Hong Kong’s SFC sets forth framework for regulation of virtual asset trading platforms

Maria Nikolova

In the initial exploratory stage, the SFC would observe the live operations of the virtual asset trading platforms without granting any licences.

The Hong Kong Securities and Futures Commission (SFC) has earlier today provided details on its approach to virtual asset portfolios managers, fund distributors and trading platform operators.

The regulator defines “virtual assets” as digital representations of value, which are also known as “cryptocurrencies”, “crypto-assets” or “digital tokens”.

Under existing regulatory remits in Hong Kong, markets for virtual assets may not be subject to the oversight of the SFC if the virtual assets involved fall outside the legal definition of “securities” or “futures contracts” (or equivalent financial instruments). The SFC has issued a number of announcements clarifying its regulatory stance on virtual assets. Where virtual assets fall under the definition of “securities” or “futures contracts”, these products and related activities may fall within the SFC’s ambit. The SFC has also reminded intermediaries about the notification requirements under the Securities and Futures Rules if they intend to provide trading and asset management services involving crypto-assets.

The SFC has undertaken a series of actions against those who may have breached its rules and regulations when carrying out activities related to virtual assets. These include providing regulatory guidance, issuing warning and compliance letters and taking regulatory action.

However, many virtual assets are not covered by the definition of “securities” or “futures contracts”. The SFC has decided to adopt an approach which will bring a significant portion of virtual asset portfolio management activities into its regulatory net.

  • Virtual asset portfolio managers

Certain virtual asset portfolio managers will be subject to the SFC’s supervision:

  • Firms managing funds which solely invest in virtual assets that do not constitute “securities” or “futures contracts” and distribute the same in Hong Kong

These firms will typically require a licence for Type 1 regulated activity (dealing in securities) because they distribute these funds in Hong Kong. The management of these funds will also be subject to the SFC’s oversight through the imposition of licensing conditions; and

  • Firms which are licensed or are to be licensed for Type 9 regulated activity (asset management) for managing portfolios in “securities”, “futures contracts” or both

To the extent that these firms also manage portfolios which invest solely or partially (subject to a de minimis requirement) in virtual assets that do not constitute “securities” or “futures contracts”, such management will also be subject to the SFC’s oversight through the imposition of licensing conditions.

Licence applicants and licensed corporations are required to inform the SFC if they are presently managing or planning to manage one or more portfolios that invest in virtual assets. Upon being so informed, the SFC will first seek to understand the firm’s business activities. If the firm appears to be capable of meeting the expected regulatory standards, the proposed Terms and Conditions will be provided to the firm (where applicable) and the SFC will discuss them with the firm and vary them in light of its particular business model so as to ensure that they are reasonable and appropriate.

If a licence applicant does not agree to comply with the proposed Terms and Conditions, its licensing application will be rejected. Similarly, if an existing licensed corporation with a VA portfolio does not agree to comply with the proposed Terms and Conditions, it will be required to unwind that portfolio within a reasonable period of time.

After the licence applicant or licensed corporation has agreed with the proposed Terms and Conditions, they will be imposed as licensing conditions.

Failure to comply with any licensing condition is likely to be considered as misconduct under the SFO.

  • Virtual asset fund distributors

Firms which distribute funds that invest (solely or partially) in virtual assets in Hong Kong will require a licence or registration for Type 1 regulated activity (dealing in securities). As such, these firms are required to comply with the Existing Requirements, including the suitability obligations, when distributing these funds.

  • Cryptocurrency platform operators

Separately, the SFC is also outlining a conceptual framework for the potential regulation of virtual asset trading platforms. It is proposed that the standards of conduct regulation for virtual asset trading platform operators should be comparable to those applicable to existing licensed providers of automated trading services.

Some of the world’s largest virtual asset trading platforms have been seen operating in Hong Kong but they fall outside the regulatory remit of the SFC and any other regulators. Owing to the serious investor protection issues identified and having regard to international developments, the SFC considers it necessary to explore in earnest whether and if so, how it could regulate virtual asset trading platforms under its existing powers.

To conduct a meaningful study of the framework, the SFC will work with interested virtual asset trading platform operators by placing them in the SFC Regulatory Sandbox.

In the initial exploratory stage, the SFC would not grant a licence to platform operators. Instead, it would discuss its expected regulatory standards with platform operators and observe the live operations of the virtual asset trading platforms in light of these standards. The SFC will critically consider whether the virtual asset trading platforms are, in fact, appropriate to be regulated by the SFC in light of the performance of these trading platforms in the Sandbox.

In case the SFC concludes that risks involved cannot be properly dealt with under the standards it would expect, and that investor protection still cannot be ensured, the regulator may decide that platform operators should not be regulated by the SFC.

If the SFC makes a positive determination at the end of this stage, it would then consider granting a licence to a qualified platform operator.

If the SFC grants a licence to a qualified platform operator, it will impose appropriate licensing conditions and the operator will proceed to the next stage of the Sandbox. This would typically mean more frequent reporting, monitoring and reviews so that through close supervision by the SFC, operators could put in place robust internal controls and address any of the SFC’s concerns arising from the conduct of their business.

The SFC may also further consider or refine its regulatory and supervisory approach through intensive dialogue with operators when they are operating in the Sandbox. After a minimum 12-month period, the virtual asset trading platform operator may apply to the SFC for removal or variation of some licensing conditions and exit the Sandbox. Licensing conditions (and terms and conditions) imposed in this stage would be made public in the usual way.

Market participants are invited to contact the Fintech Contact Point at [email protected] if they have any questions.

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