Interpretation of the Hong Kong Stock Exchange License Consultation Document: What Types of Virtual Assets Can Be Included in Trading?

Author: Joy, PANews

Last week, the market rumored that Hong Kong would issue licenses for virtual asset trading platforms aimed at retail investors. Industry insiders confirmed to PANews that the Securities and Futures Commission (SFC) would issue a consultation document this week. On February 20 (Monday), the SFC commenced its consultation on the proposed regulation of virtual asset trading platforms as scheduled, which will end on March 31, in order to align with the new licensing regime that can officially take effect on June 1.

According to the over 300-page, more than 200,000-word consultation document published by the SFC, the main focus is to consult the Hong Kong industry on ten questions:

1. Do you agree that licensed platform operators should be allowed to provide services to retail investors?
2. Do you have any comments on the proposed criteria for the inclusion of general tokens and specific tokens?
3. If the SFC intends to allow retail investors to use licensed virtual asset trading platforms, what other regulations do you think should be implemented from the perspective of investor protection?
4. Do you have any comments on the proposal to allow the combination of third-party insurance and funds allocated by licensed platform operators or corporations under the same corporate group? Do you have any other suggestions?
5. Do you have any proposals on how licensed platform operators should allocate such funds (e.g., depositing into the licensed platform operator's corporate account, or setting up custodial arrangements)? Please detail your suggested arrangements and how the protections provided by these arrangements can offer the same level of protection as third-party insurance.
6. Do you have any suggestions on which technical solutions can effectively mitigate the risks associated with the custody of clients' virtual assets (especially those held online)?
7. If licensed platform operators can provide trading services for virtual asset derivatives, which business model would you recommend? What types of virtual asset derivatives would you suggest for investors to trade? Who would be the target investors?
8. Do you have any comments on how to incorporate other provisions from the "Terms and Conditions for Virtual Asset Trading Platforms" into the "Guidelines for Virtual Asset Trading Platforms" while improving them?
9. Do you have any comments on the provisions regarding virtual asset transfers or any other provisions in Chapter 12 of the "Anti-Money Laundering Guidelines for Licensed Corporations and Licensed Virtual Asset Service Providers"? Please explain your views.
10. Do you have any comments on the "SFC Disciplinary Action Penalty Guidelines"? Please explain your views.

Among these ten questions, the most concerning to the market is whether trading platforms will be allowed to serve retail investors, what assets retail investors can trade, and what derivatives can be traded. Other questions involve operational details, security protections, and anti-money laundering measures, such as third-party insurance and technical solutions for asset custody.

SFC to Issue Virtual Asset Licenses, Intends to Allow Retail Access

The document points out that the volatility of the virtual asset market and the collapse of FTX not only reveal the risks arising from the increasingly close interconnections between the virtual asset ecosystem and the traditional financial system but also highlight the importance of implementing effective regulation and oversight of virtual assets.

Previously, under the existing system based on the Securities and Futures Ordinance, only virtual asset trading platforms providing securities token trading services fell under the SFC's regulatory scope, meaning the SFC previously had no authority to license or regulate virtual asset trading platforms that only offered non-securities token trading services.

Subsequently, in November 2020, the Hong Kong SAR government published a consultation document seeking public opinions on the proposal to establish a licensing regime for virtual asset service providers under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance. The government suggested that centralized virtual asset trading platforms (i.e., centralized exchanges) providing non-securities token trading services in Hong Kong should be licensed and regulated by the SFC.

However, since the licensing framework for virtual assets is a new concept, the SFC at that time believed that even if the system had adequate protective measures for investors, it should be more prudent to limit licensed virtual asset trading platforms under the Securities and Futures Ordinance to serving only professional investors at least in the initial stage. Therefore, Hong Kong had been very cautious about issuing licenses, with only OSL obtaining a trading license in 2020 and Hashkey in 2022, both limited to serving professional investors.

On October 31 last year, Hong Kong released the "Policy Declaration on the Development of Virtual Assets," signaling an open and friendly attitude towards virtual assets and hinting at the provision of services to retail investors, stating that the SFC is allowing public consultation on retail investors (retail) buying and selling virtual assets.

From the document, it can be seen that although it is a public consultation, the SFC is actually inclined to provide services to retail investors. The document mentions that many believe that denying retail investors access to licensed virtual asset trading platforms may inadvertently harm investors, as this could drive them to use unregulated overseas virtual asset trading platforms that are easily accessible online; and if any of these unregulated platforms collapse, retail investors will find it difficult to recover any losses. This is evident from the collapse of FTX.

The SFC also added that in January 2022, it first allowed retail investors to access a limited number of regulated virtual asset-related derivatives traded on traditional exchanges. Subsequently, in October 2022, it established a recognition system for virtual asset futures exchange-traded funds (virtual asset futures ETFs), and to date, the SFC has recognized three virtual asset futures ETFs under this system, with the Samsung Bitcoin Futures Active ETF listed on the Hong Kong Stock Exchange in January this year, and the Southern Eastern Bitcoin and Ethereum Futures ETFs listed in Hong Kong in December last year.

Therefore, retail investors in Hong Kong can already access virtual assets indirectly through compliant products. Thus, both from the practical situation and regulatory trends, allowing retail access is a change that the SFC has to permit, so that regulation can shift from passive to proactive.

Users Must Conduct Risk Assessments Before Trading

Although the Hong Kong SFC suggests allowing various types of investors (including retail investors) to use trading services provided by licensed virtual asset trading platform operators, this is contingent upon a series of proper investor protection measures.

Licensed platform operators must conduct knowledge assessments on investors before providing any services. If a client fails to pass this assessment, the operator may only provide services to that client after offering training. Operators should assess the client's risk tolerance and risk status and determine the client's risk profile accordingly, as well as evaluate whether the client is suitable to participate in virtual asset trading. Operators should also set limits for each client to ensure that the risks taken by the client regarding virtual assets are reasonable based on the operator's judgment, considering the client's financial situation and personal circumstances. These limits should be reviewed periodically to ensure they remain appropriate.

This means that in the future, Hong Kong residents will need to take a risk assessment test after registration before they can officially trade. It is worth mentioning that in informal consultations, there have been proposals to set a uniform hard cap on the maximum amount of virtual asset risk that retail investors can undertake across various virtual asset trading platforms. However, considering that everyone's financial situation varies, the SFC suggests allowing platforms to assess their clients' risk tolerance and risk status according to appropriate systems.

Tokens Must Meet Relevant Criteria, Retail Investors Can Trade Large Market Cap Virtual Assets

The SFC suggests that licensed platform operators should establish a Token Inclusion and Review Committee responsible for formulating, implementing, and enforcing the criteria for including virtual assets for trading, as well as notifying licensed platform operators of any proposed hard forks or airdrops, significant changes in the issuer's business, or any regulatory actions against the issuer.

The Token Inclusion and Review Committee should consist of senior management members primarily responsible for managing key business areas, compliance, risk management, and information technology. The committee should report to the board at least monthly, and the report should include details of virtual assets available for retail clients to trade and other issues that have been noted.

The SFC wishes to emphasize that virtual assets themselves are not regulated by the SFC, and the SFC has never audited or reviewed the offerings and promotional materials of virtual assets. In light of this, the SFC intends to adopt a more prudent approach by introducing a series of objective criteria that licensed platform operators must follow when determining whether to offer a specific virtual asset to retail clients.

Licensed platform operators bear ultimate responsibility for conducting reasonable due diligence on virtual assets before including them for trading and ensuring they meet the token inclusion criteria. Licensed platform operators should also continuously monitor the included virtual assets and ensure they continue to comply with the relevant criteria.

Factors to be considered include: a) the background of the management or development team of the virtual asset; b) the regulatory status of the virtual asset in the jurisdictions where the platform operator provides trading services, and whether its regulatory status would also affect the platform operator's regulatory responsibilities; c) the supply and demand, market maturity, and liquidity of the virtual asset, including its market capitalization, average daily trading volume, historical record (e.g., issued for at least 12 months, excluding securities tokens), whether other platform operators also provide trading for that virtual asset, whether there are relevant trading pairs (e.g., fiat currency to virtual asset), and in which jurisdictions the virtual asset can be traded; d) the technical aspects of the virtual asset; e) the promotional materials issued by the issuer of the virtual asset, which should be accurate and not misleading; f) the development status of the virtual asset; g) market risks associated with the virtual asset, including high concentration of holdings or control by a few individuals or entities, price manipulation and fraud, and the impact of broader or narrower adoption of the virtual asset on market risk; h) legal risks associated with the virtual asset; i) the utility provided by the virtual asset, the new use cases it facilitates, or whether the technology, structure, or cryptoeconomic innovations it demonstrates appear to have fraudulent or highly improper elements.

In addition to the general token inclusion criteria, if licensed platform operators intend to offer virtual assets to retail clients, they must also ensure that the selected virtual assets are qualified large virtual assets. In addition to complying with the above general inclusion criteria, they must also meet the following specific token inclusion criteria.

"Qualified large virtual assets" refer to virtual assets included in at least two "accepted indices" launched by at least two independent index providers (with at least one being an index provider with experience in traditional non-virtual asset financial markets). "Accepted indices" refer to indices with clearly defined objectives to measure the performance of the largest virtual assets in the market and must meet the following criteria: a) the index must be investable, meaning the constituent virtual assets must have sufficient liquidity. b) the index must be calculated objectively and based on rules. c) the index provider must possess the necessary expertise and technical resources to construct, maintain, and review the methodology and rules of the index. d) the methodology and rules of the index must be properly documented and consistently and transparently enforced.

According to this criterion, BTC and ETH clearly meet the requirements and can be offered to retail investors, while other crypto assets require further study.

Maintain a Minimum Paid-up Capital of HKD 5 Million and Establish an Insurance System

According to the document, platform operators must maintain a minimum paid-up capital of no less than HKD 5 million (i.e., "minimum paid-up capital amount"). Platform operators must always beneficially own sufficiently liquid assets in Hong Kong, such as cash, deposits, treasury bills, and certificates of deposit (but not virtual assets), in an amount equal to at least 12 months of actual operating expenses calculated on a continuous basis.

Additionally, it is mentioned that platform operators should establish and implement strict internal controls and governance procedures regarding private key management to ensure the secure generation, storage, and backup of all cryptographic seeds and private keys. Seeds and private keys must be stored in Hong Kong.

Licensed platform operators should have an SFC-approved compensation arrangement to provide an appropriate level of protection against risks related to the custody of clients' virtual assets (e.g., incidents of hacking or defaults by licensed platform operators or their affiliated entities). Regarding investor protection insurance regulations, the SFC suggests:

a) Licensed platform operators should have an SFC-approved compensation arrangement for risks related to the custody of clients' virtual assets.

b) Licensed platform operators should monitor the total value of the clients' virtual assets they hold daily to ensure compliance with the relevant compensation regulations.

c) If licensed platform operators allocate their own funds or funds from corporations under the same corporate group to comply with the relevant regulations, they must ensure that such funds are held in trust and designated for the relevant purposes. Such funds should also be segregated from the assets of the licensed platform operator, its affiliated entities, or corporations under the same corporate group.

List of Exchanges to Be Announced After License Takes Effect

Starting from June 1, 2023, any virtual asset trading platform operating in Hong Kong or actively promoting its services to Hong Kong investors without a valid license will violate the licensing provisions under the virtual asset service provider regime under the Anti-Money Laundering Ordinance, unless it qualifies for the transitional arrangement.

The SFC proposes to establish a 12-month transitional period to allow licensed platform operators under the Securities and Futures Ordinance to comply with the provisions related to their existing clients or the virtual assets they are currently selling. Once the provisions of the "Guidelines for Virtual Asset Trading Platforms," the "Anti-Money Laundering Guidelines for Licensed Corporations and Licensed Virtual Asset Service Providers," and other guidelines are finalized, details of the transitional arrangements will be provided.

Virtual asset trading platforms must be existing platforms that have been operating in Hong Kong and have meaningful and substantial business before June 1, 2023, to qualify for the transitional arrangements. They may continue to operate in Hong Kong from June 1, 2023, to May 31, 2024, only after meeting the conditions of the Anti-Money Laundering Ordinance. Specific considerations include whether the corporation is established in Hong Kong, whether it has a physical office in Hong Kong, whether Hong Kong employees have central management or control, whether key personnel are based in Hong Kong, whether operations have been put into service, and whether there is a significant number of clients and trading activities in Hong Kong.

Existing virtual asset trading platforms must submit a license application online under the virtual asset service provider regime under the Anti-Money Laundering Ordinance within the nine-month period from June 1, 2023, to February 29, 2024, to qualify for the licensing arrangements.

Virtual asset trading platforms that were not operating in Hong Kong immediately before June 1, 2023, may only conduct their business or actively promote their services to Hong Kong investors after obtaining formal licensing under the virtual asset service provider regime under the Anti-Money Laundering Ordinance. Engaging in any unlicensed activities is a criminal offense.

During the transitional period, the public may find it difficult to distinguish whether a virtual asset trading platform is operating legally. To eliminate such concerns, the SFC intends to publish several lists on its website to inform the public about the different regulatory statuses of virtual asset trading platforms. The SFC hopes that by publishing these lists, it can deter unlicensed or ordered-to-close virtual asset trading platforms from providing services to the public.