Interpretation of HKEX Licence Consultation Paper: What types of virtual assets can be included in trading

Focus:

• 1Despite being a public consultation, the SFC is actually interested in providing services to retail investors.
• 2Licensed platform operators are required to conduct a knowledge assessment of investors before providing any services to investors. If the customer fails the assessment, the operator may only provide services to the customer after providing training to the customer.
• 3. According to the requirements of the document, the platform operator must maintain a paid-up share capital of not less than HK$5 million at all times (i.e. the "minimum paid-up share capital").
• 4With effect from 1 June 2023, any VA trading platform that carries on its business in Hong Kong or actively promotes its services to Hong Kong investors without a valid licence is in contravention of the licensing requirements under the VAV Service Provider regime under the AMLO, unless it is eligible to participate in the transitional arrangement.

Last week, there were rumors that Hong Kong would issue a license for retail investors for virtual asset trading platforms, and industry insiders confirmed to PANews that the SFC would issue a consultation paper this week. On Monday, 20 February, the SFC commenced a consultation on the proposed regulation of virtual asset trading platforms, which will end on 31 March to coincide with the new licensing regime that can come into effect on 1 June.

According to the relevant consultation documents of more than 300 pages and more than 200,000 words released by the Hong Kong Securities and Futures Commission, 10 questions are mainly asked to the Hong Kong industry:

Do you agree that licensed platform operators should be allowed to provide services to retail investors?

Do you have any comments on the recommendations for the general token inclusion guidelines and the specific token inclusion guidelines?

If the SFC intends to allow retail investors to use licensed virtual asset trading platforms, what other requirements do you think should be implemented from an investor protection perspective?

Do you have any comments on the proposal to allow the use of third party insurance with funds allocated by licensed platform operators or corporations belonging to the same group of companies?

Do you have any other suggestions?

Do you have any proposals on how the licensed platform operator should allocate such funds (e.g. transfer to the licensed platform operator's corporate account, or set up escrow arrangements)?

Please elaborate on your proposed arrangement and how the protection provided by the arrangement can provide the same level of protection as third party insurance. Do you have any proposals for any technical solutions that can effectively mitigate the risks associated with the custody of clients' virtual assets, especially those held by online storage?

If a licensed platform operator can provide virtual asset derivatives trading services, which business model would you recommend?

What types of virtual asset derivatives do you propose to offer for investors to buy and sell? What kind of investors will be targeted?

Do you have any comments on how other provisions in the VA Trading Platform Terms and Conditions can be incorporated into the VA Trading Platform Guidelines while making amends?

Do you have any comments on the requirements relating to virtual asset transfers or any other requirements in Chapter 12 of the Anti-Money Laundering Guidelines for Licensed Corporations and SFC-Licensed Virtual Asset Service Providers? Please state your opinion. Do you have any comments on the SFC Guidelines on Disciplinary Fines? Please state your opinion.

Among the above 10 questions, the most concerned by the market is whether the trading platform is allowed to be open to retail investors, and which assets retail investors can participate in trading and which derivatives can be traded. Other issues related to operational details, security protections and anti-money laundering, such as third-party insurance, technical solutions for asset custody, etc.

The SFC will issue virtual asset licences with the intention of allowing them to be available to retail investors

The paper points out that the volatility of the virtual asset market and the collapse of FTX not only highlight the risks arising from the growing interconnection between the virtual asset ecosystem and the virtual asset market and the traditional financial system, but also highlight the importance of effective regulation and supervision of the virtual asset industry.

Previously, under the current regime under the Securities and Futures Ordinance in Hong Kong, only virtual asset trading platforms that provide security token trading services to customers fell within the scope of SFC supervision, which also meant that the SFC had no previous right to license or supervise virtual asset trading platforms that only provided non-security token trading services.

Subsequently, in November 2020, the HKSAR Government published a consultation paper to solicit public views on the proposed establishment of a licensing regime for virtual asset service providers under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance. The Government proposes that a central virtual asset trading platform (i.e. a centralized exchange) that provides non-security token trading services in Hong Kong should be licensed and regulated by the SFC.

However, as the licensing framework for virtual assets was a new concept, the SFC considered that even though the regime already had adequate safeguards to protect investors, it was prudent to restrict licensed virtual asset trading platforms under the SFO to professional investors only, at least at the preliminary stage. Therefore, Hong Kong has been very cautious about licensing in 2020, only OSL in 2020 and Hahskey in 2022 obtained exchange licenses, and only provided services to professional investors.

On October 31 last year, Hong Kong issued the Policy Declaration on Virtual Asset Development, which released an open and friendly attitude towards virtual assets and also released the rumor of providing services to retail investors, and said that the SFC is allowing retail investors (retail investors) to buy and sell virtual assets for public consultation.

As can be seen from the documents, the SFC is actually interested in providing services to retail investors, despite the public consultation. According to the document, many people believe that denying retail investors access to licensed virtual asset trading platforms may cause harm to investors, as this may drive them to switch to unregulated overseas virtual asset trading platforms that are easily accessible online; And if any of these unregulated virtual asset trading platforms fail, it will be difficult for retail investors to recover any losses. This can be seen from the collapse of FTX.

The SFC added that in January 2022, for the first time, the SFC allowed retail investors access to a small number of regulated virtual asset-related derivative products traded on traditional exchanges. This was followed by the establishment of an endorsement regime for virtual asset futures exchange-traded funds (virtual asset futures ETFs) in October 2022, under which the SFC has so far recognised three virtual asset futures ETFs, with the Samsung Bitcoin Futures Active ETF listed on the Hong Kong Stock Exchange in January this year, and CSOP listing the Bitcoin and Ethereum futures ETFs in Hong Kong in December last year.

As a result, retail investors in Hong Kong have been able to access virtual assets indirectly through compliant products. Therefore, regardless of the actual situation and regulatory trends, the CSRC has had to allow changes for retail investors, so as to make supervision passive to proactive.

Users are required to conduct a risk assessment before trading

While the SFC has proposed to allow all types of investors, including retail investors, to use trading services provided by licensed virtual asset trading platform operators, this is provided that a range of appropriate investor safeguards are under a range of appropriate investor safeguards.

A licensed platform operator is required to conduct a knowledge assessment of investors before providing any services to investors. If the customer fails the assessment, the operator may only provide services to the customer after providing training to the customer. The operator should assess the client's risk tolerance level and risk profile, determine the risk profile for the client accordingly, and assess the client's suitability to participate in virtual asset transactions. The Operator should also set a cap on each Client to ensure that the risks assumed by the Client in relation to Virtual Assets are reasonable in the judgment of the Platform Operator, taking into account the Client's financial situation and personal circumstances. The ceiling should be reviewed periodically to ensure that it remains appropriate.

This means that in the future, Hong Kong residents will also need to do a risk assessment test after registration before they can officially trade. It is worth mentioning that in the informal consultation, there is a proposal to set a unified hard upper limit for retail investors to bear the maximum amount of virtual asset risk on each virtual asset trading platform. However, considering that everyone's financial situation is different, the SFC recommends that platforms assess their clients' risk tolerance and risk profile according to appropriate regimes.

Listed tokens need to meet the relevant guidelines, and retail investors can trade large-cap virtual assets

The SFC recommends that licensed platform operators should establish a token inclusion and review committee to be responsible for establishing, implementing and enforcing the guidelines for including virtual assets for trading, informing licensed platform operators of their obligations in respect of any proposed hard fork or airdrop, any material changes in the issuer's business or any regulatory action against the issuer.

At a minimum, the Token Inclusion and Review Committee should consist of senior management members primarily responsible for managing the main business, compliance, risk management and information technology. The Token Inclusion and Review Committee shall report to the Board at least monthly, and the report should include at least details of the virtual assets available for trading by retail customers and other issues noted.

The SFC wishes to emphasise that virtual assets themselves are not regulated by the SFC and have never reviewed or reviewed offers and promotion documents for virtual assets. In view of this, the SFC intends to adopt a more prudent approach by introducing a series of objective criteria that licensed platform operators are required to follow in determining whether a particular virtual asset can be provided to retail customers.

Licensed platform operators are ultimately responsible for conducting reasonable due diligence on virtual assets before incorporating them for sale and ensuring that they comply with token inclusion guidelines. Licensed platform operators should also continuously monitor the included virtual assets and ensure that they continue to comply with the relevant standards. Factors to be considered include: a) the background of the management or development team of the virtual asset; b) the regulatory status of virtual assets in various jurisdictions in which the platform operator provides trading services, and whether its regulatory status will also affect the regulatory responsibilities of the platform operator; c) the supply and demand, market maturity and liquidity of the Virtual Asset, including its market capitalization, average daily trading volume, track record (e.g. have been issued for at least 12 months, excluding security tokens), whether other platform operators also offer transactions in relation to the VA, whether there is a relevant trading portfolio (e.g. fiat currency vs VAT) and in which jurisdictions the VA is available for trading; d) the technical aspects of virtual assets; e) the contents of the virtual asset promotion materials issued by the issuer should be accurate and not misleading; f) Development of virtual assets; g) market risk of virtual assets, including the high concentration or control of virtual asset holdings by a small number of individuals or entities, price manipulation and fraud, and the impact of broader or narrower adoption of virtual assets on market risk; h) the legal risks associated with virtual assets, i) the utility provided by virtual assets, the new use cases that enable them, or whether the technical, structural or cryptoeconomic innovations demonstrated appear to be fraudulent or grossly inappropriate.

In addition to the general token inclusion criteria, licensed platform operators wishing to provide virtual assets to retail customers should also ensure that the selected virtual assets are eligible large-scale virtual assets and, in addition to complying with the above general inclusion criteria, are required to comply with the following specific token inclusion criteria.

"Eligible Large Virtual Assets" means virtual assets included in at least two "Accepted Indices" launched by at least two independent index providers (at least one of which is an experienced index provider in traditional non-virtual asset finance markets). "Accepted Index" means an index with a clearly defined objective to measure the performance of the largest virtual asset in the market and meets the following criteria: a) the index should be investable, meaning that the constituent virtual assets should be sufficiently liquid. b) The index should be calculated in an objective manner and be rule-based. c) Index providers should have the necessary professional knowledge and technical resources to construct, maintain and review the methodology and rules for compiling the index. d) The methodology and rules for the preparation of the index should be properly documented, consistent and transparent.

According to this guideline, BTC and ETH clearly meet the requirements and can be available to retail investors, and other crypto assets need to be further studied.

It is necessary to maintain a paid-up share capital of not less than HK$5 million and establish an insurance system

According to the requirements of the document, the platform operator must maintain a paid-up share capital of not less than HK$5 million at all times (i.e. the "minimum paid-up share capital"). Taiwan operators should at all times have beneficial liquidity in Hong Kong, such as cash, deposits, treasury bills and certificates of deposit (but not virtual assets) in an amount equal to the actual operating expenses of the platform operator on a continuing basis of at least 12 months.

It is also mentioned that platform operators should establish and implement strict internal controls and governance procedures in private key management to ensure that all encrypted seeds and private keys are securely generated, stored and backed up. Both seeds and private keys are stored in Hong Kong.

Licensed platform operators should have SFC-approved compensation arrangements in place to provide an appropriate level of protection against risks associated with the custody of customers' virtual assets, such as a hacking of the platform or a default by the licensed platform operator or its associated entities. With regard to investor protection insurance provisions, the SFC recommends:

a) Licensed platform operators should have SFC-approved compensation arrangements for risks associated with the custody of clients' virtual assets.

b) Licensed platform operators should monitor the total value of their clients' virtual assets in their custody on a daily basis to ensure compliance with the relevant compensation requirements.

c) Where a licensed platform operator allocates its own funds or funds of corporations belonging to the same group of companies as it to comply with the requirements, it should ensure that such funds are held in trust and earmarked for the relevant purposes. Such funds should also be segregated from the assets of the licensed platform operator, its associated entities or corporations belonging to the same group of companies as the licensed platform operator.

The list of exchanges will be published after the license comes into force

With effect from 1 June 2023, any VA trading platform that carries on its business in Hong Kong or actively promotes its services to Hong Kong investors without a valid licence will be in contravention of the licensing requirements under the VAV Service Provider regime under the AMLO, unless it is eligible to participate in the transitional arrangement.

The SFC proposes to establish a 12-month transition period to enable licensed platform operators under the SFO to comply with the requirements relating to their existing customers or the virtual assets currently sold. Details of the transitional arrangements will be provided once the requirements of the Virtual Asset Trading Platform Guidelines, the Anti-Money Laundering Guidelines for Licensed Corporations and SFC-Licensed Virtual Asset Service Providers and other guidelines are finalized.

To be eligible to participate in the transitional arrangement, a virtual asset trading platform must have been operating in Hong Kong before 1 June 2023 and have a meaningful and substantial business. Only after meeting the conditions of the AMLO can you continue to operate in Hong Kong from 1 June 2023 to 31 May 2024. Specific considerations include whether the delegation is established in Hong Kong, whether it has a physical office in Hong Kong, whether the Hong Kong staff has central management or control, whether key personnel are based in Hong Kong, whether the operation is operational and has a large number of clients and transaction activities in Hong Kong.

To be eligible for the original VA trading platform to participate in the licensing arrangement, an application for a licence under the VASS regime under the AMLO must be submitted online between 1 June 2023 and 29 February 2024 (i.e. within nine months from 1 June 2023).

A virtual asset trading platform that was not operating in Hong Kong immediately before 1 June 2023 may only carry on its business in Hong Kong or actively promote its services to Hong Kong investors after it has been duly licensed under the VASS regime under the AMLO. It is a criminal offence to conduct any unlicensed activity.

During the transition period, it may be difficult for the public to distinguish whether a virtual asset trading platform is operating legally. To dispel such concerns, the SFC intends to publish several lists on its website to inform the public of the different regulatory status of virtual asset trading platforms. By publishing these lists, the SFC hopes to discourage unlicensed or required virtual asset trading platforms from providing services to the public.