Hong Kong Crypto Law – November 2018
- Hong Kong Crypto Regulation
- Potential Framework for Regulation of Virtual Asset Platform Operators
- Regulation of Virtual Asset Portfolio Managers
- Virtual Asset Fund Distributors
Ongoing Regulatory Standards
If a Platform Operator is granted a licence, it will be required to comply with the Hong Kong Securities and Futures Ordinance (SFO) and its subsidiary legislation as well as the Code of Conduct for Persons Licensed by or Registered with the SFC (Code of Conduct) and other codes and guidelines issued by the SFC.
In particular, licensed Platform Operators would need to comply with know-your-client procedures under paragraph 5.1 and the suitability requirement under paragraph 5.2 of the Code of Conduct, as well as the Guideline on Anti-Money Laundering and Counter-Financing of Terrorism.
The SFC has also set out terms and conditions that would generally apply to licensed Platform Operators, although these will be subject to variation depending on a Platform Operator’s particular business nature, size and model and the outcome of discussions with the SFC.
1. Financial Resources
Platform Operators will need to assess whether they are able to meet the financial qualification requirements.
To be licensed as a securities dealer and provider of automated trading services, a Platform Operator will need minimum paid-up share capital of HK$5 million and minimum liquid capital of HK$3 million under the Securities and Futures (Financial Resources) Rules.
The SFC may additionally require (on a case-by-case basis) Platform Operators to maintain a reserve equivalent to 12-months of operating expenses to cushion them against risks of theft and hacking.
2. KYC, AML and CTF Obligations
As licensed entities, platform operators would be required to perform know-your-client, AML and CTF procedures. They will also have to comply with the suitability requirement – i.e. ensure that any recommendation or solicitation made to clients with regard to virtual assets is “suitable” having regard to the information about the client of which they are or should be aware through due diligence (exemptions from this requirement are available for institutional professional investors and, subject to performing certain procedures, corporate professional investors).
With regard to AML and CTF, the SFC highlights in its Regulatory Statement that Platform Operators’ inability to comply with requirements on AML and CTF due to the anonymity of blockchain transactions may be a reason why the SFC ultimately determines that Platform Operators are not suitable for licensing. It states “the SFC is not certain at this stage whether platform operators would satisfy the expected anti-money laundering standards, given that anonymity is the core feature of blockchain, … the underlying technology of virtual assets”.
Many exchanges are already voluntarily adopting KYC and AML procedures. However, the Conceptual Framework would impose additional detailed obligations in relation to KYC/AML including requirements to:
- conduct all deposits and withdrawals of fiat currencies for a client’s account through a designated bank account opened in the client’s name with an authorised financial institution in Hong Kong or other jurisdictions agreed by the SFC;
- apply enhanced due diligence and ongoing monitoring in specified circumstances including transactions involving virtual assets with higher risk or greater anonymity (such as virtual assets which mask users’ identities or transaction details) and transactions with tainted wallet addresses such as “darknet” marketplace transactions; and
- have systems in place that are able to:
- identify and prohibit transactions with virtual asset addresses where there is a reasonable suspicion that it is used for the purposes of conducting fraud or any other criminal activity; and
- track virtual assets through multiple transactions to allow accurate identification of the source and destination of virtual assets.
3. Knowledge Requirement
Except in the case of institutional professional investors, Platform Operators will be required to assess a client’s knowledge of virtual assets (including risks associated with virtual assets) prior to provision of service. If a client does not have the required knowledge, a Platform Operator would only be able to provide services to the client if it would be acting in the client’s best interests.
This requirement is likely to be problematic for Platform Operators since the SFC does not provide guidance as to what will be considered to be sufficient knowledge or the circumstances in which a trade could be considered to be in a client’s best interests. Sufficient knowledge will be particularly difficult to assess given that virtual assets are a recent phenomenon and they vary widely. Would experience of trading Bitcoin, for example, be regarded as providing sufficient knowledge for the trading of ICO tokens? The Circular to intermediaries distributing virtual asset funds, which also imposes a knowledge assessment obligation on distributors, provides that licensed corporations may take into account a client’s prior investment experience in private equity or venture capital or whether they have provided capital for a start-up business in the previous two years. The SFC should confirm whether this would also apply to Platform Operators assessment of client knowledge.
4. Due Diligence on Virtual Assets Admitted to Trading
One of the most onerous obligations to be imposed is the requirement that Platform Operators perform all reasonable due diligence on virtual assets before listing them. Despite the broad scope of the obligation, the specified areas that Platform Operators may consider for these purposes are broad and imprecise and Platform Operators are likely to experience considerable difficulty in conducting due diligence for example in relation to:
- the security infrastructure of the blockchain protocol underlying the virtual asset and whether it may be susceptible to attack by miners controlling more than 50% of the network’s mining hash rate or computing power;
- the accuracy of the marketing materials and the requirement that they are not misleading;
- the demand, supply, maturity and liquidity of the virtual asset.
Platform Operators will need to establish and disclose their criteria for admitting virtual assets for trading. If a Platform Operator receives payments for admitting virtual assets to trade, its fee structure must avoid any actual, potential or perceived conflict of interest (e.g. by imposing a flat rate for all virtual asset issuers).
Another potential difficulty for Platform Operators may be fulfilling the requirement to take out insurance against theft or hacking.
6. Market Manipulation and Abuse
Platform Operators will be made responsible for preventing market manipulation and abuse.
7. Public Disclosure
Licensed Platform Operators would be required to make public information as to their fees and charges; the trading rules governing their platform operations and their criteria for admitting virtual assets to trading.
8. Ongoing Reporting Obligations
Potential ongoing reporting obligations will include requirements to report to the SFC details of new virtual assets to be admitted to trading on the platform and the identities and locations of its clients at month-end.
9. Other Requirements
Other, less onerous obligations include:
- Implementing written policies and procedures governing employees’ dealings in virtual assets;
- Prioritizing clients’ orders over orders for the Platform Operator’s account, accounts in which it is interested or the accounts of its employees or agents; and
- Holding clients’ money and virtual assets in a segregated account.
While Platform Operators are operating in the Sandbox, the SFC may further consider or refine its regulatory and supervisory approach through discussions with them. Licensing conditions (and terms and conditions) imposed will be made public. The SFC may also issue further guidance depending on developments in virtual asset-related activities.