Clifford Chance

Just over a year ago, the Securities and Futures Commission (SFC) announced it was exploring a conceptual framework for the potential regulation of virtual asset (VA) trading platform operators. During the Hong Kong Fintech Week 2019 the SFC has just given the green light to grant licences to VA trading platform operators under the SFC's regulatory sandbox initiative, which is great news for the crypto industry.

The new regulatory framework will be available to VA trading platforms that operate in Hong Kong and offer trading of at least one security token. The framework involves the granting of a licence for Type 1 (dealing in securities) and Type 7 (providing automated trading services) regulated activities. The details on the new regulatory framework and accompanying licensing conditions and terms and conditions for VA trading platforms are set out in SFC's position paper (6 November 2019). In its position paper, the SFC has introduced regulatory standards across various key areas to address safe custody of assets, KYC requirements, AML/CFT, market manipulation, accounting and auditing, risk management, conflicts of interests and the acceptance of VA for trading.

It is certainly exciting for crypto exchanges to be offered a path to regulation in Hong Kong (the industry has long been waiting for the SFC to announce the endgame to its explorative conceptual framework), but the SFC has made clear that it has no power to grant a licence to a platform that only trades non-security VA (where it does not involve products or services regulated under the Securities and Futures Ordinance (SFO)). Such regulatory gap will need to be resolved by way of legislative amendments. It is also acknowledged that platform operators may decide not to seek an SFC licence under the new regulatory framework by simply ensuring that no VA traded on their platforms are securities, futures contracts or other regulated instruments under the SFO. 

Accordingly there is an important 'choice' to be made by Hong Kong crypto exchanges (new start-ups or existing providers) whether or not to have an operating structure that falls within or outside the SFC's regulatory remit.  Being regulated may 'upgrade' one's reputation and branding, and enable easier access to institutional money but this may require substantial changes in business structure for existing crypto exchanges.  Ultimately crypto exchanges will need to weigh up the two options to see which one fits best with the business proposition the exchange is offering.

We have set out below some of the key regulatory requirements under the new regulatory framework that would be relevant when balancing this assessment:

Target clientele – professional investors only (as defined under the SFO which covers specific institutional and high-net-worth investors, whether they are based in or outside Hong Kong), who have sufficient knowledge of VA subject to applicable suitability assessment.

Service offering – needs to be a centralised VA trading platform providing trading, clearing and settlement services for VA and have control over investors' assets. The regime is not yet available to peer-to-peer marketplace or platforms only providing order routing services. The licensed entity cannot conduct business activities other than VA trading activities (e.g. no management of VA portfolios or distribution of VA funds). In limited cases, the SFC may allow off-platform transactions to be conducted by institutional professional investors which are settled intra-day. No proprietary trading or market-making on a proprietary basis.

Product offering – need at least one security token to be 'listed' and the SFC may also assess the legal nature of the pre-existing tokens being traded by existing providers. SFC's prior approval is required to add any product to the trading platform. No futures contracts, structured products or margining will be permitted (at least at the present time).

Custody – platform operator needs to hold client assets on trust through a wholly owned subsidiary acting as the custodian (Associated Entity) which is incorporated in Hong Kong and holds a trust and company service provider licence under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance. The platform operator and its Associated Entity need to store at least 98% of client VA in cold wallets. Insurance policy coverage is required for both hot storage (100%) and cold storage (substantial coverage, e.g. 95%).

Scope of regulatory supervision – SFC's regulatory remit will also cover trading activities of non-security tokens (without any de-minimis threshold and whether occurring on or off the platform) of the licensed entity (through licensing conditions being imposed) despite technically they may not be regulated products/services under the SFO.

Group activities – all VA trading business activities (both on and off the platform and any incidental activities) conducted by the group of companies of the platform operator which are actively marketed to Hong Kong investors or are conducted in Hong Kong will need be carried out under a single legal entity licensed by the SFC.

Market surveillance – need a reputable external market surveillance systems to supplement its internal system.