Hong Kong Crypto Law – November 2018

Potential Framework for Regulation of Virtual Asset Platform Operators

Currently, none of the cryptocurrency exchanges operating in Hong Kong are licensed by the SFC. The SFC has written to exchanges warning them not to trade virtual assets which are securities but has not named the relevant virtual assets or clarified why it considered them to be securities. Generally cryptocurrencies are regarded as “virtual commodities” and thus outside the scope of the regulatory ambit of:

The Hong Kong Monetary Authority which supervises banks;
The SFC which regulates the securities and futures industry;
The Hong Kong Customs & Excise Department which regulates Money Service Operators (i.e. a currency exchange or money remittance service provider).

Recognizing its lack of jurisdiction over exchanges which solely trade non-SF virtual assets, the SFC is offering exchanges the chance to become licensed – in order to be able to set themselves apart from unlicensed exchanges – if they trade at least one virtual asset which is a security. The SFC is proposing to regulate all activities of a crypto exchange – including those relating to virtual assets that are not securities, on the basis that the trading of one (or more) security virtual assets brings the exchange within its regulatory jurisdiction. The SFC refers to this as an “opt-in” regime.

The SFC is envisaging a staged approach comprising:

An initial exploratory phase – platform operators would not be licensed at this stage. The SFC would discuss with Platform Operators its expected standards of regulation, observe their live operations, and assess whether Platform operators are appropriate for regulation by the SFC based on the performance of those trading in the Sandbox. To avoid public confusion about Platform Operators’ regulatory status, the SFC will keep Sandbox applicants’ identity confidential.
At the end of the exploratory stage, the SFC may decide not to regulate Platform Operators. If, however, it determines that they are appropriate to be regulated, it will consider granting licences for Type 1 (dealing in securities) and Type 7 (providing automated trading services) to Platform Operators subject to stipulated licensing conditions.
The Platform Operator will then move to the second stage of the Sandbox when it will need to put in place robust internal controls and will be subject to closer SFC supervision. After 12 months, the Platform Operator will be able to apply for removal of some of the licensing conditions, e.g. on ongoing reporting obligations, and exit the Sandbox.

According to the “Conceptual framework for the potential regulation of virtual asset trading platform operators” (Conceptual Framework), if a Platform Operator is interested in becoming licensed, it must:

operate an online trading platform in Hong Kong;
offer trading of at least one virtual asset that constitutes a “security” under the Hong Kong Securities and Futures Ordinance (SFO); and
provide trading, clearing and settlement services for virtual assets and have control of investors’ assets.

These basic requirements raise a number of issues:

It is not clear at what stage the Platform Operator needs to offer trading in a virtual asset which is a security – is this a requirement for entering the Sandbox and starting the “Exploratory stage”; or only for the grant of a licence? The latter interpretation makes more sense given that the licensing obligation would be triggered once a platform provides trading for a virtual asset which is a security.
It is unclear which virtual assets will qualify as “securities”. The SFC has said that most virtual assets fall outside the scope of the definition, but has not provided any explanation for that view. To be a security, a virtual asset would need to have the features of shares, debentures, a collective investment scheme, structured product or regulated investment agreement. In some cases, it may be fairly obvious – e.g. where a virtual asset entitles the holder to a share of the issuer’s profit making it similar to a share, or where the issuer will invest the token proceeds and distribute a share of the return on investment to holders, making it a collective investment scheme. Yet there will be many virtual assets where the position is uncertain. In the UK, a report of the Cryptoassets Taskforce (October 2018) noted that the complexity and opacity of many virtual assets make it difficult to determine whether they qualify as security tokens.[4]
given that many platforms are available online, the scope of the requirement that the exchange “operates” in Hong Kong needs clarification.

Given that the framework proposed is entirely voluntary, and the SFC may decide at the end of the “exploratory phase” not to licence crypto exchanges, it is difficult to see how Hong Kong is intending to comply with the FATF’s latest recommendation. Possibly the intention is to indicate to FATF that Hong Kong is doing something. Moreover, the licensing conditions and regulatory standards the SFC is proposing may prove unattractive for exchanges.

Proposed Licensing Conditions

If the SFC grants a licence to a qualified Platform Operator, it will impose licensing conditions which are likely to include the following “core principles”:

Services must be provided only to “professional investors”
The SFC will require platforms to limit trading activities to professional investors only. For individuals, this will require them to have a portfolio of cash and securities of at least HK$8 million. The restriction on retail customers may put off platforms which currently cater for retail clients. The move could also be criticised for disenfranchising retail investors.
All virtual asset trading activities must be conducted under a single legal entity
All virtual asset trading activities conducted by the Platform Operator’s group which are: (a) conducted in Hong Kong; or (b) actively marketed to Hong Kong investors, will need to be carried out by a single SFC-licensed entity. Virtual asset trading activities include all virtual asset trading activities on and off the platform, and any activities that are wholly incidental to the provision of trading services.

The SFC notes in the Conceptual Framework that it will not license virtual asset trading platforms that only provide a direct peer-to-peer market place for investors who retain control over their own assets (whether fiat currencies or virtual assets). It is not clear therefore whether the SFC would allow operations to be split between those which the SFC is prepared to license and those it is not.
Transactions must be pre-funded and no leverage or virtual asset-related futures contracts or other derivatives are allowed
Platform Operators will only be allowed to execute a trade for a client if there are sufficient fiat currencies or virtual assets in the client’s account with the platform to cover the trade. Platform Operators will be prohibited from providing financial accommodation for clients to acquire virtual assets. No trading of virtual assets which are futures contracts or other derivatives is allowed. The limitation on providing margin financing could act as a deterrent.
Prohibition on trading ICO tokens in initial 12 months
A virtual asset issued by way of an initial coin offering (ICO) will only be acceptable for trading at least 12 months after completion of the ICO, or when the ICO project has begun to generate profit, whichever is earlier.

[4] Cryptoassets Taskforce: final report. October 2018 at page 20.