Out-Law Analysis | 20 Jan 2023 | 3:23 am | 4 min. read
A new licensing regime will be introduced for virtual asset service providers in Hong Kong Special Administrative Region (SAR). This is seen by many to be a huge step by the city to recognise and facilitate retail trading of crypto assets in the market.
Hong Kong SAR has recently approved a new proposal to establish a new licensing regime for virtual asset service providers (VASPs), requiring them to carry out customer due diligence (CDD) and comply with record-keeping requirements, as is already the case for financial institutions (FIs) and designated non-financial businesses and professions (DNFBPs). The changes have been introduced through amendments to the current Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615) (AMLO), and will come into operation in phases starting from April to July 2023. The Hong Kong Bills Committee has recently published a report (23-page / 338KB PDF) providing insight into the Hong Kong SAR administration’s consideration and policy initiative behind this new regime.
Hong Kong SAR has been leading the way globally in implementing a regulatory regime for VASPs. This regulatory move will serve as the basis of allowing and facilitating future cooperation with the overseas market. VASPs should review internal compliance measures to make sure they can meet the additional AML requirements as they come into operation over the next six months. They should also monitor the licensing requirements as further guidance from the regulator, the Securities and Futures Commission (SFC) is expected.
The primary objectives of this licensing regime are to combat money laundering and terrorist financing relating to virtual assets, and to provide a clear regulatory framework for the market to protect investors.
Those in the VA space should get prepared to meet the requirements. Records and document management would become increasingly important as the regulatory landscape further develops in Hong Kong SAR. It’s time to review whether your records/ documents are comprehensive and ready.
Given the highly technical and speculative nature of the virtual assets industry, the Hong Kong SAR administration and the regulators both consider it to be the prudent approach to restrict these services to professional investors, by imposing this onto licenced VASPs as part of the licensing conditions. Some market participants suggest that, instead of excluding non-professional investors from the service, enhancing investor education and performing suitability tests by licensed VASPs on the customers may actually be better solutions. This issue is still being considered by the regulators and it is expected that the SFC will conduct consultation on the detailed regulatory requirement in the coming months.
Under the new licensing regime for VASPs, any person seeking to carry on a business of providing a “VA service” will be required to obtain a VASP licence from the Securities and Future Commission (SFC).
In this context, “VA service” is defined to mean operating a VA exchange: that is to say, providing services through means of electronic facilities through which service users will conduct binding transactions to purchase VAs offer to sell VAs in exchange for money or any other kind of VA and where, in providing such services, client money or client VAs will come into direct or indirect possession of the service provider.
However, not all digital assets are VAs. In more technical terms, a VA includes three essential elements: a cryptographically secured digital representation of value that is expressed as a unit of account or a store of economic value; it can be transferred, stored or traded electronically; and it can be used to pay for goods or services, to discharge of a debt and investment, or to provide rights, eligibility or access to vote on matters related to any cryptographically secured digital representation of value. Common examples include cryptocurrencies and other asset classes in the virtual world, that satisfy these three elements.
Non-fungible tokens (NFTs) are generally unique cryptographic tokens that exist on a blockchain which cannot be replicated. Whether an NFT falls under the new regime will depend on its nature and function in practice rather than the marketing terminology used.
Some NFTs are designed to be collectibles and are not intended to be convertible into money or another medium of exchange accepted by the public. These NFTs may fall within the meaning of “limited purpose digital token” and would be excluded from the ambit of the new licensing regime. However, there are also NFTs that contain ‘fungible’ elements or allow holders to vote on their arrangement. In these circumstances, the arrangement of the NFT may constitute a VA. Whether the characteristics of a specific NFT go beyond the boundary of a collectible will be determined on a case-by-case basis.
Under the new licensing regime, the SFC will only grant a VASP licence to locally incorporated companies with a permanent place of business in Hong Kong SAR or non-Hong Kong companies registered in Hong Kong SAR. Each VASP applicant is required to have at least two responsible officers who will assume general responsibility of overseeing the operation of the licensed VASP. Additionally, individuals may also apply to be licensed representatives to provide VA service on behalf of the licensed VASP.
In considering whether to grant a VASP licence, the SFC must be satisfied that the applicant, its responsible officers and licensed representatives are fit and proper persons. The SFC will consider factors such as the applicant’s financial status or solvency, education and qualifications, experience and reputation, character, reliability, financial integrity, and also whether there is any record of AML-related convictions.
On granting the VASP licence, SFC may also impose certain conditions. These may include requiring the VASP to have adequate financial resources, sufficient risk management policies and procedures, proper keeping of client assets, suitable VA listing and trading policies, proper financial reporting and disclosure, as well as mechanisms to prevent market manipulative and abusive activities and conflicts of interest.
It is expected that the SFC will publish further guidelines in relation to the licensing requirements and licence conditions in the near future.
Before the creation of this new, dedicated licensing regime, Hong Kong SAR adopted a more fragmented approach towards VA activities under a principle known as “same activity, same risks, same regulation” (9-page / 187 KB PDF). Regulation of VA activities was still at a developing stage, under which only VA trading platforms that offered trading of security tokens could apply for a licence from the SFC.
Co-written by Sara Chan of Pinsent Masons.