Analysis of the Hong Kong Virtual Asset Service Provider (VASP) licensing system to be implemented on June 1

Author: Web3 Xiao Lu

In response to the Policy Declaration on the Development of Virtual Assets in Hong Kong issued by the Financial Services and the Treasury Bureau on October 31, 2022, to promote Hong Kong as an international virtual asset center, the Hong Kong Legislative Council passed the latest amendments to the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (2022 Amendment Ordinance) on December 7, 2022. This means that the new licensing regime for virtual asset service providers (VASP regime) in Hong Kong will officially come into effect on June 1, 2023.

On February 20, 2023, the Hong Kong Securities and Futures Commission (SFC) released a consultation paper on the proposed regulatory framework applicable to operators of virtual asset trading platforms licensed by the SFC (VASP Consultation Paper), seeking consultation on regulatory provisions related to the VASP regime in preparation for its upcoming implementation.

Once the VASP regime is officially implemented, all centralized virtual asset exchanges operating in Hong Kong or actively promoting their services to Hong Kong investors, regardless of whether they provide securities token trading services, will need to be licensed by the SFC and subject to its regulation. All virtual asset exchanges must comply with the provisions of the Guidelines for Virtual Asset Trading Platform Operators (VASP Guidelines), which will replace the previous requirements under the Securities and Futures Ordinance for Type 1 (securities trading) and Type 7 (providing automated trading services) licenses. The VASP Guidelines also provide transitional arrangements for relevant virtual asset exchanges.

1. Background of the VASP Regime Amendments

In the VASP Consultation Paper, the SFC clearly articulated the background for establishing the new VASP regime. Amid the ongoing crypto winter, a series of collapses have occurred, exacerbating risks in the virtual asset market, particularly the collapse of FTX, which caused significant losses for millions of investors. The increasing interconnectedness of the virtual asset market with traditional financial markets highlights the importance and necessity of implementing effective regulation in the virtual asset industry.

Major jurisdictions worldwide are shifting their regulatory approach from a lenient stance (i.e., regulating from the perspective of anti-money laundering and payments) to a more comprehensive one (i.e., regulating from the perspective of investor protection). The SFC has been a leader in this regard, gradually establishing a regulatory framework for virtual assets as early as 2018, primarily targeting virtual asset service providers offering securities token services. To date, the virtual asset industry has undergone significant changes, and in order to comprehensively regulate all centralized virtual asset trading platforms in Hong Kong and implement the latest standards from the Financial Action Task Force (FATA), the Hong Kong government has legislated the 2022 Amendment Ordinance and established the new VASP regime, aiming to achieve a more suitable balance between investor protection and market development.

2. What is Virtual Asset

According to Section 53ZRA of the 2022 Amendment Ordinance and the VASP Guidelines, Virtual Asset (VA) is broadly defined as:

(a) a digital representation of value that is cryptographically secured and meets the following descriptions:

(1) expressed in the form of a unit of account or store of economic value;

(2) meets one of the following criteria:

A. is or is intended to be a medium of exchange accepted by the public for one or more of the following purposes: (I) payment for goods or services; (II) settlement of debts; (III) investment; or

B. provides rights, qualifications, or avenues to vote on matters related to the management, operation, or governance of any cryptographically secured digital representation of value, or changes to the terms of any arrangements applicable to such value;

(3) can be transferred, stored, or traded electronically; and

(4) possesses other characteristics as may be specified by the SFC from time to time in announcements published in the Gazette;

(b) a digital representation of value that is designated as a virtual asset by the Financial Services and the Treasury Bureau in an announcement published in the Gazette.

According to Section 53ZRA of the 2022 Amendment Ordinance, the following items are excluded from the definition of VA: (1) digital currencies issued by central banks, entities performing central banking functions, or entities authorized by central banks to issue on their behalf (CBDC); (2) limited-use digital tokens (which are non-transferable, non-exchangeable, and non-fungible by nature, such as gift cards, customer loyalty rewards programs, and electronic payment services); (3) stored value payment instruments (regulated under the Payment Systems and Stored Value Facilities Ordinance); and (4) securities or futures contracts (regulated under the Securities and Futures Ordinance).

The definition of VA in the 2022 Amendment Ordinance will cover most virtual currencies in the market, including BTC, ETH, stablecoins, utility tokens, and governance tokens. Regarding stablecoins, the Hong Kong Monetary Authority released a consultation summary on the Discussion Paper on Crypto Assets and Stablecoins in January 2023, indicating the expectation to implement regulatory arrangements in 2023/24, establishing a licensing and permitting system for activities related to stablecoins.

The attributes of NFTs are linked to the attributes of the underlying assets, and currently, there is no clear definition under the VASP regime. When the SFC issued a reminder to investors about the risks of NFTs on June 6, 2022, it stated that if an NFT is a true digital representation of a collectible (art, music, or film), the activities related to it do not fall under the SFC's regulatory scope. However, some NFTs may cross the boundary between collectibles and financial assets, potentially possessing attributes of "securities" regulated under the Securities and Futures Ordinance, and thus will be subject to regulation.

3. What is Virtual Asset Service

According to Schedule 3 B of the 2022 Amendment Ordinance and the VASP Guidelines, Virtual Asset Service (VA Service) is defined as: operating a virtual asset exchange:

(a) providing services that meet the following descriptions through electronic facilities:

(1) the service:

A. involves offers to buy and sell virtual assets that are frequently made or accepted in a manner that forms a binding transaction or leads to a binding transaction; or

B. involves frequent introductions or identifications between persons with the intention of negotiating or completing the buying and selling of virtual assets, or frequent introductions or identifications under reasonable expectations that they will negotiate or complete the buying and selling of virtual assets in a certain manner, forming a binding transaction or leading to a binding transaction; and

(2) in the service, customer funds or customer virtual assets are directly or indirectly held by the person providing the service; and

(b) any virtual asset trading activities and ancillary services conducted by platform operators for their customers outside the platform.

Therefore, for (1) centralized virtual asset exchanges operating in Hong Kong, and (2) centralized virtual asset exchanges operating offshore that actively promote their services to Hong Kong investors, if they engage in the aforementioned activities, they fall within the scope of virtual asset services. Currently, other virtual asset services (such as payment exchanges, asset custody, and DEX operations) are not included, but the Financial Services and the Treasury Bureau may subsequently include other virtual asset services through announcements published in the Gazette.

According to Section 53ZRD of the 2022 Amendment Ordinance, any entity operating virtual asset services must obtain a VASP license from the SFC. Operating a business providing virtual asset services without obtaining a VASP license is a criminal offense, punishable by a fine of up to HKD 5 million and imprisonment for 7 years upon conviction; if the offense is a continuing offense, an additional fine of HKD 100,000 may be imposed for each day the offense continues.

4. Requirements for Applying for a VASP License

Under the new VASP regime, the SFC will issue licenses and regulate applicants according to the 2022 Amendment Ordinance and the VASP Guidelines. According to Section 53ZRK of the Amendment Ordinance, the SFC may only issue VASP licenses to the following applicants:

(1) companies incorporated in Hong Kong with a fixed place of business, or non-Hong Kong companies incorporated outside Hong Kong and registered under the Companies Ordinance (Cap. 622 of the Laws of Hong Kong); and

(2) the SFC is satisfied that:

(a) the applicant is a suitable candidate for licensing in relation to the virtual asset services;

(b) at least 2 individuals are applying to serve as responsible officers (Responsible Officer, RO) of the applicant, each of whom is a suitable candidate connected to the provision of the relevant virtual asset services;

(c) each director of the applicant (excluding responsible officers) is a suitable candidate connected to the provision of the relevant virtual asset services;

(d) the ultimate owners of the applicant's corporate entity are suitable candidates connected to the provision of the relevant virtual asset services; and

(e) an application has been submitted for SFC approval for a location to be used for storing records or documents.

Applicants need to submit applications to the SFC regarding VASP license application requirements, processes, and many other requirements similar to those for applying for Type 1 and Type 7 licenses under the Securities and Futures Ordinance, as specified in the VASP Guidelines. These detailed requirements include: criteria for suitable candidates, competency requirements, ongoing training requirements, general principles, financial soundness, operation of virtual assets on the platform, prevention of market manipulation and misconduct, transactions with customers, protection of customer assets, management, supervision and internal controls, cybersecurity, avoidance of conflicts of interest, record keeping, auditor audits, ongoing reporting/notification responsibilities, etc.

5. Transitional Arrangements

The 2022 Amendment Ordinance provides transitional arrangements for existing virtual asset exchanges. Exchanges that have been operating in Hong Kong and have meaningful and substantive business prior to June 1, 2023, including (1) exchanges that already have or are applying for licenses under the Securities and Futures Ordinance, and (2) unlicensed exchanges conducting business related to non-securities tokens under the Securities and Futures Ordinance, are eligible to participate in the transitional arrangements. Exchanges eligible to participate in the transitional arrangements must meet the conditions set out in Schedule 3 G of the 2022 Amendment Ordinance to continue operating in Hong Kong from June 1, 2023, to May 31, 2024, and will be subject to the VASP licensing regime starting June 1, 2024.

Companies planning to provide virtual asset services in Hong Kong after June 1, 2023, must apply to the SFC in advance and obtain a VASP license.

6. Dual Licensing

Once the VASP regime is officially implemented, all centralized virtual asset exchanges operating in Hong Kong or actively promoting their services to Hong Kong investors, regardless of whether they provide securities token trading services, will need to be licensed by the SFC and subject to its regulation. The SFC will regulate securities token trading conducted by virtual asset exchanges under the Securities and Futures Ordinance, while also regulating non-securities token trading conducted by virtual asset exchanges under the 2022 Amendment Ordinance.

Considering that the nature of virtual assets may evolve over time, such as transitioning from non-securities tokens to securities tokens, to avoid engaging in conduct that violates any licensing regime, virtual asset exchanges should simultaneously obtain dual licenses and approvals from the SFC under both the Securities and Futures Ordinance and the 2022 Amendment Ordinance. To facilitate this, the SFC has simplified the application process, requiring only the submission of a comprehensive application form online, indicating the simultaneous application for both licenses.

7. VASP Consultation Paper

Once the VASP regime is officially implemented, all virtual asset exchanges must comply with the provisions of the VASP Guidelines. The VASP Guidelines are prepared based on the provisions applicable under the Securities and Futures Ordinance, particularly the Terms and Conditions for Virtual Asset Trading Platform Operators from 2019, but with several modifications to the old conditions.

The SFC seeks public feedback on the VASP Guidelines, with key contents including: (1) proposals regarding allowing retail investors to use licensed virtual asset trading platforms, provided that the platforms comply with a series of investor protection measures, such as KYC, token governance (token inclusion and review committees), token due diligence and inclusion criteria (general, specific), other due diligence, information disclosure; (2) proposals regarding insurance/compensation arrangements; (3) trading of virtual asset derivatives; (4) other adjustments to current provisions by the VASP Guidelines; (5) Anti-Money Laundering and Counter-Terrorist Financing Guidelines (Applicable to Licensed Corporations); transitional arrangements for the VASP regime; (6) dual licensing; (7) external evaluation reports.

8. Conclusion

The deadline for the VASP Consultation Paper has passed, and the SFC is expected to announce the subsequent consultation summary, which is anticipated to have no significant changes overall. The time until the implementation of the VASP regime is very short, and regardless of the following situations: (1) virtual asset exchanges already operating in Hong Kong; (2) offshore virtual asset exchanges actively promoting their services to Hong Kong investors; (3) those planning to operate virtual asset exchanges in Hong Kong; or (4) traditional financial institutions venturing into virtual asset exchanges, VASP license applicants should prepare in advance for business compliance and related license applications.