Details of the Hong Kong Securities and Futures Commission consultation: What are the standards for listing coins? Transition period requirements? Are derivatives not allowed?

On February 20, the Hong Kong Securities and Futures Commission launched a consultation on proposals for regulating virtual asset trading platforms. Under the new licensing system that will take effect on June 1, 2023, all central virtual asset trading platforms that operate in Hong Kong or actively promote to Hong Kong investors will need to be licensed by the Securities and Futures Commission. In the more than 100-page consultation document, what content is worth paying attention to?

Consultation document download:

https://apps.sfc.hk/edistributionWeb/gateway/TC/consultation/doc?refNo=23CP1

1.

With the Anti-Money Laundering and Counter-Terrorist Financing (Amendment) Bill 2022 passed by the Legislative Council in December 2022, a new licensing regime for central virtual asset trading platforms that provide non-security token trading services will take effect on June 1, 2023. Once the new regime is implemented, all central virtual asset trading platforms that operate businesses in Hong Kong or actively promote their services to Hong Kong investors, regardless of whether they provide security token trading services, will need to be licensed and regulated by the SFC.

2.

Due to the volatility of the virtual asset market and the collapse of FTX, major jurisdictions are shifting their regulatory approach from a loose approach (i.e., regulation from the perspective of combating money laundering or payments) to a more comprehensive approach (i.e., regulation from the perspective of investor protection).

3.

Platform operators should hold customer funds and customer virtual assets on trust through a wholly-owned subsidiary. Platform operators should ensure that no more than 2% of customer virtual assets are stored in online wallets. Platform operators should not deposit, transfer, lend, pledge, re-pledge or otherwise trade customer virtual assets, or incur any encumbrances on customer virtual assets. They should also have insurance, and its coverage should cover the risks involved in the custody of customer virtual assets.

Platform operators should not engage in proprietary trading or proprietary market making activities and should have policies in place to govern employees’ trading in virtual assets in order to eliminate, avoid, manage or disclose actual or potential conflicts of interest.

Platform Operators should provide monthly reports on their business activities to the SFC within two weeks after the end of each calendar month and upon request by the SFC.

4.

The SFC has already approved three virtual asset futures ETFs under the regime. As a result, retail investors in Hong Kong are now able to gain indirect exposure to virtual assets through regulated products.

The SFC wishes to emphasize that virtual assets themselves are not regulated by the SFC, which means that the SFC has never reviewed or audited the offer and promotion documents of virtual assets. The SFC intends to adopt a more cautious approach, which is to introduce a series of objective criteria that licensed platform operators must follow when determining whether they can offer a particular virtual asset to retail customers, including:

a) The background of the management or development team of the virtual asset;

b) the regulatory status of virtual assets in various jurisdictions where platform operators provide trading services, and whether such regulatory status will also affect the regulatory responsibilities of platform operators;

c) The supply and demand, market maturity and liquidity of the virtual asset, including its market capitalization, average daily trading volume, track record (e.g. issued for at least 12 months, excluding security tokens), whether other platform operators also provide trading for the virtual asset, whether there are relevant trading packages (e.g. fiat currency against virtual assets), and in which jurisdictions the virtual asset is available for trading;

d) The technical aspects of the virtual asset, including the security infrastructure of its blockchain protocol, the size of the blockchain and network (particularly its resilience to common attacks (e.g. 51% attacks)), the type of consensus algorithm, and the risks associated with code defects, violations and other threats involving the virtual asset and its supporting blockchain, or the operating practices and procedures applicable to them;

e) The content of the virtual asset promotion materials issued by the issuer should be accurate and not misleading;

f) The development of the virtual asset, including the results of any projects related to it as contained in its white paper (if any), and any significant events in the past related to its history and development;

g) Market risks of virtual assets, including high concentration of virtual asset holdings or control by a small number of individuals or entities, price manipulation and fraud, and the impact of wider or narrower adoption of the virtual asset on market risk;

h) legal risks associated with virtual assets, including any pending or potential civil, regulatory, criminal or law enforcement actions related to their issuance, distribution or use; and

i) Whether the utility provided by the virtual asset, the novel use cases it enables, or the technological, structural, or cryptoeconomic innovation it demonstrates appears to be fraudulent or grossly inappropriate.

5.

Licensed platform operators who intend to offer virtual assets to retail clients should also ensure that the virtual assets they select are eligible large-scale virtual assets and meet the following specific token inclusion criteria. “Eligible large-scale virtual assets” refer to virtual assets that are included in at least two “accepted indices” launched by at least two independent index providers19.

An “accepted index” is an index that has a clearly defined objective to measure the performance of the largest virtual assets20 in the market and meets the following criteria:

a) The index should be investable, meaning that the relevant component virtual assets should have sufficient liquidity.

b) The index should be calculated in an objective and rules-based manner.

c) Index providers should have the necessary expertise and technical resources to construct, maintain and review the index compilation methodology and rules.

d) The index compilation method and rules should be well documented, consistent and transparent. Licensed platform operators should ensure that at least one of the two indices is launched by an index provider with experience in publishing indices for traditional non-crypto asset financial markets, such as an index provider that has launched an index tracked by an SFC-approved index fund.

6.

Under the current regime under the Securities and Futures Ordinance, licensed platform operators are not allowed to sell, trade or deal in virtual asset futures contracts or related derivatives.

The SFC understands that there is growing interest in the sale of virtual asset derivatives, especially to institutional investors. The SFC understands that virtual asset derivatives play an important role as an interface between the virtual asset sector and traditional financial markets, especially in enabling institutional investors to hedge risks more effectively.

Nevertheless, the SFC hopes to gain a clearer understanding of the business model and types of virtual asset derivatives that licensed platform operators may first adopt and sell, as well as market demand through this consultation, and then conduct an independent review and formulate policies accordingly.

7.

Operators of virtual asset trading platforms (including existing platforms) that plan to apply for a license should start reviewing and revising their systems and control measures to prepare for the new system. Operators who do not intend to apply for a license should start preparing to wind down their business in Hong Kong in an orderly manner.

The transitional arrangements (i.e. arrangements that do not constitute a breach of the rules and are deemed to be licensed) are intended to provide virtual asset trading platforms currently operating in Hong Kong with reasonable and sufficient time to apply for a licence or to wind down in an orderly manner.

Virtual asset trading platforms must be existing platforms (i.e. already operating in Hong Kong and having meaningful and substantive business before June 1, 2023) to be eligible to participate in the transitional arrangement. Eligible trading platforms will include platform operators currently licensed under the Securities and Futures Ordinance, as well as virtual asset trading platform applicants that have commenced virtual asset trading platform business in Hong Kong for non-security tokens under the existing regime under the Securities and Futures Ordinance. Virtual asset trading platforms eligible to participate in the transitional arrangement must meet the conditions set out in Schedule 3G to the Anti-Money Laundering Ordinance in order to continue operating in Hong Kong during the non-violation period (i.e. June 1, 2023 to May 31, 2024), and will be subject to the deemed licensed arrangement from June 1, 2024.

8.

The Platform Operator must at all times maintain a paid-up share capital of not less than HK$5,000,000.