Hong Kong has traditionally been a hub for digital asset businesses in the region. As regulators in Hong Kong are working to tighten the regulatory regime on virtual asset exchanges, market players and investors seeking to take advantage of the burgeoning digital asset industry should keep up-to-date with the changing regulatory landscape and policy trends.
In this article, we explore the recently proposed mandatory licensing regime for virtual asset (“VA”) exchanges. The proposed mandatory licensing regime for VA trading platforms recommended by the Financial Services and the Treasury Bureau (“FSTB”) of the Hong Kong Government in May 2021, as part of the proposed amendments to the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (“AMLO”), seeks to replace the existing voluntary opt-in regime. The amended AMLO was gazetted on June 14, 2022, and the first reading of the amended AMLO was conducted on July 6, 2022. The proposed mandatory licensing regime is expected to take effect on March 1, 2023.
Existing SFC Voluntary Opt-In Regime
The SFC introduced the existing voluntary opt-in licensing regime for VA trading platforms in November 2019. To date, only one VA trading platform has obtained the SFC license. Under this regime, the SFC grants a license for Type 1 (dealing in securities) or Type 7 (providing automated trading services) regulated activities to a VA trading platform that trades at least one security token which falls within the definition of “securities” under the Securities and Futures Ordinance (Cap. 571, “SFO”).
On May 21, 2021, the FSTB published its consultation conclusions on legislative proposals to enhance anti-money laundering and counter-terrorist financing (“AML/CTF”) regulation in Hong Kong, including a proposal to introduce a mandatory licensing regime for VA trading platforms in line with the recommendations of the Financial Action Task Force (“FATF”).
Mandatory Licensing Regime
Under the licensing regime proposed by the amended AMLO gazetted on June 14, 2022, operating a VA exchange in Hong Kong or operating a non-Hong Kong VA exchange which actively markets to the Hong Kong public will be regarded as a “regulated VA activity” under the AMLO, requiring a license granted by the SFC.
Operating a VA exchange is defined as providing services through means of electronic facilities (a) whereby (i) offers to sell or purchase VAs are regularly made or accepted; or (ii) persons are regularly introduced, or identified to other persons in order that they may negotiate or conclude sales or purchases of VAs, in each case in a way that results in a binding transaction; and (b) where client money or client VAs comes into direct or indirect possession of the operator. Notably, this indicates that pure peer-to-peer exchanges where transactions occur directly between traders will not be subject to the mandatory licensing regime.
There is no longer any requirement that the VA being traded constitutes a “security” under the SFO. The definition of VAs under the amended AMLO would include a broad range of VAs, of which typical examples are Bitcoin and stablecoins. The proposed legislation expressly provides that certain assets do not constitute VAs, such as central bank digital currencies, and limited purpose digital tokens (including customer loyalty reward points, or in-game assets). As clarified in the SFC’s recent press release, most non-fungible tokens (“NFTs”) which represent unique copies of underlying assets do not fall under the definition of VAs.
The key requirements under the proposed mandatory licensing regime include:
- Eligibility. Only Hong Kong incorporated companies with a permanent place of business in Hong Kong, or non-Hong Kong incorporated companies which have registered in Hong Kong under the Companies Ordinance (Cap. 622) are eligible for applying for a license.
- Fit-and-proper test. An applicant must pass the fit and proper person test, taking into account the applicant’s financial status or solvency; educational or other qualifications or experience in the functions to be performed; ability to provide the VA service competently, honestly and fairly; reputation, character, reliability and financial integrity; whether the applicant has been convicted of a money-laundering/terrorist-financing offence or other offences in which the applicant is found to have acted fraudulently, corruptly or dishonestly; and whether the applicant has failed to comply with a requirement imposed under the AMLO.
- Responsible officers. An applicant will have to appoint at least two (2) responsible officers to be generally responsible for AML/CTF compliance. The responsible officers are to be held personally accountable in case of non-compliance. Only responsible officers approved by the SFC may become executive directors of a VA exchange.
- Licensed representatives. Only individuals licensed by the SFC as licensed representatives may carry out the regulated functions on behalf of the VA exchange, i.e., operation of a VA exchange that is not work ordinarily performed by an accountant, clerk, or cashier. Licensed representatives must also pass the fit and proper person test.
- Licensing conditions. The SFC may impose on a license to a VA exchange certain conditions, including having adequate financial resources, knowledge and experience, risk management policies and procedures, conditions on management of client assets, financial reporting and disclosure, VA listing and trading policies, prevention of market manipulative and abusive activities, cybersecurity, and avoidance of conflicts of interest. The SFC will issue detailed regulatory requirements before the new regime comes into effect.
- Investor protection. Similar to the existing voluntary opt-in licensing regime, a licensed VA exchange will only be able to offer its services to professional investors (as defined under the SFO) initially. This will be a licensing condition imposed by the SFC.
In addition, a VA exchange must disclose in its license application its ultimate owner(s) (if any). An ultimate owner is an individual who (a) controls, directly or indirectly, more than 25% of the issued share capital or votes, or (b) exercises ultimate control over the management of the VA exchange. Notably, even if an individual remains under the 25% threshold but exercises ultimate control, he or she would be captured by the proposed legislation. If an individual proposes to become an ultimate owner of a licensed VA exchange, he or she must first obtain the SFC’s approval.
The proposed amendment bill has been introduced into the Legislative Council for the first reading on July 6, 2022. The proposed mandatory licensing regime is expected to take effect on March 1, 2023, and a nine-month transition period will be available to allow for license applications. Any existing VA exchange operators would need to file an application with the SFC before December 1, 2023 (9 months after the commencement of the mandatory licensing regime) and confirm that it will comply with the regulatory requirements of the SFC. Such operators may be deemed to be licensed on an interim basis until the SFC has made a decision on its license application.
The proposed mandatory licensing regime will increase the operational burden of VA exchanges operating and marketing in Hong Kong, and restrict retail investors’ access to these VA exchanges. The Legislative Council brief acknowledges that the proposed regime in Hong Kong would be more rigorous and comprehensive than some other comparable jurisdictions, such as Singapore, the United Kingdom, and Japan. The additional SFC regulatory requirements to be announced are expected to focus on investor protection and control of AML/CTF risks. Existing VA exchanges should assess their existing infrastructure and consider upgrading its policies and systems if they wish to continue their operations in Hong Kong. For investors of VA exchanges, in addition to examining cybersecurity, intellectual property, key person risks during the due diligence process, increasing attention should be paid to assessing operational viability and legal and compliance risks of operating in Hong Kong.