The new licensing rules: basic information

Though Hong Kong is part of China, it enjoys significant autonomy under the “one country, two systems” concept. This also applies to the regulatory regime around investment assets, including cryptocurrencies.

While crypto is virtually banned in mainland China, crypto trading is legal and flourishing in Hong Kong, though it’s available only to investors with a portfolio above 8 million HKD (around $1 million). The next step is detailed regulations that will finally open up the market to retail investors.

The new licensing rules for crypto exchanges were published in February 2023 and will come into force on June 1. From now on, all centralized crypto trading platforms that operate in Hong Kong or sell crypto to Hong Kong investors will have to get a license from the Securities and Futures Commission (SFC).

The SFC now considers crypto exchanges as more or less equivalent to securities brokers and automated trading platforms. Virtual asset (VA) platforms will need to follow the same rules as described in the 2022 Securities and Futures Ordinance.

Crypto exchange operators that plan to apply for a license need to start adapting their systems to the new regime. In turn, those who don’t plan to get a license should prepare to close down their business in Hong Kong.

The SFC plans to publish lists of virtual asset platforms with their up-to-date licensing status, as well as collaborate with the Financial Education Council to increase investor awareness.

Key requirements for crypto exchanges

Let’s now examine the new rules that VA trading platforms in Hong Kong are required to follow starting from June 1.

1) Secure asset storage. Crypto exchanges must store clients’ money and virtual assets securely through fully owned subsidiaries (“associated organizations”). No more than 2% of the clients’ cryptocurrency can be stored in hot wallets.

Further, every platform operator must develop and implement a written internal policy and procedures for managing private keys. An exchange needs to show that all the cryptographic data and keys are safely generated and stored, and that backup copies are available.

Moreover, platform operators can’t manipulate client assets: transfer them to third parties, lend them, etc. The exchange must also insure the risks associated with storing its clients’ cryptocurrency.

2) KYC (Know Your Customer). Licensed platform operators must take all possible and reasonable steps to verify each client’s identity and determine their financial status, investment experience, and investment goals.

3) Anti-Money Laundering and Counter-Terrorist Financing measures. The exchange must implement an adequate AML and CFT policy. In particular, it can use virtual asset tracking tools to monitor the history of transactions involving specific units of cryptocurrency.

4) Conflict of interest. Platform operators cannot engage in private trading or marketing activities. They also need to implement a policy for regulating their employees’ crypto operations so that there is no conflict of interest related to the cryptocurrency of their clients.

5) Virtual assets allowed for trading. The exchange must introduce functionality that will allow client assets to be traded, or block them as needed, in accordance with the new criteria (see below). Before allowing client assets to be traded, the operator also needs to make reasonable checks to make sure that the asset still satisfies the conditions.

6) Preventing market manipulations and illegal activities. The operator must develop and implement a written policy and control tools to identify, prevent, and report any manipulations or illegal trading activity on the platform.

7) Accounting and financial reporting. A platform operator must submit annual financial audit reports to the SFC, as well as monthly commercial reports. Exchanges also need to select auditors with expertise in the virtual asset industry.

8) Risk management. A crypto exchange must have a reliable system for identifying, measuring, controlling, and managing all the risks that result from its business operations. A platform operator cannot provide its clients with financing to buy virtual assets.

Key requirements for virtual assets

The SFC has also introduced a set of criteria that allow licensed crypto exchanges to decide which virtual assets they can allow for trading on their platforms.

1. An exchange can’t offer virtual assets that fall under the definition of a security in accordance with the Hong Kong Securities and Futures Ordinance (SFO), if this can violate the investment offering rules or the securities prospect rules

2. Before allowing trading in a certain asset, the operator needs to conduct reasonable checks to make sure that the token in question satisfies all the criteria. Exchanges also have to keep tracking the assets previously cleared for trading. The main criteria are as follows:

a) information about the token’s founders and development team;

b) the token’s legal status in each jurisdiction where the exchange operates, and the possible impact of the token’s legal status on the exchange’s own legal standing;

c) supply, demand, liquidity (market cap, daily trading volume, available trading pairs, and the jurisdictions where the token is traded);

d) technical aspects (blockchain protocol security, resistance to common attacks, consensus algorithm, risks and threats);

e) marketing materials published by the token issuer: they must be precise and not lead to any false conclusions;

f) the results of any projects related to the token and listed in its documentation, as well as any serious incidents related to its development history;

g) market risks (high concentration of tokens in the hands of a small number of stakeholders, price manipulation, scams, the impact of the token’s wider or narrower popularity on the market risks);

h) legal risks (any potential or ongoing legal suits and complaints related to the token’s release, distribution, or use).

In conclusion

Between February and the end of March 2023 the new rules were open for public consultation, and over 150 interested parties provided comments to the SFC. The final version should be published in May, and on June 1 the new regime will come into force.

Moreover, Hong Kong’s banking regulator has recommended banks to provide assistance to crypto platform operators wishing to open a bank account – even if their license application is still under review. The circular stresses that banks need to conduct reasonable checks of the potential corporate clients (i.e. crypto exchanges), but without creating an excessive “burden”.

We can hope that the new licensing regime will not just improve virtual asset regulations but will also increase investor trust and attract more crypto startups to Hong Kong – including those that left mainland China because of the restrictions on cryptocurrency.

References

https://www.sfc.hk/en/

https://apps.sfc.hk/edistributionWeb/api/consultation/openFile?lang=EN&refNo=23CP1

https://www.coindesk.com/policy/2023/02/20/hong-kong-proposes-rules-for-crypto-trading-platforms/

https://www.engage.hoganlovells.com/knowledgeservices/news/sfc-consults-on-licensing-requirements-for-virtual-asset-trading-platform-operators

https://www.legco.gov.hk/yr2022/english/bills/b202206241.pdf

https://decrypt.co/138158/hong-kongs-crypto-licensing-regime-expected-launch-next-month

https://www.elegislation.gov.hk/hk/cap571

https://www.legco.gov.hk/yr01-02/english/ord/ord005-02-e.pdf

FAQ

1. What are the key latest innovations in Hong Kong crypto regulations?

All centralized VA trading platforms that operate in HK or sell crypto to HK investors will need to get a SFC license. The regulator has developed special requirements for platforms and virtual assets.

2. Which official entities regulate cryptocurrencies in Hong Kong?

The main regulatory bodies are the SFC (Securities and Futures Commission - https://www.sfc.hk/en/ ) and the FSDC (Financial Services Development Council - https://www.fsdc.org.hk/ ).

3. How will the new rules affect crypto startups and investors in Hong Kong?

Retail investors (those with portfolios below 8M HKD) will be able to trade crypto legally on licensed exchanges. Moreover, many businesses may consider deploying in Hong Kong – including those that left mainland China because of its cryptocurrency restrictions. Overall, the new regime can lead to an increase in crypto trading volumes and prices.

4. Why did the authorities of Hong Kong decide to introduce new crypto regulations?

The authorities’ goal is to protect investors and users and to fight illegal activities in the crypto industry.

5. Which license will crypto businesses need to operate in HK?

A crypto exchange will now need a virtual asset trading license from the SFC SFC (Securities and Futures Commission - https://www.sfc.hk/en/).

6. What are the fines and penalties for platforms that violate the rules?

Providing unlicensed VA trading services will be punishable with a fine of up to $5 million or imprisonment for up to 7 years; if a violation continues, the fine is $100,000 for each day that it is ongoing.

7. Which measures need to be taken to prevent money laundering and terrorism financing?

Platform operators must implement an AML/CFT policy and procedures; they can use virtual asset monitoring tools to track the movements of specific units of cryptocurrency.

8. How will the new crypto regulations affect users’ privacy and anonymity?

Platform operators must take all reasonable steps to verify each client’s identity, together with their financial standing, investment experience, and investment goals. Unauthorized disclosing of this information is punishable with a fine of up to $1 million and up to 2 years in prison.

9. What are the technological requirements for crypto exchanges and other market participants under the new rules?

Trading platform operators must ensure that client assets are stored securely, as well as implement tools for identifying and preventing manipulations or illegal trading activities. Exchanges must also verify tokens’ technical features (blockchain protocol security, resistance to common attacks, consensus algorithm, etc.) and introduce features that will allow or block trading in specific virtual assets.

10. How much time do crypto exchanges have to make their activities compliant with the new rules?

The new rules should come in force on June 1, 2023.

Alexander Shtyrov

Consultant, F&L

About Alexander

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