP must be pre-existing, meaning that it should be in operation in Hong Kong prior to June 1, 2023 with a “meaningful and substantial presence”. The SFC will consider a range of factors when determining what constitutes “meaning and substantial presence”, including the place of incorporation, physical office space, location of central management and key personnel, and the platform’s active user base and trading volume in Hong Kong.

VASPs that are not deemed to be pre-existing cannot carry on their VA operations or market their services to Hong Kong investors and purchasers until they have obtained a license under the new regime. In order to best o streamline the application process, the SFC proposes to require VATP applicants to engage external assessors to assess their businesses going forward, and submit the assessors’ reports to the SFC (i) when submitting the licence application (Phase 1 Report) and (ii) after approval-in-principle is granted (Phase 2 Report), covering  design effectiveness of the VA trading platform’s proposed structure, governance, operations, systems and controls, with a focus on key areas such as governance and staffing, token admission, custody of virtual assets, KYC, AML/CFT, market surveillance, risk management and cybersecurity, and the implementation and effectiveness of the adoption thereof.

7. Application

Under the new proposed regime, corporate applicants or individual applicants must prove to the SFC that they are fit and proper to be licensed, and they satisfy the competence requirements.

When the SFC assesses whether an applicant is fit and proper, the SFC shall consider the requirements under the SFO and the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615), and the applicant’s (i) financial status or solvency; (ii) the applicant or its senior management’s educational or other qualifications or experience; (iii) ability to carry on the relevant activities competently, honestly and fairly; and (iv) reputation, character, reliability and financial integrity and its financial resources and soundness.

When the SFC assesses whether an applicant satisfies the competence requirement, the applicant must demonstrate to the SFC that the applicant possesses the necessary technical skills and professional expertise to be “fit”, and is aware of the relevant ethical standards and regulatory knowledge to be “proper” in carrying on any relevant activities. When considering corporate applicants, generally speaking the SFC will consider factors including, but not limited to, business,  corporate governance, staff competence, internal controls, operation, risk management and compliance.

When the SFC is assessing an individual applicant’s competence to carry on the relevant activities, the consideration will include, but not limited to, whether the applicant has (i) necessary academic, professional or industry qualifications; (ii) knowledge about virtual assets and the virtual asset market; (iii) sufficient relevant industry and management experience (where applicable); (iv) a good understanding of the regulatory framework, including the laws, regulations and associated codes governing the virtual asset sector; and (v) familiarity with the ethical standards expected of a financial practitioner.

On the matter of financial resources and soundness, a VATP operator shall maintain in Hong Kong at all times assets which it beneficially owns and are sufficiently liquid, for example, cash, deposits, treasury bills and certificates of deposit (but not virtual assets), equivalent to at least 12 months of its actual operating expenses calculated on a rolling basis. A VATP operator shall at all times maintain paid-up share capital of not less than HK$5,000,000. A VATP operator must account for all assets and liabilities in accordance with generally accepted accounting principles, unless otherwise specified in the Securities and Futures (Financial Resources) Rules (Cap. 571N); and the account has to recognize the substance of a transaction, arrangement or position.

The Consultation is a much anticipated and welcomed change. Although the new regime in the Consultation is not final, we do not expect there to be any material changes. The time leading up to the commencement of the new regime is short, and we recommend clients to check the nature and scope of their business to see if they are likely to fall under the scope of the new regime; if so, appropriate measures and experienced personnel are in place to ensure a swift transition. We will continue to monitor and report back on further developments.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Edwin Kwok, an O’Melveny partner licensed to practice law in Hong Kong, William K. Pao, an O’Melveny partner licensed to practice law in California, Ke Zhu, an O’Melveny partner licensed to practice law in New York and Hong Kong, AnnaLou Tirol, an O’Melveny partner licensed to practice law in California, and Wenting Yu, an O’Melveny partner licensed to practice in California and New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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