A Comprehensive Explanation of the Licensing System for Virtual Currency Exchanges in Hong Kong

Written by: Gu Jianing, Mankun Blockchain

Thanks to a relaxed regulatory environment and favorable tax policies, as well as the significant geopolitical advantage of being backed by the mainland, Hong Kong, a global financial center with abundant resources and talent, has been favored by the crypto industry. Now, under the comprehensive planning, pragmatic spirit, flexible approach, and determination of the Hong Kong government, Hong Kong is "making a comeback," aiming to become a global crypto financial center.

To wear the crown, one must bear its weight. Hong Kong may present a huge opportunity for Web 3.0 practitioners, but it is not for everyone. Only those centralized virtual asset exchanges that meet regulatory requirements can share in this vast market opportunity.

1. Voluntary Licensing System

For virtual asset trading platforms, the SFC introduced a regulatory framework for virtual asset trading platforms in 2019 and made detailed provisions in the "Position Paper - Regulation of Virtual Asset Trading Platforms" (hereinafter referred to as the "Position Paper").

The Position Paper states that the SFC has no authority to license or regulate platforms that only trade non-security virtual assets or tokens. This is because such virtual assets do not fall under the definition of "securities" or "futures contracts" under the Securities and Futures Ordinance, and the business operated by these platforms does not constitute "regulated activities" under that ordinance. Therefore, under the "voluntary licensing system," virtual asset trading platforms engaged in non-security tokens do not need to be licensed.

In fact, the Position Paper is consistent with the SFC's stance on innovation in the "fintech" sector, as outlined in the "Circular on the SFC's Regulatory Sandbox" published in 2017, and is a specific measure in the crypto financial sector. In 2018, the SFC further developed the "Statement on the Regulatory Framework for Fund Managers, Fund Distributors, and Trading Platform Operators for Virtual Asset Portfolios" (hereinafter referred to as the "Regulatory Framework").

According to the Position Paper, centralized platforms providing virtual asset trading services, if they intend to provide trading services for at least one type of security token, may apply to the SFC for a Type 1 (Securities Trading) and Type 7 (Providing Automated Trading Services) regulated activity license. This regulatory framework includes strict standards in areas such as asset custody, cybersecurity, anti-money laundering, market supervision, accounting and auditing, product due diligence, and risk management.

The SFC also specifically states that it only regulates virtual asset trading platforms (i.e., centralized virtual asset exchanges) that provide trading, settlement, and clearing services and have control over investors' assets. If a platform only provides trading services in a direct peer-to-peer market, and its investors typically retain control over their own assets (whether fiat currency or virtual assets), the SFC will not accept the license application from these platforms (i.e., decentralized virtual asset exchanges are not regulated by the SFC). Furthermore, if a platform conducts virtual asset trading on behalf of clients (including transmitting buy and sell instructions), but the platform itself does not provide automated trading services, the SFC will also not accept their license applications.

So far, only two exchanges have obtained the aforementioned two licenses. At the end of 2020, OSL Digital Securities Limited, a subsidiary of BC Technology Group, became the first compliant licensed virtual asset exchange in Hong Kong by obtaining Type 1 and Type 7 licenses. In April 2022, Hash Blockchain Limited, a subsidiary of HashKey Group, became the second virtual asset exchange to obtain Type 1 and Type 7 licenses. Although there are slightly more asset management companies that have obtained Type 9 licenses, only six institutions, including Huobi Asset Management, Lion Global Asset Management, MaiCapital, and Fore Elite Capital, have done so.

However, the licensed entities under the "voluntary licensing system" can only provide services to professional investors, making Type 1 and Type 7 licenses less attractive due to their lack of practicality for most virtual asset exchanges targeting the "retail" market. This further highlights the "rare value" of the upcoming VASP license to be introduced in June this year.

2. VASP Licensing System

On December 7, 2022, the "Anti-Money Laundering and Counter-Terrorist Financing (Amendment) Bill 2022" (hereinafter referred to as the "Anti-Money Laundering Ordinance") was passed in the Hong Kong Legislative Council to implement the virtual asset service provider licensing system (hereinafter referred to as the "VASP Licensing System"), which will take effect on June 1, 2023.

The following table summarizes a simple comparison of the old and new licensing systems in Hong Kong:

3. Dual Licensing

According to different regulatory authorizations, the SFC will regulate security token trading conducted by virtual asset trading platforms under the existing system of the Securities and Futures Ordinance; it will also regulate non-security token trading conducted by virtual asset trading platforms under the virtual asset service provider system of the Anti-Money Laundering Ordinance.

Given that the terms and characteristics of virtual assets may evolve over time, a particular virtual asset's classification may change from non-security tokens to security tokens (and vice versa). Based on the above regulatory logic, to avoid violating any licensing system's provisions and to ensure business continuity, virtual asset trading platforms should apply for approval under both the existing system of the Securities and Futures Ordinance and the virtual asset service provider system of the Anti-Money Laundering Ordinance (i.e., simultaneously apply for VASP licenses and Type 1 and Type 7 licenses) to obtain dual licensing and approval.

To simplify the application process for dual licensing, applicants wishing to apply for licenses under both the existing system of the Securities and Futures Ordinance and the virtual asset service provider system of the Anti-Money Laundering Ordinance only need to submit a comprehensive application form online and indicate that they are applying for both licenses simultaneously.

The SFC expects that platform operators with dual licenses will only need to report once to comply with the licensing or notification requirements under both the existing system of the Securities and Futures Ordinance and the virtual asset service provider system of the Anti-Money Laundering Ordinance.

4. Compliance Requirements for Exchanges

According to the SFC's "Guidelines for Virtual Asset Trading Platform Operators" and "Terms and Conditions Applicable to Virtual Asset Trading Platform Operators," centralized virtual asset exchanges must meet the following compliance requirements during their operations.

1. Secure Custody of Client Assets

Platform operators should hold client funds and virtual assets in trust through a wholly-owned subsidiary (i.e., "related entity"). Platform operators should ensure that the virtual assets stored in online wallets do not exceed 2%.

Additionally, since accessing virtual assets requires the use of private keys, the custody of virtual assets fundamentally relies on the secure management of those private keys. Platform operators should establish and implement written internal policies and governance procedures for private key management to ensure the secure generation, storage, and backup of all cryptographic seeds and keys.

Moreover, platform operators should not deposit, transfer, lend, pledge, re-pledge, or otherwise trade client virtual assets or create any proprietary encumbrance on client virtual assets. They must also have insurance that covers the risks associated with the custody of client virtual assets.

2. Know Your Customer (KYC)

Platform operators should take all reasonable steps to establish the true and complete identity, financial status, investment experience, and investment objectives of each client.

Additionally, platform operators must ensure that clients have a sufficient understanding of virtual assets (including awareness of the risks involved) before providing any services to them.

3. Anti-Money Laundering / Counter-Terrorist Financing

Platform operators should establish and implement adequate and appropriate anti-money laundering / counter-terrorist financing policies, procedures, and monitoring measures. Platform operators may use virtual asset tracking tools to trace specific virtual assets on the blockchain.

4. Conflicts of Interest

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

5. Inclusion of Virtual Assets for Trading

Platform operators should establish a function responsible for formulating, implementing, and enforcing guidelines for the inclusion of virtual assets, as well as guidelines for the suspension, halting, and withdrawal of virtual asset trading, along with options available to clients.

Furthermore, before including any virtual assets for trading, platform operators should conduct reasonable due diligence on those virtual assets and ensure that they continue to meet all guidelines.

6. Prevention of Market Manipulation and Violations

Platform operators should establish and implement written policies and monitoring measures to identify, prevent, and report any market manipulation or violation trading activities occurring on their platforms. Such monitoring measures should include restricting or suspending trading upon discovering manipulation or violations. Platform operators should adopt effective market surveillance systems provided by reputable independent vendors to identify, monitor, detect, and prevent such manipulation or violation trading activities and provide the SFC with access to this system.

7. Accounting and Auditing

Platform operators must select auditors with appropriate skills, care, and diligence, considering their experience, track record, and capability in auditing virtual asset-related businesses and platform operators.

Additionally, platform operators should submit an auditor's report at the end of each financial year, which should include a statement regarding whether any violations of applicable regulatory provisions have occurred.

Moreover, we currently impose a licensing condition requiring platform operators to provide monthly reports to the SFC regarding their business activities within two weeks after the end of each calendar month and upon the SFC's request.

8. Risk Management

Platform operators should establish a robust risk management framework that enables them to identify, measure, monitor, and manage all risks arising from their business and operations.

Platform operators should also require clients to pre-fund their accounts and must not provide any financial facilitation to clients for purchasing virtual assets.

5. Transition Period Arrangements

For "existing virtual asset trading platforms," the Anti-Money Laundering Ordinance stipulates a transition period until June 1, 2024.

If the operator submits an application to the SFC within nine months after June 1, 2023, and confirms that it will comply with the regulatory provisions set by the SFC, the operator may be considered as having been licensed until the SFC makes a decision on its license application, during which it will be able to continue providing services until (i) the end of the first 12 months, (ii) the application is withdrawn, (iii) the SFC rejects the application, or (iv) the SFC grants the license, whichever comes first.

If the application for the virtual asset service provider license is rejected by the SFC, the operator must terminate its virtual asset service business within three months of receiving the rejection notice or before June 1, 2024 (whichever is later). During this period, the operator may only take actions purely aimed at closing its services. The operator may apply to the SFC for an extension of the closure period, which will be for a duration deemed appropriate by the SFC, considering the operator's business and activities.

For "non-existing virtual asset trading platforms" planning to provide virtual asset services in Hong Kong after June 1, 2023, they must apply to the SFC for a virtual asset service provider license before commencing operations.

6. "Regulatory Arbitrage" is Fading Away

Under the Anti-Money Laundering Ordinance, relevant sanctions will be imposed for illegal and non-compliant activities, including providing virtual asset services without a license and failing to meet AML/CTF requirements. Furthermore, any act of actively marketing services to the public in Hong Kong will be considered as providing virtual asset services, regardless of where the service is provided or whether the service provider is located in Hong Kong.

After June 1, 2023, operating virtual asset services without a VASP license will be a criminal offense. If convicted through public prosecution, a fine of HKD 5 million and 7 years of imprisonment may be imposed, and if it is a continuing offense, an additional fine of HKD 100,000 may be imposed for each day the offense continues. If convicted through summary proceedings, a fine of HKD 5 million and 2 years of imprisonment may be imposed, and if it is a continuing offense, an additional fine of HKD 10,000 may be imposed for each day the offense continues.

If licensed service providers and their responsible personnel fail to comply with statutory AML/CTF requirements, they will be committing a crime, and upon conviction, each person may face a fine of HKD 1 million and 2 years of imprisonment. In addition to criminal liability, they will also face disciplinary actions from the SFC, including suspension or revocation of licenses, reprimands, orders for remedial actions, and fines.

Moreover, various "misconducts" during the operation of virtual asset exchanges may also face disciplinary fines from the SFC.

Compared to other jurisdictions, especially other regions in East Asia, Hong Kong's previous regulatory environment for virtual asset trading was quite lenient. This led to numerous exchanges, large and small, establishing their headquarters or operational centers in Hong Kong. However, with the introduction of the "new crypto policy," Hong Kong is moving further away from "regulatory arbitrage."

7. Hong Kong: The Comeback King

Thanks to a relaxed regulatory environment and favorable tax policies, as well as the significant geopolitical advantage of being backed by the mainland, Hong Kong, a global financial center with abundant resources and talent, has been favored by the crypto industry, especially in the asset management and trading sectors, which are the biggest "meat" in the industry. In addition to major Chinese exchanges rooted in Hong Kong, well-known companies like Bitfinex and Crypto.com have their headquarters in Hong Kong. The once prominent Alameda Research and FTX also started in Hong Kong, not to mention BitMEX, which rented an entire floor in the Central Plaza, becoming a neighbor of the SFC. As the focus of the crypto industry shifted from "East to West," Hong Kong once fell silent, overshadowed by neighboring Singapore and Silicon Valley across the ocean.

Now, Hong Kong is "making a comeback," aiming to become a global crypto financial center. Regarding Hong Kong's "new crypto policy," since the Hong Kong government began to signal in various forums in the second half of 2022, there have been numerous doubts and even mocking voices. However, this does not hinder the "tide surging into Victoria Harbour." In April this year, the Hong Kong Web3 Carnival not only re-gathered the strength of Chinese professionals in the industry but also attracted global attention, witnessing what may be another historical turning point of "East rising and West falling" in the crypto industry.

In the context of the fall of FTX and the subsequent tightening of Western regulations on the crypto industry, along with the competition for talent and capital from the "new Hong Kong," many believe that the Hong Kong government's "new crypto policy" may just be a fleeting moment. However, reviewing the previous discussions, from the fintech regulatory sandbox in 2017 and the regulatory framework in 2018 to the Position Paper in 2019 and now the VASP licensing system, we can see not only the good policy continuity of the Hong Kong government regarding the crypto industry but also its comprehensive planning, pragmatic spirit, flexible approach, and determination to implement.

Hong Kong is one of the top four financial centers globally and is also Asia's asset management center. The relaxed foreign exchange environment and sound legal system have attracted countless hot money. For centralized virtual asset exchanges, Hong Kong is a rare treasure. However, to wear the crown, one must bear its weight. Only by meeting regulatory requirements can exchanges participate in the distribution of this enormous cake.

If the old Hong Kong was a paradise for crypto adventurers, the future Hong Kong will belong to industry players who value rules and compliance.

References:

https://www.elegislation.gov.hk/hk/cap571!zh-Hant-HK

https://www.sfc.hk/TC/Regulatory-functions/Intermediaries/Licensing/Do-you-need-a-licence-or-registration

https://apps.sfc.hk/edistributionWeb/api/consultation/openFile?lang=TC\&refNo=23CP1

https://apps.sfc.hk/publicreg/Terms-and-Conditions-for-VATP_10Dec20.pdf

https://www.hkex.com.hk/-/media/HKEX-Market/News/Research-Reports/HKEx-Research-Papers/2023/CCEOCryptoETF202304_c.pdf