Hong Kong’s Securities and Futures Commission announces licensing framework for crypto exchanges

November 18, 2019

Blockchain & Digital Assets Alert 

Author(s): Kenneth Choy

Hong Kong’s Securities and Futures Commission issued a position paper to announce a new voluntary framework for the licensing and regulation of virtual asset trading platforms. Under the new scheme, qualified crypto exchange operators may apply for a license covering Type 1 (dealing in securities) and Type 7 (providing automated trading services) regulated activities. Upon licensing, compliance may require frequent reporting and close supervision, monitoring, and review by the SFC over the exchange’s operations, internal controls and risk management. In addition, licensed operators will be required to be in the SFC’s regulatory sandbox and subject to close supervision and monitoring by the SFC.

A year ago, Hong Kong’s Securities and Futures Commission (SFC) announced that it was setting up a financial sandbox for virtual asset trading platforms to learn how cryptocurrency exchanges operate. The sandbox was intended to help the SFC decide if it was appropriate to issue operating licenses to qualified exchanges and thereby regulate their activities. We reported on this announcement last year. After a year of consideration, on November 6, 2019, the SFC issued a position paper to announce a new framework for the licensing and regulation of virtual asset trading platforms.

The new program is voluntary and open to crypto exchanges trading virtual assets deemed as “securities” or “futures contracts” under Hong Kong’s Securities and Futures Ordinance (SFO). This is because the SFC acknowledges that under the SFO, its regulatory powers are limited and if a virtual asset does not fall within these definitions, trading of these virtual instruments would not be considered regulated activities over which it had regulatory authority.

The new scheme allows crypto-exchanges to “opt-in” to a regulated environment provided that they trade at least one qualifying virtual asset. If an exchange only trades non-security virtual assets, the SFC acknowledges it has no power to regulate its activities. The introduction of licensing is intended by the SFC to distinguish between licensed and un-regulated trading platforms so that investors may have a choice when trading their virtual assets.

In its position paper, the SFC makes clear that the new scheme only provides a framework for licensing of virtual trading platforms, but the SFC cannot take action against licensed exchanges for market misconduct activities. Under the SFO, the SFC’s authority may only take action against market misconduct in securities and futures markets. However, a virtual asset trading platform is not a “recognized stock or futures market” under the SFO and for enforcement purposes, so virtual assets traded on such an exchange are not securities listed or traded on a recognized “market” within the scope of the SFC’s enforcement powers. Currently, the SFC’s authority is limited to granting licenses and terminating them if the platform operators do not comply with terms and conditions of their licenses.

The SFO considered centralized virtual asset trading platforms to be similar to automated trading venues or equities and futures exchanges, but that instead of trading through licensed intermediaries, the public deals with the virtual asset trading platforms directly. Thus, the SFC concluded that some of these centralized trading platforms could be held to regulatory standards similar to those required of traditional licensed automated trading service providers or securities brokers. Under the program, a qualifying operator may apply for a license covering Type 1 (dealing in securities) and Type 7 (providing automated trading services) regulated activities. Upon granting of a license, the virtual trading platform is required to stay in the regulatory sandbox under “close and intensive supervision” of the SFC for an unspecified period after a license is granted. (In its Statement last year, the SFC indicated that after a minimum of 12 months, the licensed operator may apply to the SFC to exit the regulatory sandbox.)

The licensed trading platform operator must comply with standards imposed by the terms and conditions to maintain its license. It is noted that terms and conditions of the license extends supervisory power of the SFC to all aspects of a licensed exchange’s trading services, including trading of non-securities or non-futures contracts. The justification for this reach is the requirement that the operator is fit and proper to provide regulated activities. As part of this examination, the SFC views the operator’s conduct of virtual asset trading activities as a whole, covering both regulated and un-regulated virtual assets.

Key conditions of the license require that a licensed trading platform:

  • may only offer services to professional investors, not retail investors
  • should impose stringent criteria for inclusion of virtual assets listed or traded on the platform
  • serve only investors with sufficient knowledge of virtual assets

In addition, the exchange must employ a market surveillance system from a reputable third-party service provider in addition to employing its own internal market surveillance policies and controls and that at all times, it must carry insurance covering risks associated with custody of virtual assets.

Terms and conditions of licensing also impose standards on matters relating to:

  • safe custody of assets and private key management
  • know-your-client requirements
  • anti-money laundering and counter-financing of terrorism
  • market manipulation
  • accounting and auditing
  • risk management
  • conflicts of interest
  • criteria for accepting virtual assets for listing and trading on the licensed platform

At this stage, the SFC stated that it will focus on platforms which provide trading, clearing and settlement services, and have control over investors’ assets. It will not accept applications from platforms which only provide direct peer-to-peer marketplace for transactions by investors who retain control over their own assets or trade virtual assets for investors but do not provide automated trading services directly

Upon licensing, compliance may require frequent reporting and close supervision, monitoring, and review by the SFC over the exchange’s operations, internal controls, and risk management. This may prove too burdensome for some exchanges, particularly if they may have to trade or list at least one qualifying virtual instrument to trigger the SFC’s regulatory power if they currently do not trade or list such virtual assets. These platform operators may simply decide to continue operations in an unregulated environment.

Some agree that regulation is a needed step in aligning the crypto industry with more traditional and mainstream financial products. However, the scope of the new regulatory regime is fairly narrow and will require additional legislation to be practicable for the industry. However, it is a needed first step in setting up a regulatory environment for crypto-exchanges to be accepted by the mainstream investment community. It remains to be seen if many exchanges will opt-in to this licensing program.

In addition to its position paper, the SFC also issued warnings on risks associated with trading virtual asset futures contracts, which typically “allow investors to speculate on the prices of the underlying virtual assets at a future date.” The SFC considers these instruments as extremely risky as their prices tend to be extremely volatile and may expose investors to amplified risks since these are typically highly leveraged.

The SFC warned that virtual asset futures contracts may be considered “futures contracts” under the SFO and any person who operates a platform that offers or trades “futures contracts” is required to be licensed or authorized but that the SFC has not and will not license anyone to offer or trade virtual asset future contracts. The SFC also warned that virtual asset futures contracts may be considered as “contracts for differences” under the Gambling Ordinance and that all “gambling activities in Hong Kong are unlawful except those expressly authorized.”

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

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