SFC Gives Green Light to Regulation of Virtual Asset Trading Platforms in Hong Kong

Summary

The Securities and Futures Commission of Hong Kong (SFC) has issued a position paper (Position Paper) on the regulation of virtual asset trading platforms (Platforms), confirming that it is willing to license and regulate Platforms on an opt-in basis. The Position Paper includes a detailed framework for the regulation of Platforms (Regulatory Framework).

The Position Paper and the Regulatory Framework, released November 6, 2019, are the culmination of the SFC’s observations of, and discussions with, Platforms in the 12-month period following release of the SFC’s conceptual framework for the potential regulation and licensing of Platforms in November 2018¹.

Although the requirements for Platforms under the Regulatory Framework are extensive and significant, the long-awaited and much-anticipated confirmation from the SFC that it is willing to license and regulate Platforms is nonetheless expected to boost Hong Kong’s burgeoning virtual assets market and facilitate the development of secondary market liquidity for tokenized securities.

Who does this affect?

The Position Paper and the Regulatory Framework are relevant to the following groups.

Exchange Operators

Operators of Platforms who want to be licensed by the SFC will be subject to the Regulatory Framework

Issuers

Products that are to be included in a Platform that is licensed by the SFC will need to comply with the specified requirements of the Regulatory Framework

Investors

Investors now have clarity over the standards and controls that must be complied with by Platforms that are licensed by the SFC and have a clear basis for distinguishing between licensed and unlicensed Platforms

How does it affect you?

Platforms

Platforms that want to be licensed and regulated by the SFC (Licensed Platforms) must bring themselves within the regulator’s ambit by offering for trading at least one virtual asset that is a “security” (Security) as defined under the Securities and Futures Ordinance (SFO)². Platforms that trade only virtual assets that are not Securities will remain outside of the regulator’s purview.

At present, the SFC is willing to accept licensing applications only from centralized Platforms that have control over investors’ assets. Licensing applications will not be accepted from decentralized Platforms or Platforms for direct peer to peer trading.

All licenses will be granted subject to several conditions, described below.

(a) Professional Investors

Provide services only to professional investors as defined under the SFO (Professional Investors)³.

(b) Terms & Conditions

Comply with the Terms and Conditions for Virtual Asset Platform Operators set out in the Regulatory Framework (T&Cs).

Obtain prior written approval from the SFC for:

the addition of any product to the Licensed Platform and
the addition of any new service or activity or to materially change any existing service or activity.

(d) Reporting

Report to the SFC monthly on its business activities.
Engage an independent professional firm vetted by the SFC to annually report on the Licensed Platform’s compliance with licensing conditions and other regulatory requirements.

Further, all virtual asset trading business activities conducted by the operator of a Licensed Platform (Operator) and its group companies that are marketed to Hong Kong investors or conducted in Hong Kong must be carried out under a single legal entity that is licensed by the SFC to enable the SFC to exercise comprehensive oversight. This means that trading activities related to non-Securities (which would otherwise be outside of the SFC’s ambit) will also be subject to the SFC’s purview and compliance with the Regulatory Framework.

The obligations and oversight of Licensed Platforms under the Regulatory Framework are both extensive and prescriptive. The high standards dictated by the SFC will require Operators to deploy considerable resources in order to meet the licensing criteria and satisfy the continuing conduct requirements.

Issuers

Issuers who seek admission of their virtual assets on a Licensed Platform will need to ensure that they and their virtual assets can satisfy the requirements set out in the T&Cs, including those described below.

(a) Reasonable due diligence must be conducted on the issuer and its product, prior to the product being admitted to the Licensed Platform

(b) Each product must be approved in writing by the SFC prior to it being admitted to the Licensed Platform

(c) A written legal opinion or memorandum on the legal and regulatory status of each product that will be available for trading in Hong Kong, including whether it is a Security under the SFO and the implications for the Licensed Platform, must be submitted to the SFC⁴

The above requirements will apply to all products that are listed on a Licensed Platform, whether the products are Securities or non-Securities. In addition, for virtual assets that are Securities, admission to a Licensed Platform is only permitted if the product meets the below requirements.

(i) The product is asset backed.

(ii) The product is approved or qualified by, or registered with, regulators in comparable jurisdictions (as agreed by the SFC from time to time).

(iii) The product has a post issuance track record of at least 12 months.

Investors

Only investors who qualify as Professional Investors are permitted to trade on Licensed Platforms. Investors who meet this qualification can take comfort that Licensed Platforms will be closely monitored on an ongoing basis to ensure that all of the Licensed Platform’s activities comply with the SFC’s rigorous requirements.

Those investors who trade on Platforms that are not licensed and regulated by the SFC will not have such assurances and accordingly should exercise greater care in the selection and use of unlicensed Platforms.

Overview of the Regulatory Framework

The Regulatory Framework sets out prescriptive operational and compliance requirements and focuses on the SFC’s core areas of concern, some of which are unique to the nature of virtual assets.

The key features of the Regulatory Framework are summarized below.

Clients and Know Your Customer

Serve Professional Investors only.
Ensure that clients (other than institutional and certain qualified corporate investors) have sufficient knowledge of virtual assets.
Accounts must be prefunded. No financial accommodation is permitted.

Virtual Assets for Trading

SFC approval is needed for each virtual asset included in the Licensed Platform.
Criteria for inclusion on the Licensed Platform must be established.
Due diligence must be conducted on all virtual assets.
Securities can be included only if they (i) are asset backed, (ii) are approved or qualified by, or registered with, regulators in comparable jurisdictions and (iii) have a track record that is at least 12 months post-issuance.
A legal opinion or memorandum is required for each virtual asset that will be available in Hong Kong.
Establish and enforce rules setting out obligations of and restrictions on virtual assets issuers, and Platform trading rules.

Custody

Client assets (virtual assets and client money) must be held on trust through an associated entity⁴(Associated Entity) of the Operator incorporated in Hong Kong that (i) holds a “trust or company service provider license”⁵ (ii) is a wholly owned subsidiary of the Operator and (iii) does not conduct any business other than holding client assets of the Licensed Platform.
At least 98 percent of client virtual assets should be stored in cold wallets. No more than 2 percent of client virtual assets should be held in hot wallets.
Client money should be held in segregated accounts of the Associated Entity that are maintained with an authorized financial institution in Hong Kong.
Insurance coverage must be in effect at all times for risks associated with the custody of virtual assets that are held in hot storage (for which full coverage is required) and for cold storage (for which substantial coverage is required).

AML

Adequate and appropriate anti-money-laundering/countering financing of terrorism policies, procedures and controls must be implemented.

Market Manipulation and Abuse Prevention

Implement and regularly review written policies and controls for the proper surveillance of activities on the Licensed Platform to identify, prevent and report any market manipulative or abusive trading activities.
Adopt an effective market surveillance system provided by a reputable and independent provider.

Conflicts of Interest

The Operator should not engage in proprietary trading, including any market-making activities on a proprietary basis.
The Operator and its Associated Entity should have a policy governing employees’ dealings.

Investor Disclosure

The Operator must disclose certain prescribed risks in relation to virtual assets and the Licensed Platform.
The Operator must provide contract notes, statements of accounts and receipts to clients (similar to a regular SFC-licensed corporation).

Change in Business

The SFC’s prior written approval is required for any plan or proposal (i) to introduce or offer a new or incidental service or activity or (ii) to make a material change to an existing service or activity of the Licensed Platform.

Reporting

The Licensed Platform must provide certain reports to the SFC on its business activities in accordance with the prescribed format and timing.
The Licensed Platform must engage an independent professional firm acceptable to the SFC to conduct an annual review and confirm compliance with the T&Cs and all relevant legal and regulatory requirements

Regulatory Requirements

The Operator is required to observe existing regulatory requirements, such as (i) the SFC Code of Conduct for Persons Licensed by or Registered With the SFC, (ii) Guidelines for the Regulation of Automated Trading Services and (iii) Guidelines on Online Distribution and Advisory Platforms.

What happens next?

Closely following release of the Position Paper and the Regulatory Framework, at least one Platform has publicly confirmed its submission to the SFC of an application for licenses to conduct Type 1 and Type 7 regulated activities⁶in order to operate a licensed virtual assets exchange in Hong Kong. The SFC noted in the Position Paper that the time required to process a licensing application from a Platform would likely be longer than for a standard licensing application. This means that it could be several months before Hong Kong sees its first licensed and regulated virtual assets exchange.

Although the requirements for Licensed Platforms are stringent, and the ongoing requirement for SFC approval of every product traded on a Licensed Platform may slow or stymie the expansion of Licensed Platform products, the SFC’s confirmation that it will indeed license and regulate such Platforms nonetheless remains a critical milestone in the development of the virtual assets industry in Hong Kong and for the nascent security tokens market in particular. It also positions Hong Kong to be a hub and a market leader for virtual assets.

Sidley is at the cutting edge of virtual assets legal work in Hong Kong. Our experience is comprehensive in all core aspects that are relevant to the virtual assets ecosystem, including advising on the formation of virtual assets funds, advising on regulatory requirements for virtual asset exchange operators and virtual asset fund managers and advising on early stage financing/merger and acquisition transactions for technology and virtual assets growth companies. Most notably, Sidley is the legal team behind Asia’s first (and to date only) tokenized fund.

If you would like to hear some of the insights that we have gained from our groundbreaking work in the virtual asset segment or explore how we may be able to assist you, please contact us.

¹ https://www.sfc.hk/web/EN/files/ER/PDF/App%202_%20Conceptual%20framework%20for%20VA%20trading%20platform_eng.pdf

²As defined under section 1 of Part 1 of Schedule 1 to the SFO.

³As defined under section 1 of Part 1 of Schedule 1 to the SFO.

⁴As defined under section 1 of Part 1 of Schedule 1 to the SFO.

⁵Issued under Anti-Money Laundering and Counter-Terrorist Financing Ordinance.

⁶As defined under Schedule 5 to the SFO

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