The Hong Kong Securities and Futures Commission published a consultation document of more than 300 pages and more than 200,000 words, mainly asking the Hong Kong industry 10 questions. The exchange must comply with relevant guidelines when listing tokens, and retail investors can trade large-cap virtual assets.
Hong Kong will issue retail licenses to virtual asset trading platforms. Industry insiders confirmed to PANews that the SFC will issue a consultation document this week. On February 20 (Monday), the Hong Kong SFC launched a consultation on the proposal to regulate virtual asset trading platforms as scheduled. The consultation will end on March 31 to facilitate the new licensing system that can officially take effect on June 1.
According to the more than 300 pages and 200,000 words of relevant consultation documents published by the Hong Kong Securities and Futures Commission, the Hong Kong industry was mainly asked 10 questions:
Do you agree that licensed platform operators should be allowed to provide services to retail investors?
Do you have any comments on the proposed general token inclusion criteria and the token-specific inclusion criteria?
If the SFC intends to allow retail investors to use licensed virtual asset trading platforms, what other regulations do you think should be implemented from the perspective of investor protection?
Do you have any comments on the proposal to allow a combination of third party insurance and funds allocated by a licensed platform operator or a corporation within the same group of companies as the licensed platform operator? Do you have any other suggestions?
Do you have any proposal on how the licensed platform operator should allocate such funds (e.g. transfer to the licensed platform operator's corporate account, or set up an escrow arrangement)? Please explain in detail the arrangement you propose and how the protection provided by the arrangement can provide the same level of protection as third party insurance.
Do you have any suggestions on which technical solutions can effectively mitigate the risks associated with the custody of clients’ virtual assets (especially those held in online storage)?
If a licensed platform operator can provide virtual asset derivatives trading services, which business model would you recommend? What type of virtual asset derivatives would you recommend for investors to buy and sell? What type of investors would be the target?
Do you have any suggestions on how to improve the Virtual Asset Trading Platform Guidelines while incorporating other provisions in the Virtual Asset Trading Platform Terms and Conditions?
Do you have any comments on the requirements on virtual asset transfers or any other requirements in Chapter 12 of the Anti-Money Laundering Guidelines for Licensed Corporations and Virtual Asset Service Providers Licensed by the SFC? Please state your views.
Do you have any comments on the CSRC Disciplinary Penalty Guidelines? Please state your views.
Among the above 10 issues, the most concerned issue in the market is whether trading platforms are allowed to target retail investors, what assets retail investors can participate in trading, and what derivatives they can trade. Other issues involve operational details, security protection and anti-money laundering, such as third-party insurance and technical solutions for asset custody.
The China Securities Regulatory Commission will issue virtual asset licenses and intends to allow retail investors
The document pointed out that the volatility of the virtual asset market and the collapse of FTX not only revealed the risks brought about by the increasingly close interconnections within the virtual asset ecosystem and between the virtual asset market and the traditional financial system, but also highlighted the importance of effective supervision and monitoring of the virtual asset industry.
Previously, under the current system under the Securities and Futures Ordinance in Hong Kong, only virtual asset trading platforms that provide security token trading services to customers were within the scope of supervision of the SFC. This also meant that the SFC had no right to license or supervise virtual asset trading platforms that only provided non-security token trading services.
Subsequently, the Hong Kong SAR government published a consultation document in November 2020 to solicit public opinions on the proposed establishment of a licensing system for virtual asset service providers under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance. The government proposes that central virtual asset trading platforms (i.e. centralized exchanges) that provide non-security token trading services in Hong Kong should be licensed and regulated by the SFC.
However, because the licensing framework for virtual assets is a new concept, the SFC believed at the time that even though the system already had proper protective measures to protect investors, in order to be more prudent, licensed virtual asset trading platforms under the Securities and Futures Ordinance should be restricted to provide services only to professional investors at least in the initial stage. Therefore, Hong Kong has been very cautious about issuing licenses before. Only OSL obtained exchange licenses in 2020 and Hahskey in 2022, and they were limited to providing services to professional investors.
On October 31 last year, Hong Kong issued the "Policy Declaration on the Development of Virtual Assets", expressing an open and friendly attitude towards virtual assets, and also released a message of providing services to retail investors. It also stated that the Securities and Futures Commission is allowing retail investors (retail investors) to buy and sell virtual assets to conduct public consultation.
It can be found from the document that although it is a public consultation, the CSRC actually intends to provide services to retail investors. The document mentioned that many people believe that refusing retail investors to use licensed virtual asset trading platforms may in turn cause harm to investors, because this may drive them to switch to unregulated overseas virtual asset trading platforms that can be easily accessed online to trade; and once any of these unregulated virtual asset trading platforms go bankrupt, retail investors will find it difficult to recover any losses. This can be seen from the collapse of FTX.
The SFC also added that in January 2022, the SFC allowed retail investors to access a small number of regulated virtual asset-related derivatives traded on traditional exchanges for the first time. Subsequently, in October 2022, the SFC established an approval system for virtual asset futures exchange-traded funds (virtual asset futures ETFs). So far, the SFC has approved three virtual asset futures ETFs under the system. Samsung Bitcoin Futures Active ETF was listed on the Hong Kong Stock Exchange in January this year, and CSOP listed Bitcoin and Ethereum Futures ETFs in Hong Kong in December last year.
Therefore, retail investors in Hong Kong can already indirectly access virtual assets through compliant products. Therefore, regardless of the actual situation and regulatory trends, the SFC has to allow changes to retail investors, so that supervision can be transformed from passive to active.
Users are required to conduct risk assessment before trading
Although the Hong Kong Securities and Futures Commission proposes to allow all types of investors (including retail investors) to use trading services provided by licensed virtual asset trading platform operators, this is subject to a series of appropriate investor protection measures.
Licensed platform operators must conduct a knowledge assessment on investors before providing any services to them. If a client fails the assessment, the operator may only provide services to the client after providing training to the client. Operators should assess the client's risk tolerance level and risk profile, and determine the risk profile for the client accordingly, as well as assess whether the client is suitable for participating in virtual asset transactions. Operators should also set a cap for each client to ensure that the risk borne by the client in relation to virtual assets is reasonable in the judgment of the platform operator, with reference to the client's financial status and personal circumstances. The cap should be reviewed regularly to ensure that it remains appropriate.
This means that in the future, Hong Kong residents will need to do a risk assessment test after registration before they can officially trade. It is worth mentioning that in informal consultations, there is a proposal to set a unified hard cap on the maximum amount of virtual asset risk that retail investors can bear on various virtual asset trading platforms. However, considering that everyone's financial situation is different, the SFC recommends that platforms assess their customers' risk tolerance level and risk situation based on appropriate systems.
The tokens listed must comply with relevant guidelines, and retail investors can trade large-cap virtual assets
The SFC recommends that licensed platform operators should set up a Token Inclusion and Review Committee to be responsible for developing, implementing and enforcing the criteria for including virtual assets for trading, and the obligation to notify licensed platform operators of any proposed hard fork or airdrop, any significant changes to the issuer's business or any regulatory actions against the issuer.
The Token Inclusion and Review Committee shall at least consist of senior management members who are primarily responsible for managing key businesses, compliance, risk management and information technology. The Token Inclusion and Review Committee shall report to the Board of Directors at least monthly, and the report shall at least include details of virtual assets available for retail customers to buy and sell and other issues noted.
The SFC wishes to emphasize that virtual assets themselves are not regulated by the SFC and it has never audited or reviewed the offer and promotion documents of virtual assets. In view of this, the SFC intends to adopt a more cautious approach, namely, to introduce a series of objective criteria that licensed platform operators must follow when determining whether they can offer a particular virtual asset to retail customers.
Licensed platform operators are ultimately responsible for conducting reasonable due diligence on virtual assets before including them for trading and ensuring that they meet the token inclusion criteria. Licensed platform operators should also monitor included virtual assets on an ongoing basis and ensure that they continue to meet the relevant criteria.
Factors that should 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 where the platform operator provides trading services, and whether such regulatory status will also affect the platform operator's regulatory responsibilities; c) the supply and demand, market maturity and liquidity of the virtual asset, including its market value, average daily trading volume, track record (e.g., issued for at least 12 months, excluding security tokens), whether other platform operators also provide trading for the virtual asset, whether there are relevant trading combinations (e.g., fiat currency against virtual assets), and in which jurisdictions the virtual asset is available for trading; d) the technical aspects of the virtual asset; e) the promotional materials of the virtual asset issued by the issuer, which should be accurate and not misleading; f) the development status of the virtual asset; g) the market risks of the virtual asset, including the high concentration of virtual asset holdings or control by a few individuals or entities, price manipulation and fraud, and the impact of wider or narrower adoption of the virtual asset on market risks; h) the legal risks associated with the virtual asset, i) Whether the utility provided by the virtual asset, the novel use cases it enables, or the technological, structural, or cryptoeconomic innovation it demonstrates appears to be fraudulent or grossly inappropriate.
In addition to the general token inclusion criteria, licensed platform operators who intend to offer virtual assets to retail customers should also ensure that the virtual assets they select are eligible large-scale virtual assets. In addition to complying with the above general inclusion criteria, they also need to meet the following specific token inclusion criteria.
“Eligible large-cap virtual assets” refer to virtual assets that are included in at least two “accepted indices” published by at least two independent index providers (and at least one is an index provider with experience in indices for traditional non-virtual asset financial markets). “Accepted indices” refer to indices with clearly defined objectives to measure the performance of the largest virtual assets in the market and meet the following criteria: a) The index should be investable, meaning that the relevant constituent virtual assets should have sufficient liquidity. b) The index should be calculated in an objective manner and be rules-based. c) The index provider should have the necessary expertise and technical resources to construct, maintain and review the index’s methodology and rules. d) The index’s methodology and rules should be properly documented, consistent and transparent.
According to this criterion, BTC and ETH clearly meet the requirements and can be marketed to retail investors, while other crypto assets require further research.
It is required to maintain a paid-up capital of not less than HK$5 million and establish an insurance system
According to the document, platform operators must always maintain a paid-up share capital of not less than HK$5 million (i.e. the "minimum paid-up share capital"). Platform operators should always beneficially own fully liquid assets in Hong Kong, such as cash, deposits, treasury bills and certificates of deposit (but not virtual assets), the amount of which should be equal to the actual operating expenses of the platform operator calculated on an ongoing basis for at least 12 months.
It is also mentioned that platform operators should establish and implement strict internal control measures and governance procedures in terms of private key management to ensure that all encryption 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 a compensation arrangement approved by the SFC to provide an appropriate level of protection against risks associated with the custody of client virtual assets (such as incidents of platform hacking or default by the licensed platform operator or its associated entities). Regarding investor protection insurance requirements, the SFC recommends:
a) Licensed platform operators should have in place compensation arrangements approved by the SFC for the risks associated with the custody of client virtual assets.
b) Licensed platform operators should monitor the total value of client virtual assets in their custody on a daily basis to ensure compliance with relevant compensation provisions.
c) If a licensed platform operator allocates its own funds or the funds of a corporation in the same group of companies as the licensed platform operator to comply with the relevant requirements, it should ensure that such funds are held in trust and earmarked for the relevant purpose. Such funds should also be segregated from the assets of the licensed platform operator, its associated entities or the corporation in the same group of companies as the licensed platform operator.
The list of exchanges will be announced after the license takes effect
From June 1, 2023, any virtual asset trading platform that operates its business in Hong Kong or actively promotes its services to Hong Kong investors without a valid license will be in violation of the licensing requirements under the Virtual Asset Service Provider Regime under the Anti-Money Laundering Ordinance, unless it is eligible to participate in the transitional arrangements.
The SFC proposes to establish a 12-month transition period for licensed platform operators under the Securities and Futures Ordinance to comply with the requirements in relation to their existing clients or the virtual assets they are currently selling. 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 Virtual Asset Service Providers Licensed by the SFC and other guidelines are finalised.
Virtual asset trading platforms must be existing platforms that have been operating in Hong Kong and have established meaningful and substantial businesses before June 1, 2023 to be eligible for the transitional arrangement. They can continue to operate in Hong Kong from June 1, 2023 to May 31, 2024 only after meeting the conditions of the Anti-Money Laundering Ordinance. Specific considerations include whether a group is established in Hong Kong, whether there is a physical office in Hong Kong, whether Hong Kong employees have central management or control, whether key personnel are stationed in Hong Kong, and whether the operation has been put into service and has a large number of customers and trading activities in Hong Kong.
If existing virtual asset trading platforms wish to be eligible to participate in the deemed licensing arrangement, they must submit a licence application online under the Virtual Asset Service Provider Regime under the Anti-Money Laundering Ordinance between 1 June 2023 and 29 February 2024 (i.e. within nine months from 1 June 2023).
Virtual asset trading platforms that were not operating in Hong Kong immediately before 1 June 2023 may only operate their business in Hong Kong or actively promote their services to Hong Kong investors after being formally licensed under the Virtual Asset Service Provider Regime under the Anti-Money Laundering Ordinance. Carrying out any unlicensed activities is a criminal offence.
During the transition period, it may be difficult for the public to tell whether a virtual asset trading platform is operating legally. In order to dispel such doubts, the SFC intends to publish several lists on its website to inform the public of the different regulatory status of virtual asset trading platforms. The SFC hopes that by publishing these lists, it will deter virtual asset trading platforms that are not licensed or are required to close from providing services to the public.
