Compulsory Licensing Regime for Virtual Asset Exchanges in Hong Kong | Goodwin

Introduction

Hong Kong has traditionally been a hub for digital asset businesses in the region. As Hong Kong regulators work to tighten the regulatory regime on virtual asset trading, market participants and investors looking to take advantage of the booming digital asset industry need to stay abreast changes in the regulatory landscape and political trends.

In this article, we explore the recently proposed compulsory licensing regime for virtual assets (“Virginia“) exchanges. The proposed compulsory licensing regime for VA trading platforms recommended by the Financial Services and Treasury Office (“FSTB”) of the Hong Kong government in May 2021, as part of proposed amendments to the Anti-Money Laundering and Anti-Terrorist Financing Ordinance (“AMLO”)[1], aims to replace the existing voluntary participation scheme. The amended AMLO was published in the Official Gazette on June 14, 2022 and the first reading of the amended AMLO took place on July 6, 2022. The proposed compulsory licensing regime is expected to enter into force on March 1, 2023.[2]

Existing SFC voluntary opt-in scheme

The SFC introduced the existing opt-in voluntary licensing scheme for VA trading platforms in November 2019[3]. To date, only one VA trading platform has obtained the SFC license. Under this regime, the SFC grants a Type 1 (securities trading) or Type 7 (provision of automated trading services) regulated activity license to a VA trading platform that trades at least one token of security which falls within the definition of “securities” under the Securities and Futures Ordinance (Cap. 571, “FSO”).

On May 21, 2021, the FSTB published its consultation conclusions on the legislative proposals aimed at strengthening the fight against money laundering and terrorist financing (“AML/CTF”) regulation in Hong Kong, including a proposal to introduce a compulsory licensing regime for VA trading platforms in line with the recommendations of the Financial Action Task Force (“FATF”).[4]

Compulsory licensing regime

Under the amended AMLO Proposed Licensing Regime published on June 14, 2022, the operation of an AV exchange in Hong Kong or the operation of an AV exchange outside of Hong Kong that actively trades to the public in Hong Kong will be considered a “regulated AV activity”. as part of the AMLO, requiring a license granted by the SFC.

The operation of a AV exchange is defined as the provision of services by means of electronic facilities (a) through which (i) offers to sell or buy AV are regularly made or accepted; or (ii) persons are regularly introduced or identified to other persons so that they may negotiate or enter into sales or purchases of VA, in each case in a manner that results in a binding transaction; and (b) when Customer Money or Customer VA comes into the direct or indirect possession of the Operator. In particular, this indicates that pure peer-to-peer exchanges where transactions take place directly between traders will not be subject to the compulsory licensing regime.

There is no longer a requirement that the AV being transacted constitute a “security” under the SFO. The definition of AVs under the amended AMLO would include a wide range of AVs, typical examples of which are Bitcoin and stablecoins. The proposed legislation expressly provides that certain assets do not constitute VA, such as central bank digital currencies and limited-use digital tokens (including customer loyalty points or in-game assets). As detailed in the recent SFC press release, most non-fungible tokens (“NFT”) that represent unique copies of underlying assets do not fall under the definition of AVs.[5]

The main requirements of the proposed compulsory licensing regime include:

  • Eligibility. Only companies incorporated in Hong Kong with a permanent establishment in Hong Kong, or companies not incorporated in Hong Kong that have registered in Hong Kong under the Companies Ordinance (Cap. 622) can apply for a license.
  • Good and good test. A candidate must pass the fit and suitable person test, taking into account his or her financial situation or creditworthiness; diplomas or other qualifications or experience in the functions to be performed; ability to provide VA service competently, honestly and fairly; reputation, character, reliability and financial integrity; if the applicant has been convicted of a money laundering/terrorist financing offense or other offenses where the applicant is found to have acted fraudulently, corruptly or dishonestly; and if the applicant has failed to comply with a requirement imposed under the AMLO.
  • responsible officers. An Applicant shall appoint at least two (2) Responsible Officers who will generally be responsible for AML/CTF compliance. Responsible officers should be held personally liable for non-compliance. Only responsible leaders approved by the SFC can become executive directors of a VA exchange.
  • Authorized representatives. Only persons authorized by the SFC as authorized representatives may perform regulated functions on behalf of the VA exchange, that’s to say, operating a VA exchange that is not a job usually done by an accountant, clerk, or cashier. Authorized representatives must also pass the fit and proper person test.
  • License Terms. The SFC may impose certain conditions on a AV exchange license, including having financial resources, adequate knowledge and experience, risk management policies and procedures, conditions on the management of customer assets, reporting and financial information, AV listing and trading policies, prevention of market manipulation and abuse activities, cybersecurity and prevention of conflicts of interest. The SFC will publish detailed regulatory requirements prior to the entry into force of the new regime.
  • Investor protection. Similar to the existing voluntary licensing regime, a licensed AV exchange will initially only be able to offer its services to professional investors (as defined in the SFO). This will be a condition of license imposed by the SFC.

In addition, a VA scholarship 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. In particular, even if a person remains below the 25% threshold but exercises ultimate control, they would be caught by the proposed legislation. If a person proposes to become the ultimate owner of a licensed VA exchange, they must first obtain approval from the SFC.

The proposed Amendment Bill was presented to the Legislative Council for first reading on July 6, 2022. The proposed compulsory licensing regime is expected to come into force on March 1, 2023, and a nine-month transition period will be available to allow license applications. Any existing VA exchange operator will need to file an application with the SFC by December 1, 2023 (9 months after the start of the compulsory licensing regime) and confirm that it will comply with the SFC’s regulatory requirements. These operators may be deemed to hold a provisional license until the SFC has ruled on its license application.

Conclusion

The proposed compulsory licensing regime will increase the operational burden of AV exchanges operating and trading in Hong Kong, and restrict retail investors’ access to these AV exchanges. The Legislative Council’s brief acknowledges that the proposed regime in Hong Kong would be more stringent and comprehensive than in other comparable jurisdictions, such as Singapore, the UK and Japan. Additional SFC regulatory requirements to be announced are expected to focus on investor protection and AML/CTF risk control. Existing AV exchanges should assess their existing infrastructure and consider upgrading their policies and systems if they wish to continue operations in Hong Kong. For VA exchange investors, in addition to considering cybersecurity, intellectual property, key person risks during the due diligence process, increasing attention should be paid to assessing operational viability and risks legal and compliance matters related to operations in Hong Kong.


[1] https://www.fstb.gov.hk/fsb/en/publication/consult/doc/consult_conclu_amlo_e.pdf
[2] https://www.fstb.gov.hk/fsb/en/legco/docs/AML(A)Bill%202022_legco%20brief_e%20(Issue).pdf
[3] https://www.sfc.hk/-/media/EN/files/ER/PDF/20191106-Position-Paper-and-Appendix-1-to-Position-Paper-Eng.pdf
[4] https://www.fstb.gov.hk/fsb/en/publication/consult/doc/consult_conclu_amlo_e.pdf
[5] https://apps.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=22PR34

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Michael J. Birnbaum