Interpreting the Hong Kong Securities and Futures Commission Consultation Document: Is Virtual Trading "Less Restrictive" or "High Threshold"?

Written by: Xiao Za Lawyer

On February 20, 2023, the Hong Kong Securities and Futures Commission (hereinafter referred to as "SFC") released a consultation document titled "Consultation Paper on Proposed Regulatory Framework for Virtual Asset Trading Platform Operators Licensed by the Securities and Futures Commission" (hereinafter referred to as the "Consultation Paper"). What is the purpose of this Consultation Paper? In simple terms, the SFC, as the regulatory body, has developed some mature and feasible ideas regarding the regulation of virtual asset trading. However, due to the novelty, technical nature, and characteristics of virtual assets that differ from other traditional financial products, the SFC is uncertain about (1) whether this set of regulatory measures, which is still in the idea stage, is practically feasible, and (2) whether it can promote the development of virtual assets in Hong Kong while ensuring the financial stability of Hong Kong, laying the foundation for the continued brilliance of Hong Kong over the next 50 years.

Therefore, the SFC has proactively made a series of potential regulatory measures public, welcoming opinions from both regulated and unregulated parties, as well as stakeholders and non-stakeholders, with the aim of ultimately implementing the best policies that are most suitable for Hong Kong and can promote social development.

I. What are the key contents of this public consultation?

To be honest, the team is quite satisfied with the "substance" revealed by the SFC in this public consultation. As one of the few regions in China with a long history and mature capital markets, Hong Kong has consistently adhered to the regulatory philosophy of "stability as a prerequisite for innovation," implementing strong regulatory measures in the financial sector. (Especially after 2019, Hong Kong has taken strong actions in financial regulation to become the first jurisdiction in the Asia-Pacific region to pass the FATF "Mutual Evaluation Report," and this effort continues to this day).

However, this time the SFC has directly presented feasible, credible, predictable, and detailed regulatory measures in the public consultation, demonstrating Hong Kong's boldness in allowing free trading of virtual assets and compliant operation of platforms. At the same time, it has adopted a humble attitude, sincerely listening to industry voices, which truly reflects the greatest sincerity and goodwill towards the virtual asset industry. Under the pressure of the FTX crisis, the SFC has fulfilled its commitment made in the "Policy Declaration on the Development of Virtual Assets in Hong Kong" (referred to as the "Hong Kong Declaration") released at the end of 2022.

To get to the point, this public consultation mainly aims to discuss: Should licensed platform operators be allowed to provide services to retail investors (commonly known as "retail investors")? If permitted, in addition to the series of investor protection measures suggested in the consultation document, what other measures should be implemented? With these two consultation questions in mind, the SFC has thoroughly discussed its existing countermeasures and measures with the public, including: ensuring the compliance and credibility of virtual assets on licensed trading platforms, establishing insurance or user compensation mechanisms for trading platforms, compliant trading of virtual asset derivative financial products, accelerating the licensing review process, and very importantly, after the formal implementation of the "Anti-Money Laundering Ordinance," transitional arrangements and exit measures for virtual asset service providers, which is quite substantial and reassuring.

Next, the team will explain the potential practical impacts of this series of "big moves" by the SFC from a legal perspective.

II. For virtual asset trading platforms: New obligations, licensing review adjustments, and exit

First, it is clear that the SFC has already expressed its regulatory inclination in this public consultation. In question 3 of Part III of the "Consultation Paper," the SFC explicitly states, "If the SFC intends to allow retail investors to use licensed virtual asset trading platforms, you believe…" Therefore, the licensed trading platforms, as the main characters, have received the most attention in this public consultation.

01. Platforms have a large number of new compliance obligations and must verify whether third-party virtual assets are compliant

Although it is currently rumored that Hong Kong licensed virtual asset trading platforms are only allowed by the SFC to conduct large transactions of Bitcoin and Ethereum with "retail investors," merely two virtual currencies clearly cannot meet market demand. For the long term, more types of virtual assets must "enter the game." However, the SFC itself is a relatively traditional financial regulatory agency, and most of its staff do not come from technical backgrounds. So how can they accurately and efficiently determine whether virtual assets other than Bitcoin and Ethereum are reliable and compliant? Are they trustworthy investments? And can they enter licensed trading institutions, allowing risk-averse "retail investors" to trade?

The SFC understands that to let professionals do professional work, rather than having its non-technical staff review the numerous virtual assets one by one like traditional financial regulators, it is better to delegate this task to professionals—the licensed virtual asset trading platforms. Therefore, licensed virtual asset trading platforms will essentially have an additional obligation to identify and manage the compliance of third-party virtual assets for trading, in addition to the various compliance obligations they have already established (such as safe custody of assets, KYC, anti-money laundering and counter-terrorism financing, conflict of interest management, prevention of market manipulation and illegal activities, accounting and auditing, risk management).

In short, the SFC hopes that licensed virtual asset platform operators will conduct reasonable due diligence on third-party virtual assets that are financialized before including them, to ensure they meet the general criteria for inclusion. If the platform fails to fulfill the aforementioned reasonable due diligence obligations or does so incompletely, it will bear ultimate responsibility for any resulting losses. Furthermore, after allowing third-party financialized virtual assets to enter trading, licensed platform operators must continuously monitor these virtual assets to ensure they remain compliant.

Additionally, for previously unclear regulatory attitudes and vague regulatory rules regarding non-financial securities-type virtual assets (such as NFTs as pure mathematical artworks), the SFC requires platforms to provide two documents to be included in trading: (1) a smart contract review report issued by the platform itself or a qualified independent third-party institution, proving that its smart contract does not have exploitable defects or vulnerabilities; and (2) a legal opinion from a lawyer, proving its compliance. Only then can they be included and allowed to trade with professional investors or "retail investors."

Moreover, the SFC has established information disclosure obligations for platforms similar to those for traditional financial institutions, with specific disclosure obligations referenced in the SFC's previously published "Guidelines for Virtual Asset Trading Platforms," paragraph 9.28.

02. Accelerated licensing review: Introduction of external expert evaluations

Historically, compared to other financial licenses, the licensing review for virtual asset trading platforms has been extremely slow. The existing two licensed platforms have both waited nearly two years to successfully obtain their licenses, and the time cost has deterred most virtual asset practitioners. This is mainly due to the large workload of the review, unclear regulatory measures, and insufficient personnel at the SFC. Now, to simplify the application process and significantly increase the speed of licensing, the SFC will introduce an external expert evaluation system, and will no longer directly review original materials.

Note that licensed platforms need to submit two expert evaluation reports to the SFC in two phases: (1) at the time of submitting the license application (first phase report); (2) after receiving the SFC's preliminary approval (second phase report).

The first phase expert report includes (1) the design effectiveness of the proposed structure, governance, operations, systems, and monitoring measures of the virtual asset trading platform, personnel structure, and token evaluation mechanism; (2) custody of virtual assets; (3) KYC, anti-money laundering, and counter-terrorism financing; (4) market monitoring, risk management, and cybersecurity, etc.

The second phase expert report assesses the implementation arrangements and actual effectiveness of the platform's policies, procedures, and system security, as well as monitoring measures. As for the criteria for qualified experts, further clarification from the SFC is awaited.

03. How to exit for platforms that do not wish to be licensed?

According to SFC regulations, any virtual asset platform operating in Hong Kong or targeting Hong Kong residents must be licensed, regardless of whether the virtual assets are financial securities. Those that do not wish to be licensed must exit in an orderly manner.

Existing virtual asset trading platforms in Hong Kong that do not intend to apply for a license must end their business in Hong Kong in an orderly manner, with a deadline of May 31, 2024, to complete the exit. Otherwise, they will violate the virtual asset service provider system under Hong Kong's "Anti-Money Laundering Ordinance," and the SFC will take strong action at that time. If a platform is not originally from Hong Kong but operates for Hong Kong residents, it must also be licensed; otherwise, it will face the same treatment as the aforementioned local platforms and may potentially be implicated in criminal activities, depending on the circumstances.

Of course, the SFC does not require everyone to complete licensing by this June. As long as certain conditions are met, even if a license has not yet been granted, they can be "deemed" as licensed platforms. The specific details are numerous, and the team will not elaborate further at this time.

III. What will happen to NFTs and other virtual assets? Dual licensing is the answer

Before the release of this "Consultation Paper," due to the ambiguity of regulatory rules for non-financial securities-type virtual assets and the SFC's reluctance to regulate non-financial securities-type virtual assets (mainly due to lack of capacity), NFTs as pure digital artworks and other virtual assets with weak or no financial attributes were not included in the SFC's licensed regulatory framework. In other words, it seemed unnecessary to enforce mandatory licensing.

However, the situation has now changed. After the introduction of the "Anti-Money Laundering Ordinance," to unify regulation, the Hong Kong government ultimately decided to assign all regulatory responsibilities for virtual assets to the SFC. Therefore, the team can provide a definitive conclusion: NFT trading platforms operating in Hong Kong also need to be licensed.

To address the significant differences between financial securities-type virtual assets and non-financial securities-type virtual assets, which may lead to conflicting regulatory measures, the SFC has decided to introduce a "dual licensing" system. The so-called "dual licensing" means that the SFC will differentiate based on whether virtual assets have financial attributes and grant licenses with different permitted contents, such as granting License Type 1 (allowing trading of financial securities-type virtual assets) and License Type 2 (allowing trading of both financial and non-financial securities-type virtual assets).

This is mainly because the SFC has realized that the nature and characteristics of virtual assets may change over time, and the classification of a particular virtual asset may shift from non-financial securities-type to financial securities-type tokens (and vice versa, which is quite complex, hence the initial reluctance to regulate). To accommodate this potential dynamic change, the SFC has tentatively adopted the "dual licensing" system for future dynamic adjustments of virtual assets. Of course, when applying for the second license, if the platform is already licensed (or in the process of applying), there will be certain procedural simplifications and preferential measures, as the SFC's goal is not to make things difficult for everyone or delay approval times.

IV. Can citizens from mainland China trade virtual currencies in Hong Kong?

As is well known, after the ten ministries of mainland China issued the "Notice on Further Preventing and Dealing with Risks of Virtual Currency Trading and Speculation" (referred to as the "9.24 Notice") in 2021, virtual currency trading and related financial businesses were completely banned from mainland China. However, in reality, our country has not prohibited citizens from legally holding virtual currencies. So, can we trade the virtual currencies we legally hold in Hong Kong after the complete establishment of the virtual asset regulatory system?

In fact, this is a question of great concern to many mainland citizens. Unfortunately, in the documents of this public consultation, the SFC did not mention this issue (seemingly deliberately avoiding it), mainly because Hong Kong, as a special administrative region of China, should not, in principle, conflict with or contradict the laws or policies of mainland China in legislative and policy-making unless approved or exempted by the constitution (for example, certain basic laws of mainland China are stipulated not to be effective in Hong Kong in the Hong Kong "Basic Law").

If Hong Kong allows citizens from mainland China to trade virtual currencies in Hong Kong, it could very likely render the 9.24 Notice ineffective. Therefore, on this issue, the team finds it difficult to make a judgment or evaluation and will need more time to observe.

Final Thoughts

The team has always maintained a high level of attention to the legislation and policies regarding virtual assets in Hong Kong. At the same time, we welcome individuals from all walks of life (especially those within the virtual asset industry) to actively participate in this legislative consultation in Hong Kong. This not only concerns the future of industry development but also serves as a good opportunity to express demands. Similarly, for readers interested in establishing virtual asset institutions in Hong Kong but who have questions about Hong Kong's virtual asset legislation and policies, please feel free to contact the team for consultation.