Hong Kong – Unlicensed VASPs Need To End Services By May

Hong Kong SAR’s government Financial Services department has highlighted a February 29th deadline for unlicensed Virtual Asset Service Providers (VASP) to make applications to register with the Hong Kong Securities and Futures Commission (“SFC”). If not, any unlicensed crypto entity in Hong Kong will have to cease operations by May 31st. 

In an official blog post, Christopher Hui Hong Kong’s Secretary for Financial Services and the Treasury, explains these dates and the logic behind a transitionary period for any unlicensed virtual asset service provider who has not yet applied for a license or cannot yet meet the requirements for a license. He states that if existing crypto services cannot apply and meet the requirements of the SFC they will be issued a “no-deeming notice.” Firms who receive the notice either have to cease operations by May 31st or within 3 months of receiving a notice.

The new exchange regime for crypto in Hong Kong will represent one of the clearest, most black-and-white structures ever for centralized cryptocurrency exchanges and other service providers to operate and offer their products to retail investors. All VASPs in the SAR, now must register and report to the SFC which has laid out its requirements for firms that include investor protections, onboarding processes, governance procedures, insurance, and KYC/AML.   

This announcement follows moves in 2023 by Hong Kong authorities to expand retail access to crypto products and allow intermediaries to offer “Virtual Asset-Related “ or VA-related products to retail customers.

Previously these VA-related products products, which can include spot-Crypto and Bitcoin ETFs, could only be accessed by institutional investors.  “The policy is updated in light of the latest market developments and inquiries from the industry seeking to further expand retail access through intermediaries and to allow investors to directly deposit and withdraw virtual assets to/from intermediaries with appropriate safeguards,” The Securities and Futures Commission (SFC) and the Hong Kong Monetary Authority (HKMA), wrote in a circular released on October 20th 2023.

There are stipulations, however, for intermediaries to consider. The circular states “An overseas VA non-derivative ETF would very likely be considered a complex product and it should only be offered to professional investors.” This means a product like Blackrock’s spot Bitcoin ETF will not be available to retail investors in HK just yet.

This expansion follows the establishment of a licensing regime for virtual asset trading platforms (“VATPs”) in Hong Kong. The regime sets up a framework for exchanges, brokers, and other crypto service providers to offer their services to investors in a secure, informed, regulated manner.

The need for crypto regulation in Hong Kong has also come under scrutiny following the JPEX scam scandal that has led to a slew of arrests. HK financial regulators have said JPEX operated without a proper VATP license.

Background to Hong Kong Crypto Regulation Updates

On Thursday, the 1st of June 2023, a much anticipated digital asset regulatory regime came into effect in the Hong Kong SAR. To appreciate how fast things have moved in the SAR, the new trading rules and licensing guidelines were only finalized the week before the rules went live, and just eight months after the proposed changes were announced in October 2022.

The new exchange regime for crypto in Hong Kong will represent one of the clearest, most black-and-white structures ever for centralized cryptocurrency exchanges to operate and offer their products to retail investors. This rapid and dramatic shift has caught the attention of market observers because of the size of the Hong Kong financial market.

The Hong Kong public equity market is the 7th largest stock exchange in the world by market capitalization and beats out the national stock markets of India and the UK. Hong Kong has been a global financial center for decades. It has utilized a low tax regime and incredible local human capital, to become a de-facto hub between China and the West. Hong Kong is the historical center of ‘East meets West’ business and financial activity.

What the new Hong Kong crypto laws mean

The legislation that came into play on June 1st is a licensing regime for virtual asset trading platforms (“VATPs”). Platforms that apply to be a part of the regime will be regulated by the Hong Kong Securities and Futures Commission (“SFC”).

The SFC has begun to offer guidance to potential VATPs. The SFC’s ‘Consultation Conclusions on the Proposed Regulatory Requirements for Virtual Asset Trading Platform Operators Licensed by the Securities and Futures Commission’ was also released on June 1st. It contains some practical takeaways and guidance for hopeful VATPs to try to follow when applying for a license with the SFC. A license will allow successful applicants to offer virtual assets (that are considered securities by the SFC) to retail customers. The consultation is a guideline document for potential Virtual Asset Trading Platform Operators applying for a license with the SFC.

Key aspects of the consultation —

• Platform Operators will only be allowed to provide their services to retail investors if they comply with a range of robust investor protections that cover onboarding, governance, disclosures, token due diligence, and admissions. The SFC says these requirements will broadly be in line with the requirements applied to traditional licensed corporations.
• The SFC notes that it is important for clients of the platform to understand the features and risks of investing in virtual assets. During the onboarding process the SFC says platforms will have to assess an investor’s risk tolerance, conducting an holistic assessment of the investor’s understanding of the nature and risks of virtual assets amongst other assessments. This type of onboarding will apply to both retail and institutional investors.
• Operators will be required to set up robust governance procedures that may include setting up a token admission and review committee that consists of senior management who are principally responsible for managing the key business line, compliance, risk management, and information technology functions.
• The tokens must also be incorporated in at least two cryptocurrency indexes from prominent institutions, one with a background in traditional finance.
• Disclosing information surrounding listed Virtual Assets. The SFC notes that while it understands the potential challenges of obtaining and verifying information provided by the issuer of a digital asset, it will still expect a Platform Operator to conduct due diligence on each virtual asset prior to admission for trading. As such, Platform Operators will still be expected to obtain information for each listed digital asset, reliable and sufficient enough, to base a token admission decision on. This information will need to be disclosed to the SFC.
• Custodian insurance for platforms. Platforms are required to have in place insurance/compensation, approved by the SFC, to cover the risks tied to being custodians of digital assets. An example of how compensation can be set-up is in the form of bank guarantees, along with funds held in the form of demand deposits or fixed deposits with a maturity of six months or less. The SFC has stated that 98% of client’s assets need to be held in cold storage.
• The consultation document states clearly that platforms must not engage in proprietary trading activities of virtual assets from their own accounts or any account connected to the platform.
• There is also a stated ban on VATPs offering any kind of virtual asset derivatives style product. This may include offering, trading, or dealing in virtual asset future contracts or related derivatives.
• The trading of stablecoins is also banned for VATPs. The consultation explains that stablecoins fall under the jurisdiction of the Hong Kong Monetary Authority (“HKMA”). The HKMA is expected to launch a more robust framework around stablecoins in sometime in the next 12 months.
• The consultation has also stated that firms applying for VATP licenses with the SFC should as a matter of prudence, apply for approvals under both the existing SFC licensing regime and the AMLO licensing regime. AMLO is the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO). It is designed to bring exchanges that offer crypto-assets that do not qualify as “securities” within the regulatory oversight of the SFC (VATP regime). The SFC states that both licenses should be applied in the instance that some asset listed by a VATP may change to become a non-security and would therefore be regulated under AMLO.

Why Hong Kong is Embracing Digital Assets

It has been reported that the new ‘crypto for retail’ framework by Hong Kong is part of a wider initiative to help the city reclaim its position as a leading, cutting-edge financial hub. Some of this sheen has been lost because of the city’s extended isolation during COVID-19 and a period of social/political unrest before this.

Hong Kong has had crypto regulatory regimes before this latest initiative. There was previously a voluntary license program in Hong Kong run by the SFC but there were only two applicants— OSL and the Hashkey Group. Providers were permitted to offer crypto trading services solely to professional investors with portfolios of at least HK$8 million ($1 million). Notable crypto exchanges Crypto.com and FTX were also founded in Hong Kong but both shifted their base away from the country and were not part of any local licensing regime.

Paul Chan, the Financial Secretary of Hong Kong, has championed digital assets and Web3 in the past. Speaking in January he said “Hong Kong has become a quality standing point for digital asset corporates,” and continued that the city has a robust regulatory framework that matches international standards. He added that it also prohibits free riders and described virtual assets as “unstoppable new financial innovations” and implored that there is a need for Hong Kong to embrace them.

Hong Kong Crypto Licensing Not Without Issues

Likely the biggest issue tied to the new SFC licensing regime for digital assets is its ambiguity. While it seems clear that the trading of what can be understood as larger crypto assets like Bitcoin and Ethereum will fall under the jurisdiction of the SFC, there is no mention of DeFi, NFTs, and many other key components of the wider digital asset sector. They appear to fall outside what is regulated — so is it to be assumed that these aspects of crypto are illegal in Hong Kong? Digital asset derivatives are stated to be outside the scope of the SFC, does this mean that they are also illegal?

Digital asset firms in Hong Kong need to determine if the products they offer constitute securities. If they do, then they may need to apply for a license with the SFC. This will be challenging for firms that operate in gray areas offering services related to staking, NFTs, or play-to-earn blockchain products. Companies based in Hong Kong offering these types of services are still operating in uncertain territory – and will likely have one eye looking over their shoulder expecting one of Hong Kong’s numerous financial watchdogs to come down on them.

The regime shift nonetheless sparks an opportunity to be a part of one of the most exciting jurisdictional crypto projects in recent times. The SFC license program is designed to attract fresh capital and talent to Hong Kong. It will likely do this. The opportunity to offer digital asset products to Hong Kong’s immense retail investor base is immense and it is no surprise that major international crypto firms including Huobi, OKX, and Amber Group have said they intend to pursue licenses with the SFC. International crypto exchange BTSE announced in March that it would seek to apply for a license with the SFC to operate within its planned Virtual Asset License regime.

This interest comes despite the SFC licensing regime including numerous requirements which may put off some potential applicants. It has been reported that companies are wary of the potential costs tied to gaining an SFC license. Information gathering, reporting obligations and KYC/AML infrastructure will need to be set up to obtain an SFC license.

This will take investment, time, care, and skill. Hong Kong, however, may be ahead of the curve. Frameworks like the SFC’s are being implemented, or at least discussed, in major financial hubs including the US and the EU. Thus companies that meet the requirements of the SFC license will likely be well placed to expand and receive licenses in other regions. They will also be more appealing to investors and traders because of assurances that they have to meet high standards of security and transparency.

In comments shared with Brave New Coin, Joey Garcia, Director and Head of Public Affairs, Policy, and Regulation at Xapo Bank notes further challenges with the HKSFC framework. Garcia is a pioneer in the regulation of virtual currency and distributed ledger technology (DLT). He co-chaired the Gibraltar government’s working group on blockchain for three years, which was established to develop the infrastructure to accommodate a DLT regulatory framework.

He notes that while there has been a lot of publications advertising how ‘retail investors’ will now be permitted access to a regulated HK platform. What is less reported is that the retail investor will still be subject to ‘suitability’ requirements. These requirements may include asset training, work experience related to virtual assets, or prior trading experience.

Garcia also notes aspects of the framework that may need adjusting. He tells Brave New Coin “the SFC will not permit 3rd party custodians anywhere in the world, as they will require a direct regulatory handle over the custodians. I see this as quite a negative as there have been years of developments from the most secure custodian providers to arrive at the very tried and tested position of security offered by those platforms.” Specialist custodians will have to register in Hong Kong in order to provide their services which will likely be unappealing. Therefore, regulated platforms will have to develop their own systems and infrastructure.

The China question

On the 1st of July 1997, Hong Kong became a Special Administrative Region of the People’s Republic of China. The city is therefore sometimes referred to as HK SAR. Chinese national law does not generally apply in the region, and Hong Kong is treated as a separate jurisdiction. It is allowed to have its own laws and legal system under the Basic Law, which came into force at the time of the Handover in 1997. The Basic Law was designed as the SAR’s Constitution, both to maintain a high degree of continuity from the common law regime inherited from the UK, and to enable Hong Kong to operate under the “One Country, Two Systems” model with a considerable level of autonomy. As such Hong Kong can continue to be open and encouraging toward digital assets, despite the outright ban on anything related to the industry in mainland China.

There are, however, systems in place like the Office for Safeguarding National Security of the CPG in the HK SAR, that are designed to ensure that Hong Kong remains subordinate to China. While on paper Hong Kong has jurisdictional independence from China, there have been times in the past when Chinese courts and national laws have trumped those local to Hong Kong.

This potential roadblock to the emergence of the new ‘crypto for retail’ regime has been raised in Hong Kong. Regulators in the city have pushed against this assumption stating that the ‘One Country, Two Systems’ model is still valid and Hong Kong is allowed to have its own financial regulations. This confidence from Hong Kong regulators has been seen as a sign that, behind closed doors, China is comfortable with Hong Kong’s open-for-business attitude with regard to its own digital assets policy. There have been rumors circulating that Chinese officials have even been seen at local Hong Kong crypto meetups and have been positive about the space.

The word ‘testing ground’ for Hong Kong has been thrown around. Will China embrace crypto if Hong Kong’s plan for a regulated digital asset registry shows signs of success? Time will tell.

In the early years of Bitcoin, Chinese investors and traders were early adopters of Bitcoin and Chinese mining pools quickly became some of the largest in the world. The availability of cheap electricity and hardware made China an attractive location for Bitcoin mining operations, and the country became a hub for Bitcoin mining activity. This naturally led to the development of several major exchanges in the country including Okex (OKX) and Huobi. Chinese trading hours and trading activity believed to have originated from China, drove the price activity of BTC.

BTC became popular for wealthy Chinese to escape the country’s strict capital controls. This, amongst many other factors, led to the outright banning of anything crypto-related in China.

Hong Kong continues to plow forward with its compliant crypto mission. In a press release shared with Brave New Coin, the HashKey group announced that it had just partnered with Quam Securities and Longbridge Whale to complete the first virtual asset online trade for securities firms in Hong Kong. Livio Weng, COO of HashKey Group, said: “HashKey Group has always prioritized the protection of customers’ funds and assets and adhered to a regulatory-first policy.” The move signals that some digital asset entities in Hong Kong are willing to play ball with the city’s regulators.

Conclusion

The recent introduction of new digital asset regulatory measures by the Hong Kong Securities and Futures Commission (SFC) marks an important step forward in the city’s efforts to provide a structured, secure, and sustainable environment for digital asset trading targeted at retail customers. These measures, which offer clear licensing guidelines and robust investor protections, align Hong Kong’s approach to digital assets with its well-regulated traditional financial markets.

Will investors be more confident in gaining access to a HK-regulated crypto market, or investing in that market? Xapo Bank’s Garcia thinks they will, in the context of knowing that there are not only “high standards being applied to it, but also serious standards for that platform including market misconduct and insider trading which are well reported in the crypto exchange environment.”

There are also a number of unknowns tied to the framework. The potential influence of mainland China’s crypto policies adds another layer of complexity to the issue. What is the legal status of digital asset derivatives, stablecoins, and Defi? Additionally, the high information requirements for retail users will create barriers to entry.

As this landscape unfolds, Hong Kong’s regulatory actions will undoubtedly shape not only its own digital asset markets but potentially, those of other major financial hubs around the globe. The city is taking an exciting step that continues its proud trend of being a financial markets innovator.