HK’s SFC Finalises New Regulatory Framework For Virtual Asset Trading Platforms

Herbert Smith Freehills | William Hallatt and co-authors | Nov 22, 2019

digital and virtual - HK's SFC Finalises New Regulatory Framework For Virtual Asset Trading PlatformsOn 6 November 2019, Hong Kong's Security and Futures Commission (SFC) issued a position paper setting out a new regulatory framework for the licensing of centralised virtual asset trading platforms, following the SFC's conceptual framework issued last year.

The SFC's CEO, Ashley Alder, made clear in his speech at Hong Kong FinTech Week that the new framework is intended to be "principles-based and technology neutral", applying consistent principles of investor protection in order to encourage "FinTech to flourish in a way that promotes a high level of confidence in all who participate". The new framework is comparable to the regulatory standards for licensed security brokers and automated trading venues, adapted to deal specifically with the technology on which the virtual asset trading platform industry is based.

Platforms which "opt-in" to the new framework will no doubt benefit from the clear competitive advantage a SFC licence represents, acting as an indicator to the market and investors that the operator is willing to adhere to a high level of standards and practices.

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However, as discussed in this bulletin, the new regulatory framework which is created within the current legislative framework has a number of limitations. It also does not apply to virtual assets which are futures contracts and the SFC said that it is unlikely to issue licences to carry on a business in such contracts, given the SFC considers them to be extremely risky. The SFC has indicated it will continue to monitor the virtual asset market and explore the need for legislative changes in the longer term.

Global landscape and the SFC's regulatory approach

Together with other regulators, the SFC has taken note of the exponential growth of virtual assets (also known as cryptocurrencies, crypto-assets and digital tokens). Globally, there are now around 3,000 digital tokens and 200 virtual asset trading platforms. Notwithstanding a period of erratic volatility in 2019, the virtual asset market looks unlikely to substantially diminish.

With the entrance of greater numbers of traditional financial institutions and service providers, the virtual asset ecosystem has steadily grown and become more sophisticated in providing services comparable to traditional mainstream finance.
In Hong Kong, the SFC is principally mandated to regulate "securities" and "futures contracts". Where virtual assets fall within the scope of these definitions, they are likely to fall within the SFC's jurisdiction. However, many virtual assets, including Bitcoin, do not fall within the scope of these definitions and are likely not within the SFC's regulatory remit.

In light of this gap, the SFC has taken steps to bring some virtual asset activities into its regulatory net. In November 2018, it published a statement setting out regulations for virtual asset fund managers and fund distributors and a conceptual framework for virtual asset trading platforms. Earlier this year, it published licensing conditions for certain virtual asset fund managers.

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In the new position paper, the SFC said it remains concerned about investor protection in the virtual asset platform industry. In particular, it cited reports of platforms being hacked, with investors suffering substantial losses. It said trading rules may not be transparent and fair, and crypto markets are vulnerable to manipulation. In addition, the anonymity and other technical features of blockchain-based virtual assets are of concern from an anti-money laundering (AML) and counter-financing of terrorism (CFT) perspective.

The new regulatory framework

The SFC's new regulatory framework covers various key investor protection concerns, including the safe custody of assets, know-your client (KYC) requirements, AML/CFT and market manipulation.

The framework is essentially an "opt-in" licensing system, offering a route to licensing only for those "centralised platforms" in Hong Kong which offer trading of at least one virtual asset which is a security token. "Centralised platforms" are platforms that provide trading, clearing and settlement services, and have control over investors' assets.

Where the framework applies to a platform, it covers all platform operations, even if the majority of virtual assets traded are not securities. For example, when considering whether a licence applicant is fit and proper to be granted (and to continue to hold) an SFC licence, the SFC will take into account the manner in which the applicant conducts its entire virtual asset trading business, as this may impact upon its fitness and properness to undertake regulated activities. This includes whether the platform follows (or is willing and able to follow) expected regulatory standards, whether this involves security or non-security virtual assets and whether occurring on or off its platform.

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Licenced platforms will be subject to licensing conditions to address specific risks associated with their operations. These may include a restriction that platform services can only be provided to professional investors who can demonstrate that they have sufficient knowledge of investing in this area. Platforms may also be required to obtain the SFC's prior written approval for any plan or proposal to add products to their platforms.

Licenced platforms will also be subject to an initial period of close and intensive supervision in the SFC Regulatory Sandbox, entailing more frequent reporting, monitoring and reviews.

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