Interpretation of Hong Kong's "Virtual Asset Consultation Summary": Can retail investors from the mainland enter the market?
Author: Sister Sa Team
On the afternoon of May 23, 2023, Beijing time, the Securities and Futures Commission of the Hong Kong Special Administrative Region (hereinafter referred to as the Hong Kong SFC) released the "Consultation Summary on Proposed Regulatory Requirements Applicable to Operators of Virtual Asset Trading Platforms Licensed by the Securities and Futures Commission" (hereinafter referred to as the Virtual Asset Consultation Summary), demonstrating the open attitude and regulatory approach of the Hong Kong SAR towards virtual asset trading, with a comprehensive response to public suggestions, a transparent and clear amendment process, which is impressive.
Document Directory, Extremely Impressive
In terms of structure, the Hong Kong SFC's Virtual Asset Consultation Summary is divided into four parts: Summary, Collected Opinions and SFC Responses, Implementation Timeline, and Appendix (the appendix includes the final version with modification marks).
The summary, at first glance, resembles the "abstract" in academic papers, aimed at allowing readers unfamiliar with the field or those pressed for time to quickly grasp the issues and ideas the document seeks to address. Unlike the concise text of an academic paper's abstract, the summary written by the Hong Kong SFC highlights 7 key points: Point 1 is the legal basis; Point 2 clarifies the consultation deadline and the number of submissions received; Point 3 responds to opinions; Point 4 introduces Appendix ABC; Point 5 thanks the public; Point 6 directly informs the effective date; Point 7 provides a website for querying the consultation document and response. The logic is clear and straightforward.
Regarding the collected opinions, the Hong Kong SFC adopted a Q&A format, directly responding to various public opinions, categorizing and abstracting them according to the structure. The most impressive aspect is the clear logical hierarchy. Part 1: Regarding the proposed regulatory requirements applicable to licensed virtual asset trading platform operators, A allows retail investors to use licensed virtual asset trading platforms:
The first question {Do you agree that licensed platform operators should be allowed to provide services to retail investors, provided they take appropriate investor protection measures? Please explain your view.} Discussed in points -- Allowing retail investors to use licensed virtual asset trading platforms (public opinion + Hong Kong SFC response) -- Regulations for establishing business relationships with clients (public opinion + Hong Kong SFC response) -- Regulation (public opinion + Hong Kong SFC response) -- Disclosure responsibilities (public opinion + Hong Kong SFC response); The second question asks if you have any opinions on the proposed criteria for including general tokens and specific tokens? … (Among them, the SFC specifically explained why it is necessary to retain the opinion that non-security tokens must have a 12-month track record to reduce the risk of fraud that is difficult to detect) and so on.
In summary, before soliciting public suggestions, the Hong Kong SFC specifically listed the core issues on which public opinions and suggestions were needed to avoid missing the point. After the deadline, they listed everyone's opinions, where the differences lie, the basic reasons, and ultimately the SFC provided its explanations and a balanced result.
The implementation timeline is clear: it will take effect on June 1, 2023, but a transition period is provided to allow existing businesses time and opportunity to transform or obtain licenses.
The appendix contains the full text of the guidelines, the valuable part is that it retains the original annotations, similar to the review function in Word documents, with red font indicating where changes were made, how they were modified, what the original text was, and even including footnotes and formatting changes. From these traces of modification, scholars can infer the regulatory agency's thinking and value orientation, and market participants can clearly understand that some behaviors have been marked as red lines, while others are outside the red lines.
The Sister Sa Team has organized the most important issues from the Virtual Asset Consultation Summary for operators of virtual asset trading platforms and mainland investors, and presents a brief overview for readers.
Allow Licensed Virtual Asset Platforms to Provide Services to Retail Investors
Under the current system in Hong Kong, licensed virtual asset trading platforms can only provide services to professional investors as required by the Securities and Futures Ordinance. In recent years, there has been a persistent call both within and outside Hong Kong to break this restriction. The Hong Kong SFC also specifically solicited public opinions on this matter in previous consultation documents, namely, "Should licensed platform operators be allowed to provide corresponding services to investors, provided they take appropriate investor protection measures?"
In this "Virtual Asset Consultation Summary," the SFC organized the responses, with most respondents believing that if licensed virtual asset trading platforms provide relevant knowledge training, risk investment, information disclosure, and other protective measures for investors, retail investors (the so-called "small investors") should be allowed to use licensed virtual asset trading platforms.
Accordingly, the SFC responded: It will implement the proposal to allow licensed virtual asset trading platforms to provide services to retail investors. However, licensed virtual asset trading platforms must comply with a series of protective measures to safeguard the interests of retail investors. The key points of these protective measures include:
1. Conducting Risk Assessment and KYC Work
Before providing services to retail investors, appropriate knowledge and risk assessments and investor training should be conducted, and risk tolerance limits should be established. The SFC stated that it had considered relaxing the requirements for establishing relationships with retailers in certain circumstances, but ultimately determined that retail investors are generally unlikely to understand the terms, characteristics, and risks of virtual assets. Moreover, since transactions on virtual asset trading platforms are conducted automatically, even if a transaction is unsuitable, the virtual asset trading platform cannot intervene. Therefore, ensuring suitability becomes extremely important when establishing business relationships with retail clients. Only by fully implementing the aforementioned KYC requirements can the interests of retail investors be safeguarded. Thus, even if retail clients have an understanding of virtual assets, virtual asset trading platforms cannot be exempted from conducting risk assessments. Similarly, the SFC determined that since the regulations for establishing business relationships with clients are designed to follow the principle of suitability, individual professional investors should enjoy protections similar to those of retail investors.
2. Fulfilling Disclosure Responsibilities
In the consultation document, most respondents believed that imposing disclosure responsibilities on various virtual assets included by virtual asset trading platforms is crucial for protecting investors' interests. The SFC also responded to this, acknowledging in this "Virtual Asset Consultation Summary" that due to the unique nature of virtual assets, which differ from traditional securities, the regulation of virtual assets is not conducted at the product level and is traded on multiple platforms. Therefore, obtaining and verifying information from the issuers of virtual assets may pose difficulties. Nevertheless, virtual asset trading platforms must conduct due diligence on each virtual asset before including it for trading, and platform operators should obtain information regarding each virtual asset (whether directly or indirectly) and take all reasonable steps to ensure that the information disclosed about specific products is not false, misleading, or deceptive.
Virtual Asset Trading Platforms Should Have Insurance or Compensation Arrangements for Custody of Client Funds
In response to this issue, the SFC widely solicited public opinions in the consultation document regarding whether licensed virtual asset trading platforms should have insurance or compensation arrangements for risks related to the custody of client assets. For the sake of safeguarding investors' funds, most respondents held a positive view. However, some respondents pointed out that allocating funds for insurance and compensation arrangements could lead to high funding costs for virtual asset trading platforms, affecting their competitiveness. Based on the above considerations, some compromise opinions suggested that the risks associated with client virtual assets held through offline storage are relatively low and do not require comprehensive protection, but only protection for online storage.
In response to the above debate, the SFC made the following arrangements in this "Virtual Asset Consultation Summary":
1. Different Protection Thresholds for Online and Offline Storage Methods
In short, the protection threshold for client virtual assets held through offline storage has room for adjustment. The SFC believes that the risks associated with offline storage of client virtual assets are similar to those related to the custody of client assets in traditional financial markets (such as employee misappropriation and fraud). Therefore, the protection threshold for client virtual assets held through offline storage has room for adjustment. Since the risks associated with online and other storage methods for client virtual assets are not the same as those typically associated with the custody of client assets in traditional financial markets, the SFC determined that client virtual assets held through online and other storage methods should be fully covered by compensation arrangements from licensed virtual asset trading platforms.
2. Virtual Asset Trading Platforms Can Flexibly Adopt Protection Forms
Regarding what form of protection virtual asset trading platforms should establish, the SFC also confirmed in the "Virtual Asset Consultation Summary" that licensed virtual asset trading platforms can establish a fund pool in the form of insurers, either individually or jointly, to provide protection against losses of client assets. The "Guidelines for Virtual Asset Trading Platforms" have stipulated this flexibility.
Combating Money Laundering / Terrorist Financing
Most respondents supported the inclusion of provisions to combat money laundering and terrorist financing in the "Anti-Money Laundering Guidelines" and recognized that it could reduce the risks of money laundering and terrorist financing associated with virtual assets. In response to concerns about the transfer, return, and cross-border agency of virtual assets, the SFC provided further clarifications in the consultation document.
1. Implementation of Transfer Principles
According to the transfer principles provided in the "Anti-Money Laundering Guidelines," licensed virtual asset trading platforms (i) when acting as remittance institutions, must obtain, hold, and immediately and securely submit the required information about the remitter and payee to the receiving institution; and (ii) when acting as receiving institutions, must obtain and hold the required information from the receiving institution. This will provide information for the SFC to conduct sanctions screening and transaction monitoring, and further help prevent and investigate virtual asset transfers to unlawful individuals and designated persons.
Regarding respondents' concerns that existing technology is insufficient to strictly comply with transfer rules, the SFC, after considering the implementation status in other major jurisdictions, believes that if the required information cannot be submitted to the receiving institution immediately, licensed virtual asset trading platforms should adopt temporary measures to submit the required information within a practical range before January 1, 2024. Specific regulatory requirements will be listed in subsequent FAQs.
2. Transfers Involving Non-Custodial Wallets
The SFC has stricter controls over transfers involving non-custodial wallets, requiring licensed virtual asset trading platforms to take reasonable measures based on risk, such as obtaining the required information from clients and conducting sanctions screening. In addition, licensed virtual asset trading platforms should only accept virtual asset transfers involving non-custodial wallets assessed as reliable after considering the screening results of the relevant virtual asset transactions and related wallet addresses, as well as the assessment results of ownership or control of the non-custodial wallets.
3. Return of Virtual Assets
To reduce the money laundering/terrorist financing risks associated with incoming virtual asset transfers lacking required information, the SFC has decided that licensed virtual asset trading platforms should only return virtual assets in appropriate circumstances, without suspicion of money laundering/terrorist financing activities, and after considering the due diligence of the virtual asset transfer counterparty and the screening results of the virtual asset transactions and related wallet addresses. Furthermore, the relevant virtual assets should be returned to the account of the remittance institution, not the account of the remitter.
4. Cross-Border Agency
When licensed virtual asset trading platforms provide virtual asset services defined in Section 53ZR of the "Anti-Money Laundering and Terrorist Financing Ordinance" (i.e., operating virtual asset exchanges) to virtual asset service providers or financial institutions acting for relevant clients located outside Hong Kong, the provisions regarding cross-border agency relationships apply to the platform. This includes situations where licensed virtual asset trading platforms execute buy and sell transactions for these institutions, but does not include virtual asset transfers with these institutions. Additionally, the SFC requires licensed virtual asset trading platforms to continuously monitor virtual asset transactions and related wallet addresses to more timely and accurately identify the sources and destinations of the relevant virtual assets, as well as any wallet addresses involved or subsequently involved in illegal or suspicious activities/sources or designated persons.
Disciplinary Fines
According to the "SFC Disciplinary Fines Guidelines," the SFC may impose a fine of up to HKD 10 million or three times the amount of profits gained or losses avoided, whichever is higher, and will not automatically link the fine amount to the profits gained or losses avoided. Regarding respondents' concerns about specific fine amounts and considerations, the SFC will adopt fine guidelines consistent with the "Securities and Futures Ordinance." The SFC will not automatically link the fine amount to the profits gained or losses avoided. Instead, the SFC will determine the relevant factors when assessing fines on a case-by-case basis to flexibly respond to market changes, such as the nature and characteristics of the misconduct and whether it may involve multiple offenses or omissions. Regarding how to decide whether to take disciplinary action against individuals and/or companies, the SFC will consider the behavior of the relevant company and individual, and for those involved in the management of the company, whether the behavior involves that person's consent, tolerance, or neglect, as well as deficiencies in the supervision or management of the business.
In Conclusion
This "Virtual Asset Consultation Summary" indicates the Hong Kong government's strong pursuit of a dynamic balance between supporting virtual asset trading platform practitioners and protecting the interests of virtual asset investors. In this process, the SFC not only designed the obligations that virtual currency trading platform practitioners should fulfill under the framework of the "Anti-Money Laundering Guidelines," but also fully considered the protection of the interests of retail investors such as "small investors," promoting the long-term stable development of the financial market. The establishment of this mechanism also provides a sense of security for investors outside Hong Kong to invest in the Hong Kong virtual currency market. The Sister Sa Team continues to uphold the previous view that Hong Kong and mainland regions exhibit "complementary" characteristics in the field of virtual asset development, and this complementary nature may become more pronounced in the future. The SFC's prudent response to public concerns about the feasibility and sustainability of a model led by licensed virtual platforms, regulated by the SFC, and involving retail investors also indicates that the SFC's attempt to establish a transparent and highly operable mechanism in the consultation document is a significant step towards helping Greater China enter the Web 3.0 era. This will not only promote the development of the digital economy but also greatly enhance the vitality and competitiveness of the Greater China market.