After challenges with strict COVID restrictions and political issues in the last several years, Hong Kong is fighting to bolster its status as a global financial hub - and prove its unique advantage as the gateway between mainland China and the rest of the globe. As a result, technological developments and the regulations required to stay ahead of a rapidly evolving financial landscape are now a priority in the region.
Regarding virtual assets (i.e., digital assets and cryptocurrency), the financial industry faces significant challenges due to regulators catching up to the “crypto craze”. For example, just last year, the virtual assets and cryptocurrency markets gained global news headlines - for all the wrong reasons. The collapse of the Luna Token, Terra Stablecoin, the epic implosion of the FTX crypto exchange, and the high volatility of virtual asset prices have all emphasised the risks associated with virtual assets. See our recent eBook, Cryptocurrency in Singapore: a Time of Turmoil or Hope Ahead, for more detail on these and other crypto issues experienced in the region.
In recent years, inadequate and unethical management of virtual assets and marketplaces has resulted in a considerable financial impact on real investors. The Luna and TerraUSD crashes caused a domino effect, which affected Bitcoin and the global cryptocurrency market to an estimated US $300 billion in losses.
The headlining crypto woes of 2022 have made it more apparent than ever that proper regulation must exist to protect investors and customers - and enable long-term stability within the virtual asset space. Accordingly, Hong Kong’s SFC (Securities and Futures Commission) is taking a forward-thinking stance, developing and enhancing policies to effectively regulate virtual assets within the region.
This article explores the SFC Consultation Conclusions on the Proposed Regulatory Requirements for VATPs with summary highlights with a particular focus on conduct, CTP, conflicts of interest, and compliance management.
A Brief Note About Terminology
Hong Kong regulators refer to digital assets and crypto assets as “virtual assets”. Other jurisdictions may reference the same technology as “digital assets” or “crypto assets”.
Virtual assets can include:
- NFTs (Non-Fungible Tokens)
- CBDC (Central Bank Digital Currency)
- Tokenised Securities
- Security Tokens
The Changes to Virtual Asset Regulation in Hong Kong that Are Happening Now
Many regulators are transitioning from a light-touch approach with virtual assets, focusing on anti-money laundering (AML), to regulating from an investor protection perspective.
The SFC has so far faced limitations in its regulation abilities of Virtual Asset Trading Platforms (VATPs). The regulatory remit of the SFC thus far under the Securities and Futures Ordinance (SFO) has only extended to activities relating to securities and futures contracts. In 2019, the SFC created an opt-in framework under the SFO for centralised VATPs that provide trading services for at least one security token. And although the SFC maintains a licensed VATP listing, only two Platform Operators have so far signed up.
The SFC’s limited scope has also prevented it from issuing licences or regulating the many VATPs that only provide non-security tokens and trading services. This limitation means that many VATPs in Hong Kong have primarily been unlicensed.
To address these constraints, the Hong Kong government passed legislative amendments to the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO) in 2022 to regulate virtual asset service providers (VASPs) dealing in non-security tokens.
Finally, under the new regime, every centralised VATP conducting business in Hong Kong or actively marketing to Hong Kong investors must be licensed by the SFC - irrespective of whether or not they provide trading services in security tokens. This new regulatory regime was enacted on 1 June 2023, with a transitional period for VATPs to become licensed.
As Ms Julia Leung, the SFC’s Chief Executive Officer, explains in a recent news announcement, “Hong Kong’s comprehensive virtual assets regulatory framework follows the principle of ‘same business, same risks, same rules’ and aims to provide robust investor protection and manage key risks. This will enable the industry to develop sustainably and support innovation.”
Hong Kong SFC’s Consultation Conclusions for a Comprehensive Framework to Govern VATPs
On 20 February 2023, the SFC published a consultation paper on the proposed regulations for VATPs. The SFC has now also published its consultation conclusions, which sets out the comprehensive regulatory framework to govern virtual asset trading platforms.
As the regulatory scope of virtual assets expands, firms dealing in these assets must understand and prepare for the changes ahead. For example, any Platform Operators licensed under both SFO and ALMO must now adhere to the more stringent requirements to remain compliant (further detail contained in section 1.5 - Interpretation of the Consultation Conclusions).
VATPs who obtain SFC licensing under the new regime will also be subject to ongoing supervision. This extended regulatory oversight may reassure clients of proper virtual asset governance and controls - a proposition that is now more critical than ever, given the tumultuous cryptocurrency environment seen in recent years.
The Release of SFC Consultation Conclusions on the Proposed Regulatory Requirements for VATPs
In May 2023, Hong Kong’s SFC released its Consultation Conclusions on the Proposed Regulatory Requirements for Virtual Asset Trading Platform Operators Licensed by the SFC.
Industry and professional associations, professional and consultancy firms, market participants, licensed corporations, individuals and other stakeholders responded with 152 written submissions during the consultation period.
The regulator has now considered comments and suggestions provided by respondents and further modified or clarified some of the proposed requirements.
A Short Summary of the SFC Consultation Conclusions for VATPs
The following provides a short overview of particular highlights from the Consultation Conclusions. VATPs and those dealing in virtual assets are encouraged to review the full detail of the regime, as published here: SFC Consultation Conclusions on the Proposed Regulatory Requirements for VATPs.
Fitness and Properness Requirements
The SFC will determine whether a licence application satisfies the criteria to be deemed a “fit and proper” to carry out regulated activities. These criteria include areas such as financial status, education and experience, competency, honesty, reputation, reliability, and financial integrity.
See Section 2 - Fitness and Properness Requirements for further detail.
General Business Conduct
The SFC expects VATPs (and their representatives) to conduct themselves with high ethical standards, including:
- Acting honestly and fairly
- Acting in its clients’ best interests and the market’s integrity
- Have due skill, care, and diligence
- Have appropriate resources and procedures to support the proper performance of business activities
- Seeking to avoid conflicts of interest, and when they cannot be avoided, ensuring clients are fairly treated
See Section 5 - Conduct of Business Principles for further detail.
For more information about minimising conflict of interest and misconduct risk, see MCO’s detailed eBook, The Ultimate Guide to Conflicts of Interest in Financial Services.
Financial Resources and Soundness
VATPs will be required to maintain, at all times, adequate financial resources and assets within Hong Kong, which it beneficially owns and are sufficiently liquid. These assets may include cash, deposits, treasury bills and certificates of deposit (but not virtual assets). They must be equivalent to at least 12 months of the organisation’s actual operating expenses, calculated on a rolling basis.
Additionally, VATPs must meet minimum capital requirements of:
- A minimum paid-up share capital of HK$5 million
- A minimum liquid capital of HK$3 million
VATPs must also appoint an external auditor to conduct audits of their financial statements. Financial returns must also be submitted monthly.
See Section 6 - Conduct of Business Principles for further detail.
Demonstrating Competence and Compliance
The SFC will consider various key elements of a VATP to determine satisfactory competence to carry out regulated activities, including the organisation’s business, corporate governance, internal controls, operational review, risk management and compliance. The combined competence of a firm’s senior management and other staff members will also be considered.
As part of an organisation’s assurance of competence, any individuals applying to carry out the Relevant Activities must satisfy the SFC that they have the necessary academic, professional or industry qualifications, sufficient relevant industry and management experience (where applicable), familiarity with the ethical standards expected of a financial practitioner, and possess a good understanding of the regulatory framework, including the laws, regulations and associated codes governing the virtual asset sector.
VATPs must also ensure proper regulatory compliance, including:
- Policies and procedures to ensure the organisation’s compliance with all applicable legal and regulatory requirements and internal policies and procedures
- Arrangements to ensure that proper audit trails are maintained
- Reporting systems that enable robust information to be produced for risk management and decision-making purposes
- Policies and procedures that ensure the information submitted to the SFC is complete and accurate
- Defined policies and procedures for dealing with non-compliance
See Section 3 - Competence Requirements for further detail.
Continuous Professional Training Requirements
The SFC highlights the importance of continuous professional training (CPT). The regulator notes the general necessity for individuals to undertake CPT to maintain technical knowledge and professional expertise beyond work experience or on-the-job training. By undertaking CPT requirements, individuals can reasonably assure investors that they possess the technical knowledge, professional skills and ethical standards required to carry on Relevant Activities efficiently, effectively and fairly.
Individuals must comply with the continuous professional training (CPT) requirements, also known as Continuing Professional Development programs (CPD programs). Failure to satisfy any applicable CPT requirements will cast doubt on the fitness and properness of corporations and individuals to remain licensed and may lead to disciplinary action by the SFC.
See Section 4 - Continuous Professional Training Requirements for further detail.
Our in-depth article, Addressing Compliance Within Financial Firms’ CPD Requirements also provides further insight into CPD compliance.
Effective Prevention of Market Abuse and Manipulation
VATPs will need to implement documented controls, policies, and procedures to ensure proper surveillance of trading activity. In addition, platform Operators must take appropriate measures to identify, prevent, and report market manipulation or trading activities causing market abuse.
The SFC specifies the minimum efforts for these requirements to include:
- Identifying and detecting anomalies, which includes performing periodic independent reviews of suspicious price spikes
- Monitoring and preventing any potential use of abusive trading strategies
- Taking immediate steps to restrict or suspend trading upon discovery of manipulative or abusive activities (e.g. temporarily freezing or suspending accounts)
See Section 8 - Prevention of Market Manipulative and Abusive Activities for further detail.
Avoiding Conflicts of Interest and Upholding Regulatory Compliance
VATPs must appropriately segregate duties within the organisation, particularly with multiple functions performed by the same individual, which may lead to conflicts of interest. For example:
- Front-end roles such as sales staff and persons handling client orders should be executed by separate staff to back-office roles such as settlements, accounts, and handling of client assets
- Internal audits and compliance reviews should be completely independent of front-end and back-end roles mentioned above - and should report directly to senior management of the Platform Operator
It is also essential to ensure compliance with the law, rules, regulations and codes administered or issued by the SFC, along with any regulatory authority requirements that may apply to the VATP and its internal policies and procedures.
The remit for compliance teams and/or Chief Compliance Officers, together with senior management of the organisation, is to:
- Establish, maintain and enforce clear and effective compliance policies and procedures
- Conduct regular compliance reviews to identify any potential compliance breaches of legal and regulatory requirements and the organisation’s internal policies and procedures
See Section 11 - Management, Supervision and Internal Control for further detail.
Understanding the SFC Requirements in Greater Detail
The above summary provides only a brief interpretation of the Consultation Conclusions with a particular focus on conduct, CTP, conflicts of interest, and compliance management.
VATPs and firms dealing in virtual assets are encouraged to review the complete Consultation Conclusions document.
The Immediate Future for VATPs
From 1 June 2023 onwards, any VA trading platform carrying on its business in Hong Kong or actively marketing its services to Hong Kong persons will need to obtain a VASP licence. However, the AMLO allows for a grace period to transition to the new regime.
Existing VATPs operating within Hong Kong before 1 June 2023 will be allowed to continue operating in Hong Kong without a licence for up to 12 months (until 31 May 2024). During this time, the VATP must apply for a licence or plan to discontinue its operations. It is noted that the SFC’s requirement for existing VATPs applies to those it deems to have a “meaningful and substantial presence”.
The SFC will publish further guidance so the industry can better understand the implementation of the new regulatory regime and transitional requirements for VATPs.
How MyComplianceOffice (MCO) Can Help
VATPs considering their applicant for licensing under the new SFC regime must document and demonstrate upholding their regulatory compliance obligations.
MyComplianceOffice (MCO) enables firms to monitor and avoid internal virtual asset conflicts of interest, just like traditional securities. Part of the Know Your Employee Compliance Suite, MCO’s Personal Trade Manager solution allows organisations to seamlessly manage the preclearance and reporting of crypto investments.
Particularly in light of the cryptocurrency turmoil of recent years, a VATP’s ability to monitor, identify, prevent, and report trading abuse or market manipulation activities is crucial.
Find out how MCO can help you stay ahead of virtual assets regulation, demonstrate proper virtual asset governance and controls to regulatory bodies, and reduce non-compliance risk.
Download your detailed Virtual Asset Compliance Brochure or request your tailored demonstration of the MCO’s powerful compliance management platform now.