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On 23 May 2023, the Securities and Futures Commission of Hong Kong (SFC) released its long-awaited consultation findings on proposed regulatory requirements for virtual asset trading platform (VATP) operators.
This did not come a moment too soon, given that the licensing regime came into force barely a week later, on 1 June 2023. The document also included in its appendices the final revised guidelines for VAT, Anti-Money Laundering and Financing of Terrorism (AML/CFT), and disciplinary fines that took effect on the same day.
In a coordinated move on 25 May 2023, the Hong Kong Monetary Authority (HKMA) issued its findings on industry consultations held between 18 January and 8 March 2023 on proposed amendments to the AML/CFT Guidelines (for authorized institutions) (AML /CFT guidelines). The paper summarizes the key comments received from four industry associations and the HKMA’s responses to the revised AML/CFT Guideline which was published in the Gazette on the same day and will come into force on 1 June 2023.
Investor protection
The SFC’s more substantive comments and responses revolve around three main areas – namely, investor protection, industry development and AML/CFT provisions.
In general, there was strong support for a retail approach, provided that licensed VATPs comply with strong investor protection measures covering inclusion, management, disclosure and token due diligence. Acknowledging requests for additional guidance, the SFC will issue frequently asked questions (FAQs) on inclusion requirements, including how to assess a client’s risk tolerance and exposure to virtual assets.
The SFC will also strengthen the specific token acceptance criteria that apply to retail tokens. It will do this by requiring an index provider with experience in the conventional securities market to comply with the International Organization of Securities Commissions’ principles for financial standards.
This ensures that it has appropriate internal arrangements to protect the integrity and quality of its indices. The SFC explains that such rigor is needed because non-security tokens are not regulated by any product-level regulatory body in order to protect retail investors.
Other investor protection measures that the SFC has either introduced or explained its reasoning include:
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Prohibition of gifts for trading certain Virtual Assets – other than discounts on fees or charges – consistent with the prohibition of advertising any specific Virtual Asset.
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VATPs must not be allowed to provide services such as making money, taking deposits, lending and borrowing as they may lead to potential conflicts of interest.
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Retail investors cannot trade stablecoins until the HKMA implements its regulatory regime, due to concerns about their stability, liquidity and redemption.
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Allowing only related entities to maintain secure custody of client virtual assets due to the lack of a regulatory regime for third-party virtual asset custodians and the need for direct regulatory management of such firms.
Industry development
Despite enhanced investor protection measures, it would be a mistake to assume that the SFC is not concerned about over-regulation. In fact, the SFC has adapted some of them precisely because to such concerns expressed by respondents.
For example, a significant concession was to halve the coverage threshold for a client’s virtual assets held in cold storage compared to other warehouses, given that the majority of such assets (98%) held there would be less vulnerable to cyber risks.
Similarly, the regulatory status of virtual assets in other jurisdictions no longer needs to be considered as part of the pre-listing due diligence process. The SFC agreed with industry comments that any restrictions in other jurisdictions (such as banning privacy coins) – which do not affect the regulatory status of tokens in Hong Kong – may not be a relevant consideration. However, failure to comply with regulations in those jurisdictions may affect suitability and propriety in Hong Kong.
The SFC also committed to examining other market-related issues in the future, including:
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A separate review of virtual asset derivatives (which is not allowed for VATPs) should be carried out in due course.
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Additional guidance on security tokens to be issued on time.
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Circulars, frequently asked questions and a licensing handbook will be issued to provide further guidance on application matters.
Provisions on AML/CFT
With respect to the AML/CFT provisions, the SFC has made changes to further clarify its regulatory expectations. An important amendment was to revise the token due diligence requirements to be more principles-based and less prescriptive based on the assumption that licensed VATPs should exercise due skill, care and diligence in evaluating virtual assets for listing. It added a factor to be considered during the due diligence process on the money laundering and terrorist financing (ML/TF) risks associated with virtual assets – a position espoused by Elliptic.
The SFC also clarified that due diligence measures applied to counterparties in virtual funds transfers should use a risk-based approach, including ongoing monitoring of such counterparties. Given the potentially higher PN/TF risks posed by unhosted wallets, such measures are extended to all transfers involving them.
Understanding concerns about the sunrise issue for the Travel Rule, the SFC will implement it in phases, with a temporary measure allowed until 1 January 2024 to submit information to beneficiary institutions as soon as practicable if immediate submission is not possible.
In comparison, the HKMA’s responses to the AML/CFT Guidelines in relation to virtual assets and related service providers are relatively brief.
It states that authorized institutions should adhere to the guidance given in their circulars published recently – including the circular dated 27 April 2023 which calls on authorized institutions (AIs) to “support Virtual Asset Service Providers (VASPs) licensed and regulated by the Commission on securities and futures (SFC). ) on their legitimate need for bank accounts in Hong Kong”. He reiterated that authorized institutions are not prohibited from transferring our virtual funds on behalf of clients provided that requirements for preventing money laundering and terrorist financing, such as client due diligence, are met.
A fair regulatory approach
In summary, the SFC retained most of its proposed regulatory requirements and clarified its views when rejecting certain feedback – for example, no third-party custodians, a high ratio of virtual client assets in cold storage and a ban on certain services – especially if the rationale is to protect investors.
At the same time, there are also positive changes for the development of the industry – for example, the affirmation of the retail approach, principle-based requirements for token due diligence and the lowering of the coverage threshold for clients’ cold storage assets. Again, this reflects Hong Kong’s measured approach to balance regulation and innovation by focusing on investor protection while ensuring that requirements are fit for purpose.
If you would like to learn more about Hong Kong’s new licensing regime for crypto exchanges, please contact us to speak to one of Elliptic’s experts and discuss in more detail how we can help you meet the city’s AML/CFT requirements.
Regulation of APAC Crypto Businesses
