Key Points in the FSTB Consultation Paper to the new licensing regime for VASPs

The Financial Service and Treasury Bureau released a consultation paper on 3 November 2020, proposing amendments to the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Chapter 615, Laws of Hong Kong)(“AMLO”) to introduce a licensing regime for virtual asset services providers (“VASP(s)”). River Stone, Pádraig Walsh and Alan Wong from the Technology and Regulation practices of Tanner De Witt summarise the key features proposed for the new VASP licence.

What activities are going to be regulated?

The VASP licence will be mandatory for any person seeking to carry out business in proposed regulated activities involving virtual assets. These activities include:

• exchange between virtual assets and fiat currencies.
   
• exchange between one or more forms of virtual assets.
   
• transfer of virtual assets.
   
• safekeeping or administration of virtual assets or instruments enabling control over virtual assets.
   
• participation in and provision of financial services related to an issuer’s offer or sale of virtual assets (commonly known as initial coin offerings).

The primary intention is to regulate the common activities and operations of a virtual asset exchange. This is a trading platform operated to allow an offer or invitation to be made to buy or sell virtual assets in exchange for money or virtual assets, and which the platform has custody, control, power or possession of money or virtual asset in its business. Although that may be the primary intent, the scope of proposed regulated activities will encompass more than virtual asset exchanges.

Some businesses will be expressly excluded. These are:

• Peer-to-peer trading platform, to the extent that actual transaction is conducted outside the platform and the platform is not involved in the underlying transaction (that is, decentralized exchanges).
   
• virtual asset  payment systems or custodian services operating as a standalone business.
   
• over-the-counter trading and crypto-ATMs.

What are virtual assets?

Under the proposal, virtual assets must have three key characteristics. Virtual assets will be a digital representation of value that:

• is expressed as a unit of account or a store of economic value;
   
• functions as a medium of exchange accepted by the public as payment for goods or services or for the discharge of a debt, or for investment purposes; and
   
• can be transferred, stored or traded electronically.

This will cover virtual assets backed by some form of assets (commonly known as “stablecoins”).

There are some exclusions from the scope of virtual assets. These are:

• digital representations of fiat currencies (including digital currencies issued by central banks).
   
• financial assets (e.g. securities and authorized structured products) already regulated under the Securities and Futures Ordinance.
   
• Closed-loop, limited purpose items that are non-transferable, non-exchangeable and non-fungible (such as Asia miles, credit card rewards, gift cards, customer loyalty programmes, or gaming coins).

It would be helpful if stored value facilities were also expressly excluded. The operation of some SVFs could fall within the scope of the proposed definition for virtual assets. However, there is a separate regulatory regime for SVFs, and this should be recognized with an appropriate exclusion to avoid any overlap in the proposed regime.

What are the licensing requirements?

An applicant must fulfil these licensing requirements:

• The applicant must be incorporated in Hong Kong and with a permanent place of business in Hong Kong. A natural person or a business without a legal personality will not be eligible.
   
• An applicant, its responsible officers and ultimate owners must satisfy the fit-and-proper test that applies to other financial institutions regulated under the AMLO.
   
• An applicant must appoint at least two responsible officers to assume the general responsibility of ensuring compliance. These individuals will be held personally accountable in case of non-compliance. All executive directors of the applicant must be responsible officers. The competence criteria for responsible officers has not been outlined as yet.
   
• An applicant must observe the AML/CTF requirements under Schedule 2 of the AMLO.
   
• The applicant must possess the technological capacity and know-how to operate the virtual asset exchange.

We expect the requirement for a locally incorporated Hong Kong company may change as the consultation progresses. Other regulatory regimes in Hong Kong allow for a non-Hong Kong company that has registered a place of business in Hong Kong, and there is no particular reason why the holder of a VASP Licence should be treated more restrictively.

Will there be any licensing conditions?

A VASP licence holder may be required to comply with additional licensing conditions, which are similar to those imposed on an SFC licensed exchange. These may include:

• Services can only be provided to clients who are professional investors.
   
• An applicant should possess adequate financial resources. These can be expected to be the same as required for an SFC licensed exchange and holding at least 12 months operating expenses.
   
• There should be a proper corporate governance structure, and an applicant is staffed by personnel with the necessary knowledge and experience.
   
• The business should be operated prudently and soundly.
   
• There should be appropriate risk management policies and procedures for AML/CTF, cybersecurity and other risks.
   
• There should be proper segregation of client assets by placing them in an associated entity with adequate policies and governance procedures to ensure proper management and custody.
   
• There should be robust rules for the listing and trading of virtual assets. All virtual assets must be subject to reasonable due diligence before listing. The extent of the due diligence required is likely to be similar to those required for an SFC licensed exchange.
   
• An applicant should observe prescribed auditing and disclosure requirements and publish audited accounts.

• There should be policies and controls to identify, prevent and report any market manipulative or abusive trading activities.
   
• An applicant should avoid any conflicts of interests. Particular attention will be paid to conflicts arising from engaging in proprietary trading or market-making activities on a proprietary basis. Applicants will be expected to use information barriers and firewalls between different functions of the corporate structure and to implement other appropriate policies to avoid conflicts.

We can expect further consultation and more detail on applicable codes and guidelines.

Who will supervise and regulate the licence?

The Securities and Futures Commission will process, grant, supervise and regulate the VASP licence.

SFC regulatory powers will include the power to:

• enter business premises.
   
• request the production of documents and records.
   
• investigate and to impose administrative sanctions.
   
• appoint an auditor to look into affairs of a VASP licence holder.
   
• apply to the Court for injunction orders.

The SFC will also be given these intervention powers:

• Prohibit the virtual asset exchange from executing further transactions and requiring it to carry out business in a specified manner.
   
• Restrict the virtual asset exchange from disposing of its property.
   
• Require the virtual asset exchange to maintain its property in a specified manner.

The VASP licence will be an open-ended licence. This means there will not be any renewal application and a VASP licence will remain valid until revoked by the SFC.

When must an applicant apply?

There will be a 180-days transition period for all operators to apply for a VASP licence once the licence becomes available for application. Any businesses that fail to obtain a VASP licence after the transition period will commit a criminal offence.

What happens if a virtual asset exchange fails to comply?

Operation of a virtual asset exchange without a licence is a criminal offence. This will be punishable, on conviction on indictment, to a fine of HK$5,000,000 and to imprisonment for seven years. This will also cover any virtual asset exchange that operates overseas but actively markets its services to the public of Hong Kong without a VASP licence.

There will be a range of other offences which will address false or misleading statements in an application, breach of AML/CTF requirements, and fraudulent or reckless misrepresentations to in the sale of virtual assets.

Is the VASP licence the same as a virtual asset exchange trading securities licensed by the SFC?

There are several requirements imposed on a virtual asset exchange trading securities licensed by the SFC (“SFC Licensed Exchange”). Some additional requirements on an SFC Licensed Exchange include:

• A licensed holder must obtain and submit to the SFC written legal opinion on the legal and regulatory status of a virtual asset.
   
• There cannot be any financial accommodation to clients by an SFC Licensed Exchange.
   
• The fee structure of a licensed holder must be clear, fair and reasonable.
   
• A licensed holder cannot publish advertisements in connection with a specific virtual asset.
   
• A client’s knowledge in virtual assets must be assessed, and a licensed corporation is subject to the suitability requirement.
   
• There must be an effective insurance policy in place.
   
• SFC’s approval must be obtained before incorporating new services or activities or adding any product to the trading platform.
   
• Monthly reports and an annual review prepared by a professional firm must be submitted to the SFC.

We expect that some of these requirements will be applied under the VASP license regime, once codes and guidelines are prepared by the SFC.

What does this all mean?

The proposed licensing regime will work side-by-side with the existing licensing regime for SFC Licensed Exchanges. The regulatory objective is to have a virtual asset trading environment where substantially all cryptocurrency exchanges will be licensed, even if they only deal with virtual assets that are not securities or futures contracts.  Hong Kong will become one of the few jurisdictions in the world that fully regulates its cryptocurrency market.

Given the cost and burden of regulation, these changes may cause some virtual asset exchanges in Hong Kong to consider the scope of their operations in Hong Kong and may raise the bar too high for some innovative startups or early-stage businesses to select Hong Kong as its launching pad. However, the stable and consistent regulatory environment should be a magnet for more mature virtual asset exchanges that have already factored appropriate regulatory workstreams into their business.

The deadline to submit comments to the Financial Services and Treasury Bureau on the consultation paper is 31 January 2021. Once the consultation conclusions are taken into account, we expect there will be more consultation papers from the SFC soon that will shed more light on the specific details of the VASP licence. A busy regulatory year in cryptocurrency lies ahead. We, at Tanner De Witt, are ready to help.

River Stone, Pádraig Walsh & Alan Wong

If you would like to discuss any of the matters raised in this article, please contact:

Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.