Listen to the Article: A Guide to HK SFC's Latest Consultation on Virtual Assets Regulation

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On February 20th, 2023, the Securities and Futures Commission (SFC) of Hong Kong released a consultation paper titled "Proposed Regulatory Framework for Virtual Asset Trading Platform Operators Seeking to be Licensed by the Securities and Futures Commission". The paper proposed relaxing the ban on retail investors purchasing cryptocurrencies from licensed platforms, signaling an important step for the Hong Kong government in opening up the cryptocurrency trading sector​. The mainland China-based People's Daily commented on this development, stating that it "signals the official recognition of virtual asset services in Hong Kong and their complete integration into regulation."

The Consultation Paper: A Substantive Step After the 2022 "Statement"

In October last year, the Hong Kong government released the "Policy Statement on the Development of Virtual Assets in Hong Kong" at the opening ceremony of the Hong Kong Fintech Week. The Statement aims to clarify the policy positions and guidelines for developing a vibrant virtual asset industry and ecosystem in Hong Kong. After the statement was issued, it was imperative to establish a comprehensive regulatory framework for Hong Kong's virtual asset industry. The openness and clear regulatory compliance of the policy undoubtedly injected great confidence into the entire crypto industry entering Hong Kong and expressed the city's ambition to compete as the global hub for Web3.

In terms of regulation, Hong Kong had actually established a preliminary framework for virtual assets before the Statement. However, the release of "the Paper" in 2023 indicates that the city will establish a comprehensive framework, aiming to better and faster build itself into a global hub for virtual asset management and bring new vitality to the economy. The main goal of this framework is to ensure that regulation keeps pace with the rapid development of the virtual asset market, protect the interests of investors, and prevent money laundering and other financial crimes.

Hong Kong SFC serves as the regulatory body. Since 2019, SFC has begun to regulate crypto trading platforms, and expanded its scope to cover digital asset fund managers and exchanges in 2020.

Consultation Paper Outlines A Detailed Framework for Hong Kong Crypto Regulation

- Dual Licensing: Securities + Non-Securities

SFC has invited market participants and interested parties to provide written comments on the proposal and any issues that may have significant impacts on it by March 31 2023. The Paper offers a glimpse of the future of the cryptocurrency market in the city.

According to the Paper, SFC will adopt a dual licensing approach for virtual asset trading platforms. They will be required to comply with existing securities and futures regulations and obtain a license for trading "security-type tokens". Once the Virtual Asset Service Provider (VASP) regime under the Anti-Money Laundering Ordinance is implemented, brokers will need to apply for a license to trade "non-security-type tokens," i.e. those classified as virtual assets. The prominent crypto exchange Huobi Global has already announced plans to establish a new platform to apply for the VASP license​.

- "Allowed If Not Expressly Prohibited": A Licensed Broker May Provide Services to Global Clients

The Paper does not limit the business scope of licensed brokers to operate only within the Hong Kong SAR. As per 9.3 of the Paper, the "platform operator" only needs to comply with the laws and regulations applicable to the jurisdiction in which it operates, including disclosing the areas with crypto bans, ensuring the promotion of business in jurisdictions where permitted, and using technological means to prevent individuals from prohibited regions from accessing brokerage services. In other words, the regulatory requirements laid out by SFC can be summarized as "anything is allowed if not expressly prohibited". Crypto brokers licensed in Hong Kong in the future will be able to expand their business globally to crypto-friendly jurisdictions.

What Are the Limits for Brokers to Avoid Noncompliance?

According to the Consultation Paper, the regulatory focus is placed on "due diligence," "full disclosure of the nature of virtual asset transactions," and "offering promotion" to maximize investor protection, and ensure compliance.

For brokerages, particular attention should be paid to section 9.18, which states that operators should not publish any advertisements about specific virtual assets; and section 7.23 under the "Operation" regarding "Virtual Asset Futures Contracts", stating that operators should not engage in any sales, trading, or transaction activities of related derivative instruments; and section 13.2 under the "Conflict of Interest", which states that operators should not engage in proprietary trading unless it is a back-to-back transaction or a few exceptions permitted by the Securities and Futures Commission.

However, most cryptocurrency exchanges currently do involve derivatives and proprietary businesses, with derivatives trading accounting for a significant portion of their revenue. Therefore, it is challenging for these brokers to relocate entirely to Hong Kong. In this case, one feasible solution is to establish a branch or independent subsidiary in Hong Kong.

The SFC's "Consultation Paper" brings stricter compliance requirements for crypto exchanges, aimed at protecting trader interests. For brokerages, compliance with these regulations is critical; otherwise, they will face fines and other legal consequences.

Vision for the Future

The Paper places great emphasis on "Knowing Your Customer" and “Anti-Money Laundering/Terrorist Financing”, with specific guidance on KYC/AML provided in the appendix. As a result, we can anticipate that KYC/AML services will become a non-negotiable requirement for brokers in the Hong Kong market, driving the growth of local regtechs providing tailored services for cryptocurrency. Additionally, the Paper provides specific regulations on cybersecurity, regulatory frameworks, assessments, and external insurance, which will undoubtedly create huge market demand for brokerage services.

While many details remain unclear at present, this will not impede more large crypto exchanges from establishing a presence in Hong Kong. In addition to Huobi, which was mentioned earlier, Fazzaco reported at the end of February that Gate Group, the owner of crypto exchange Gate.io, was eyeing the expansion of its presence in Hong Kong. The group plans to apply for a new crypto license in the city, which will enable it to establish a new platform - Gate HK, focused on the local market​.

The past records of regulating virtual assets suggest that Hong Kong has been actively advancing the regulation. Nonetheless, in recent times, the city's position as an international financial hub has faced difficulties as a result of the pandemic and geopolitical factors. Nevertheless, by setting up a comprehensive regulatory framework, the city will be better equipped to synchronize with the progress of the virtual asset market, reinforce regulatory competence, safeguard the interests of investors and consumers, and offer a more steadfast and trustworthy ambiance for the thriving expansion of the virtual asset industry in Hong Kong.