Etelka Bogardi and Amy Chung say Hong Kong’s efforts to regulate the crypto sector and stablecoin market are on the whole in line with international trends while leaving room for further development.
Hong Kong has had a number of notable regulatory developments in the past twelve months affecting the crypto sector. These developments are in line with international trends and seek to move Hong Kong towards a more robust regulatory oversight framework, as crypto activity across the territory shows no signs of abating. Not surprisingly, traditional banks are also increasingly active in this space, ranging from buying virtual plots of land to establish their digital presence in the metaverse or developing institutional custody solutions in the crypto space. With the recent flurry of activity, this article revisits some of the key developments in Hong Kong over the last twelve months, and explores the potential ramifications of these changes on the market.
Licensing regime for VASPs
On 3 November 2020, the Financial Services and the Treasury Bureau (FSTB) published a consultation paper on its proposals to amend the Anti-Money Laundering and Counter Terrorist Financing Ordinance (AMLO) to bring exchanges which offer virtual assets (VA Exchanges) that do not qualify as “securities” (such as Bitcoin and altcoins) within the regulatory oversight of the Securities and Futures Commission (SFC). The SFC currently operates a regulatory framework for virtual asset trading platforms (VATPs) on an opt-in basis, available only to exchanges that offer trading in at least one token that qualifies as a security under the Hong Kong securities regime. The new rules (the VASP regime) were designed to close the existing regulatory gap and regulate certain providers of non-securities virtual assets services for the first time.
The FSTB published its consultation conclusions on the VASP regime in May 2021 after receiving broad support from the public on its legislative proposal. A number of refinements were made to the original proposal, including expanding the eligibility requirements to not only allow Hong Kong incorporated companies with a permanent place of business in Hong Kong to apply for a VASP licence, but also companies that are incorporated elsewhere but registered in Hong Kong under the Companies Ordinance. According to a discussion paper tabled at the meeting of the Legislative Council Panel on Financial Affairs in February 2022, an amendment bill is expected to be introduced into the Legislative Council in the second quarter of 2022. The VASP regime will likely come into effect in 2022/2023.
Implications on the market
Offshore exchanges: The proposed VASP regime will prohibit any person from actively marketing a regulated virtual assets activity (or services associated with a VA Exchange) to the Hong Kong public, unless it is licensed by the SFC. At present, the draft rules do not clarify what the term “actively markets” means, other than drawing a parallel with the “actively markets” concept under existing securities legislation. Crypto exchanges are awaiting the release of formal rules to determine their application and regulatory reach given that there is currently no statutory guidance on the meaning of “actively markets” in the securities legislation (although supplemental guidance is offered by way of FAQs and case law). When formal rules and guidance are released, offshore crypto exchanges will need to carefully review their activities to ensure that they do not (inadvertently) fall foul of the rules.
Extension to other VASPs: The VASP regime will initially only apply to exchanges dealing in virtual assets but as the proposed licensing regime will have flexibility built in to enable modification, the regulatory perimeter will likely expand over time to capture other types of service providers. This would be in line with existing Financial Action Task Force (FATF) guidance that targets are wider spectrum of VASPs.
HKMA discussion paper on stablecoins
The Hong Kong Monetary Authority (HKMA) issued a discussion paper on 12 January 2022 on crypto-assets and stablecoins. The HKMA has been considering the need to revise the scope of the existing stored value facilities legislation to capture payment-related stablecoins (or alternatively, introduce new legislation) due to the possible risks that payment-related stablecoins may pose to financial stability.
Whilst these proposals are very much in the discussion phase, it appears that regulation of stablecoins is a matter of when, rather than if. The proposals put forward in the discussion paper, a wide range of activities (collectively, Stablecoin Activities) may become subject to licensing and regulatory requirements, including:
- issuing, creating or destroying stablecoins;
- managing reserve assets to ensure the stabilisation of a stablecoin’s value;
- authorising or verifying the validity of transactions and records;
- storing the private keys to access the stablecoins;
- facilitating stablecoin holders to redeem stablecoins to fiat currencies or other assets;
- ensuring settlement of transactions and the transmission of funds; and
- executing transactions in stablecoins.
Under the HKMA’s proposals, a foreign company or group cannot carry out, as a business, the proposed Stablecoin Activities in Hong Kong or actively market to the public of Hong Kong such activities. Instead, they will need to incorporate a company under Hong Kong law, and the Hong Kong incorporated company would be the entity to apply to the HKMA for a licence and hold that licence if and when granted. A mere Hong Kong branch or office of a foreign corporation will be regarded as not meeting the requirement of being “an entity incorporated in Hong Kong”.
Possible overlap with VASP regime?
Although the HKMA is still soliciting feedback on its proposals, it has clearly expressed that it intends to be the frontline regulator for administering the new regime to govern payment-related stablecoins. While the HKMA has acknowledged that there may be possible regulatory overlap with the VASP regime, it assures the industry that it will work with other financial regulators to develop an appropriate and cohesive framework, with a view to reducing any regulatory arbitrage. The HKMA has stated that the new regime will be introduced no later than 2023/2024.
Joint circular issued by the HKMA and the SFC
On 28 January 2022, the HKMA jointly issued a circular with the SFC which comprehensively sets out requirements that licensed intermediaries (corporations licensed by the SFC and authorised institutions registered with the HKMA) are required to comply with when conducting virtual assets (VA) related activities. “VA-related activities” covers, (i) the distribution of VA-related products; (ii) the provision of VA-dealing services; and (iii) provision of VA-advisory services (each activity is specifically defined in the circular). For intermediaries that are already providing VA-related activities to existing clients, there will be a six-month transition period (i.e. until 28 July 2022) to comply with the new requirements.
The guidance is a welcome development as it clarifies what licensed intermediaries can do within this space and provides a greater level of certainty across the market on minimum expected conduct.
How does this change the state of play?
A few important ramifications emerge from the joint circular:
Additional investor protection: The regulators have imposed additional investor protection measures on the distribution of VA-related products citing, among other things, that a number of overseas VA-related non-derivative products, such as VA exchange-traded funds and exchange-traded products are investing directly in VAs. Such additional measures comprise selling restrictions and a VA-knowledge test.
In terms of selling restrictions, the regulators explained that except for a limited suite of products, VA-related products which are considered complex products should only be offered to professional investors. For example, an overseas VA non-derivative ETF would very likely be considered a complex product and it should only be offered to professional investors. Having said that, it is perhaps an encouraging sign that the circular no longer takes an overarching “professional investors only” approach to VA-related activities, and an (albeit limited) suite of VA-related products may be suitably for distribution to non-professional investors, subject to compliance with all relevant investor protection requirements.
Partnering with licensed platforms only: intermediaries must partner with SFC-licensed VATPs to provide VA-dealing services when introducing clients to the platform for direct trading or establishing an omnibus account with the platform. Currently, the SFC has only granted one licence under the VATP regime, although a number of other platforms are in the process of obtaining a licence. The introduction of this requirement is likely to encourage more platforms to seek licensing, and significantly reduce the scope within which an unlicensed platform can operate in Hong Kong going forward. It also suggests that the SFC may be prepared to grant more VATP licences to cater for the likely spike in demand as a result of the new rules.
Lastly, at the same time as releasing the joint circular, the HKMA issued a separate circular to provide additional guidance to authorised institutions (AIs) in respect of their dealings with VAs and VASPs. The guidance provides that prior to engaging in any VA activities, AIs should undertake appropriate due diligence and risk assessments, discuss their intention to engage in such activities with the HKMA (and other regulators where appropriate), and obtain the HKMA’s feedback on the adequacy of their risk-management controls.
Encouragingly, the HKMA has made it clear that it does not currently intend to prohibit AIs from incurring financial exposures to VAs, such as through investment in VAs, lending against VAs as collateral, or allowing their customers to use credit cards or other payment services to acquire VAs. This is on the basis that AIs have put in place adequate risk-management controls, with sufficient oversight by their senior management over such activities.
Whilst there has been some market feedback that the recent regulatory developments will make Hong Kong less competitive in the crypto sector as a result of some of the restrictions on the retail segment and the requirement to partner only with SFC licensed VA exchanges, the regulatory guidance is nevertheless welcome, as it provides an initial roadmap for market participants, including established financial services providers.
The relevant guidelines leave room for development to the regulatory perimeter (including the retail space), and whilst signifying a cautious approach, are on the whole in line with the international trend of further regulation. This year we expect regulators to continue to grapple with the further expansion of DeFi solutions, increasingly complex crypto related products, as well as the growth of the NFT market and its widening use cases.
This article was contributed to Regulation Asia by Norton Rose Fulbright Partner Etelka Bogardi and Associate Amy Chung.