This week, Hong Kong's Securities and Futures Commission (SFC) issued an opt-in virtual asset trading protocol. The new regulations cover all digital asset trading platforms operating in Hong Kong. Surprisingly, due to the legal structure of the city’s financial regulatory bodies, the new regulations are purely voluntary.
As such, the SFC hopes that the new regulations will help investors to better determine a platform's licensing status. The new regulatory regime covers any exchange that offers security tokens. In other words, any token that falls under the definition of “securities” under the Securities and Futures Ordinance (SFO).
Interestingly, the decision to make the regulations opt-in was out of necessity. Basically, the SFC is bound by the Securities and Futures Ordinance (SFO). As such, the SFC can only provide enforcement up to the actions specified in the SFO. Basically, the SFC must wait until the SFO is amended to include digital assets prior to creating a mandatory stature on digital securities.
Opt-in Virtual Asset Trading
The new regulatory regime was first announced by the SFC CEO Mr. Ashley Alder at this year’s Hong Kong Fintech Week 2019. During the announcement, Alder explained the details set out in the SFC’s position paper. Importantly, the Position Paper is an extension of the SFC’s statement made on 1 November 2018 in regards to online virtual assets exchanges.
As it stands today, you can think of these regulations as a conceptual framework for the potential regulation of exchanges. Basically, virtual asset trading platform operators can base their company's operations on these regulations to ensure they remain compliant, even during the development of further regulations in the sector.
The Position Paper detailed terms and conditions applicable to the licensed platforms. It also states the reason for the opt-in licensing mechanism and the overall goal of the concept which is to help investors better distinguish regulated platforms from unregulated ones.
Opt-in Virtual Asset Trading
Any virtual asset trading platform that operates within the city limits of Hong Kong should evaluate the Position Paper carefully. The document can help a company to determine whether it would benefit from a regulated status. Additionally, the paper helps new exchanges determine what changes they need to make in order to receive licensing in the sector.
As it stands today, the SFO only has jurisdiction of virtual assets that fall within the definition of securities. In other words, trading of virtual assets that are not securities tokens will not be subject to these regulations, market misconduct, or other provisions listed in the paper.
What's in the Regulations – Opt-in Virtual Asset Trading
According to the Position Paper, any centralized virtual asset trading platform that offers the trading of at least one security token in Hong Kong can apply for a license. There are two types of licenses available. These licenses include Type 1 (Dealing in Securities) and Type 7 (Providing Automated Trading Services) licenses. Once a firm receives a license, it automatically qualifies for the SFC’s regulatory sandbox.
Any exchanges that wish to apply for an SFC license must meet a few key requirements. For one, the exchange must be based in Hong Kong and operated by one group entity only. Additionally, all trading business activities of the group in Hong Kong and the active marketing must originate from the same firm.
Opt-in Virtual Asset Trading Oversight
Once licensed, the exchange is subject to the SFC’s oversight. This requirement means that licensed exchanges must comply with the paper's specific licensing conditions and additional terms. In the event that the exchange fails to do so, the SFC will take disciplinary action against licensed platform operators for breaches of the conditions listed in the paper.
Interestingly, non-security tokens traded on a licensed platform will not be authorized by the SFC. Basically, ICOs won't require registration under the Winding-Up and Miscellaneous Provision Ordinance.
Regulatory Requirements for Licensed Platforms
As a licensed exchange, operators must seek the SFC’s prior written approval to offer new services or products to their users. This requirement extends to both securities tokens and non-securities tokens.
Also, all licensed exchanges must provide monthly business reports by the end of the second week of each calendar month. This is a common practice for traditional securities firms. On top of the monthly reports, these exchanges need to find an independent auditor to conduct an annual review of the licensed operator’s business operations. Exchanges need to submit reports for review to the SFC by the end of the fourth month of each year.
Opt-in Virtual Asset Trading Matches Securities Regulations
Importantly, nearly all the terms and conditions of the new licensing are based on the current existing framework for the regulation of securities and futures contracts. These terms fall under the SFO and it's subsidiary legislation. This legislation includes the Code of Conduct for Persons Licensed by or Registered with the SFC, guidelines, and circulars issued by the SFC. In some cases, additional requirements applicable specifically to digital asset trading activities apply.
Additionally, all licensed exchanges need to maintain sufficiently liquid assets of at least 12 months of their actual operating expenses on a rolling basis according to the documentation. Also, exchanges are now responsible to conduct due diligence on each virtual asset prior to admitting it to the platform.
Hong Kong Regulations Moving Forward
Interestingly, the SFC stated it isn't prepared to accept licensing applications from operators of decentralized platforms at this time. Decentralized exchanges differ from their centralized counterparts in operations in some key ways. Basically, these exchanges provide a direct peer-to-peer marketplace for investors.
Opt-in Virtual Asset Trading
You have to hand it to Hong Kong's financial regulators. These guys understand that the market moves faster than regulations. As such, the new opt-in protocol provides much-needed guidance to virtual asset exchanges seeking to remain compliant as new regulations come into play. You can expect to see many exchanges make the leap towards full licensing to avoid future headaches.