Welcome to Hong Kong: The Government Extends Open Arms to Crypto Exchanges Amidst Global Regulatory Shifts

In the past, Hong Kong enjoyed a reputation as a hub for cryptocurrencies, hosting numerous initial coin offerings and exchanges.

However, the scenario changed when regulatory authorities started expressing concerns about retail investment bans, causing many industry players to seek safe havens in different regions. Presently, regulators are making efforts to entice these businesses back.

The introduction of Hong Kong’s licensing system for cryptocurrency firms serving individual traders, especially while the United States maintains a more cautious regulatory stance, could be seen as a potential opportunity for the city, according to insiders from the industry. The prospect of establishing operations in Hong Kong has garnered increasing attention from digital asset businesses, including exchanges. This interest has grown since local regulatory authorities unveiled their licensing initiative earlier this year.

Factors Driving Change: Overview of New Regulatory Framework

In October of the year 2022, Hong Kong issued a policy statement outlining the trajectory of cryptocurrencies, often referred to as “virtual assets,” through which the government expressed its readiness to adjust its legal and regulatory framework as a component of its endeavor to establish the facilitating environment, taking into consideration the dynamic nature and inventive approach of virtual assets. The policy states that in recent years, both the Government and regulatory bodies have collaboratively established an all-encompassing structure for overseeing Virtuaхфх Asset (VA) activities, adhering to the principle of aligning regulation with activities and associated risks. A comprehensive regulatory system has been initiated for granting licenses to VA Exchanges, utilizing an “opt-in” methodology; furthermore, within the realm of asset management, directives have been disseminated concerning the administration of VA funds and discretionary accounts. Additionally, the policy mentions that the financial institutions and banks have received instructive guidance pertaining to the dissemination, trading, and advisory aspects of products related to Virtual Assets.

Hong Kong’s securities regulator has implemented stricter rules for digital asset companies starting from June 1, 2023 as part of its cryptocurrency licensing framework. 

The newly established licensing structure comprises two tiers:

The focus is on safeguarding retail investors, as only licensed providers may engage in the provision of virtual asset services. The only Virtual Asset service currently regulated under the AMLO is the VATP transaction, whereby 

(i) mandatory sales and purchases of Virtual Assets are or are to be made, negotiated or entered into; and 

(ii) the customer’s money is received or the customer’s virtual assets are taken over by the VATP. Thus, the new licensing regime covers centralized VATPs and mechanisms that trade or support trading of virtual assets, excluding peer-to-peer platforms that simply provide a forum for offers and offers and do not trade or support trading of virtual assets on the platforms. 

The move to allow retail trading in cryptocurrencies follows a challenging year for the sector, marked by the collapse of FTX exchange. The new rules require licensing for all trading platforms and exchanges, with penalties for non-compliance. Operators must ensure compliance with local laws and regulations, and the measures include setting exposure limits for retail investors and restricting trading to established tokens. The regulations also cover marketing by unlicensed platforms, including through social media influencers.

Besides, local fund managers overseeing funds with 10% or more of their gross asset value in digital assets are required to seek an upgrade to their “Type 9” license. Initial interest has been relatively low, but there is now an increasing trend, with several managers making the upgrade in the last six months. The SFC is now more open to granting the ‘virtual asset license upgrade’ to fund managers, provided they have the necessary expertise, experience, and engage appropriate service providers such as trading platforms, custodians, fund administrators, and auditors.  

There exist certain stages within the application procedures that remain undisclosed to the public. It is believed that the licensing application process with the SFC has become smoother and quicker compared to the past. The licensing framework is designed to enable “crypto choices for individual traders,” along with facilitating “entry and exit points.” The latter aspect, in particular, holds significant importance.

Nevertheless, the city has potentially positioned itself to benefit from businesses searching for respite from regulatory crackdowns in other regions. This could involve either relocating entirely from the US or, at the very least, setting up a presence beyond its borders.

Moreover, financial regulatory bodies in Hong Kong established a scheme allowing fund managers who exclusively trade crypto investment products to register. This initiative opens avenues for alternative investment managers focusing on digital assets, particularly those associated with institutional limited partners.

Hong Kong has also taken steps to enhance its standing in the crypto sector through other avenues. The government established a Web3 “task force” earlier this year with the purpose of investigating and offering suggestions for the “sustainable and conscientious growth of Web3 in Hong Kong.” Regulators believe that the notion is that Web3 could potentially tackle and surmount obstacles in domains such as finance, trade, business processes, and even daily routines.

A significant development has occurred in Hong Kong’s legal landscape, as in April 2023, Hong Kong’s High Court has officially classified cryptocurrency as a form of property, and ruled that it is capable of being held on trust. This groundbreaking decision represents the first instance of such a determination concerning digital assets within the city-state. The significant judgment in the case of Re Gatecoin Limited (In Liquidation) brings Hong Kong in line with the stance of several comparable common law jurisdictions. This decision offers clear legal assurance regarding the validity of cryptocurrency transfers or loans, as well as the legal rights of parties should instances of fraud, theft, or breach of trust involving these assets arise. Undoubtedly, this ruling is a positive advancement for enterprises engaged in this swiftly evolving domain.

The initial response from the cryptocurrency industry to the new regulations

HashKey Exchange and OSL Digital Securities Ltd. have recently secured the first cryptocurrency exchange licenses in Hong Kong’s updated framework, allowing them to service retail clients. HashKey Exchange, affiliated with HashKey Group, revealed the license expansion to cover retail users alongside professional investors. Following suit, OSL Digital Securities, a subsidiary of BC Technology Group, also confirmed acquiring a license for serving retail customers. These two entities previously held licenses under Hong Kong’s former opt-in regime for crypto asset service providers, potentially facilitating their swift approval under the new system. 

While it’s still in the initial stages, prominent worldwide crypto exchanges like Huobi, OKX, and BitMEX have expressed their intention to establish a presence in this area. The allure surrounding Hong Kong’s cryptocurrency prospects may have been ignited by its accommodating business climate, attractive tax rates, skilled workforce, and strategic proximity to mainland China. It’s worth mentioning that the SFC is presently enabling managers to explore a broader range of digital assets for investment and create more intricate Web3-oriented products. Earlier this year, the city-state’s largest digital bank announced plans to service locally regulated cryptocurrency exchanges with fiat deposits and withdrawals.

The regulatory progress in Hong Kong seems favorable, especially as the US continues to grapple with regulatory measures for its domestic crypto sector. The Hong Kong administration is staying true to its commitment of expanding the virtual asset sector, aiming to position the region as a competitive hub for virtual assets in Asia. Hong Kong’s objective is not to impede financial innovation but to establish fairness among all stakeholders, thereby unleashing the industry’s potential, by using Web3 for the positive impact. To sum up, stricter jurisdictions’ loss is Hong Kong’s gain when it comes to crypto. 

The content of this article is intended to provide a general guide to the subject matter, not to be considered as a legal consultation.


photo source

Amendments in Hong Kong Crypto regulation

The government of Hong Kong has maintained a relaxed approach towards cryptocurrencies for years, regarding them as virtual commodities which are not legal tender, money, or payment methods.

In essence, they do not fall under the supervision of the Hong Kong Monetary Authority.

Recently, the government has represented that it will have a more balanced approach to regulation of the cryptocurrency sphere, to ensure investor and user protection. In particular, the Amendment Bill announced in 2022, aims to introduce important changes to regulation of Virtual Assets under the auspices of the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (hereinafter:-“AMLO”). “Joint Circular on Intermediaries’ Virtual Asset Related Activities” (hereinafter:-“2022 Crypto Regulation Circular”) which came into force On February 2022, serves the purpose of providing the global standards in this field. The article focuses on the how the proposed legislative changes regulatory landscape of Hong Kong’s Virtual Assets business.

Updates in AML law

New legislation which is currently under the parliamentary reading aims to develop a licensing scheme for virtual service providers (hereinafter:-“VASPs”), imposes statutory anti-money laundering and counter-terrorist financing (hereinafter:-“AML/CTF”) duties on VASPs as well as improve proper investor protection for virtual asset owners. As a result, once implemented, the VASP regime will not only impose a stringent licensing regime on VASP operators, but will also criminalize a wide range of crypto-related wrongdoing, regardless of whether it occurs on a licensed VASP exchange. The Bill is designed to govern the cryptocurrency market in Hong Kong have been presented to the members of the Legislative Council of China’s special administrative region and need their approval in two readings to become law. The provisions relating to the VASP regime is expected to take effect on March 1, 2023.

It is important to further note that, the Amendment Bill has defined a Virtual Assets (hereinafter:-“VA”) as a digital representation of value that:

  • is expressed as a unit of account or a store of economic value;

either:

  • functions (or is intended to function) as a medium of exchange accepted by the public as payment for goods or services or for the discharge of debt, or for investment purposes; or
  • provides rights, eligibility or access to vote on the management, administration or governance of the affairs in connection with any cryptographically secured digital representation of value; and
  • can be transferred, stored or traded electronically. (Section 53ZRA(1), Amendment Bill)

Finally, while the definition of a VA does not currently cover non-fungible tokens, the Amendment Bill provides that the Secretary for Financial Services and the Treasury may expand the categories of tokens captured by the “VA” definition by publication of a notice in the Gazette. (Section 53ZRA (4)(a), Amendment Bill)

Scope of proposed licensing regime for VASPs

The new requirements for VASPs are comparable to those that apply to traditional institutions in the financial services sector and they will have to meet similar financial adequacy requirements. Under the upcoming legislation, the SFC will also be responsible to ensure that virtual asset service providers adopt proper listing and trading policies as well as financial reporting and disclosure procedures. The Commission will also observe the implementation of mechanisms designed to prevent market manipulation and conflicts of interest.

As was mentioned before, Amendment Bill introduces a licensing regime for VASPs which provides that the business of operating a VA service – the operation of a VA exchange – is a “regulated function” requiring a license.

Entities working with cryptocurrencies that want to launch a trading platform, for example, would have to:

  1. obtain a license from the Hong Kong Securities and Futures Commission (hereinafter:-”SFC”) and
  2. fulfill a number of requirements, including:
  3. be a locally incorporated company with a permanent place of business in Hong Kong or a company incorporated elsewhere but registered in Hong Kong under the Companies Ordinance;
  4. an applicant must demonstrate:
  • it is a fit and proper entity to be licensed to provide the Virtual assets service;
  • it has at least 2 company secretaries who are each fit and proper to be responsible officers (hereinafter:-“ROs”), each of whom are of sufficient authority within the applicant and at least one of whom must be an executive director; and
  • the ultimate beneficial owner of the applicant is fit and proper to be the ultimate beneficial owner of a VASP licensee.
  1. fulfill the factors that the SFC will consider in evaluating the fitness and properness of VASP applicants and associated individuals:
  • whether the applicant has been convicted of offences relating to money laundering / terrorist financing, fraud, corruption or dishonesty;
  • the applicant’s financial status or solvency;
  • its experience and qualifications; and
  • its reputation, reliability and integrity.

Another significant matter to highlight is criteria for fit and proper test. Fit and Proper test on the context of AML Amendment bill is modeled on the fit and proper requirements for the licensing of regulated activities under the Securities and Futures Ordinance (Cap. 571).

Licensing conditions and AML/CTF requirements

The Amendment Bill, which gave the SFC significant supervisory powers over licensed VASPs, provides that the SFC may impose a range of licensing conditions on a VASP licensee, including, but not limited to, requirements in relation to:

  • financial conditions (e.g. capital requirements);
  • risk management policies and procedures;
  • anti-money laundering and counter-terrorism financing policies and procedures;
  • management of client assets;
  • financial reporting and disclosure;
  • virtual asset listing and trading policies;
  • market abuse policies;
  • cybersecurity; and
  • avoidance of conflicts of interest

It’s also important to note that the Amendment Bill also provides that licensed VASPs must comply with the AMLO’s requirements such as customer due diligence and record keeping measures.

CIRCULAR

The SFC and the Hong Kong Monetary Authority (hereinafter:-“HKMA”) jointly issued a “2022 Crypto Regulation Circular” on January 28, 2022. This Circular outlines the approach to regulating the distribution of crypto assets, which include “virtual assets” and “virtual asset related items,” as well as the supply of dealing and consulting services in relation to such assets.

The Crypto Regulation Circular focuses on the provision of distribution, dealing, and consulting services in relation to crypto assets through intermediaries licensed or registered with the SFC. What matters is that the Circular imposes a number of selling restrictions on the sale of virtual asset related products – which will be very likely as complex products – with a view to investor protection. The SFC and the HKMA granted a six-month transition period for intermediaries which are already engaged in virtual asset related activities. Intermediaries which do not currently engage in virtual asset related activities should ensure compliance with the requirements in 2022 Crypto Regulation Circular before introducing such services.

Requirements under the Circular

Under the existing complex product regime, an intermediary should comply with enhanced suitability requirements, in particular, they should:

  • ensure the virtual asset or virtual asset related product is suitable for a client in all the circumstances
  • provide sufficient information on the key nature, features and risks of the assets so as to enable a client to under the product before making an investment decision;
  • provide a warning statement to the client;
  • ensure that any recommendations or solicitations made are suitable for clients in all circumstances;
  • where the virtual asset related product is to be regarded as a derivative, assess the client’s knowledge of derivatives; and
  • conduct proper due diligence on the virtual asset related products.

As a result, in order to provide adequate investors protection, intermediaries licensed by or registered with the SFC are required to:

  • execution via SFC Licensing Virtual Asset Trading Platforms;
  • dealing Only for Professional Investors;
  • dealing Only with Clients Trading Securities;
  • meet Securities Regulatory Standards for All Virtual Assets.

Conclusion

Hong Kong’s new legislation establishes of new licensing regime, criminalizes crypto-related misconduct, imposes statutory AML/CTF obligations. Proposed amendments also covered restrictions on the sale of virtual asset related products with a view to investor protection. The first reading of the amendment bill was scheduled to took place on July 6, 2022, with the with the provisions relating to the VASP regime are due to take effect as of March 1, 2023. We keep an eye on further developments with law adoption and enforcement measures.

The content of this article is intended to provide a general guide to the subject matter, not to be considered as a legal consultation.


Photo credits