The Hong Kong Government has concluded a consultation on proposals to regulate virtual asset service providers (VASPs), which are, in essence, cryptocurrency exchanges. The proposed new legislation will establish a VASP licensing regime that is intended to apply where the VASP operates in Hong Kong or targets the Hong Kong market. Under this licensing regime, amongst other things, VASPs will be required to conduct customer due diligence to meet global anti-money laundering standards and will be prohibited from dealing with retail investors. In this article, we provide an overview of the proposed legislation.
In May, 2021, the Hong Kong Government published its Consultation Conclusions on Legislative Proposals to Enhance Anti-Money Laundering and Counter-Terrorist Financing Regulation in Hong Kong ("AML Consultation"). Amongst other things, the AML Consultation proposes new legislation ("VASP Regulation") to amend the Anti-Money Laundering and Counter-Terrorist Financing Ordinance ("AMLO") to establish a new regulatory framework by which the Securities and Futures Commission ("SFC") will license operators of cryptocurrency exchanges, known as virtual asset service providers ("VASPs").
The new regulatory framework will extend anti-money laundering and counter-terrorist financing ("AML/CFT") customer due diligence requirements to the cryptocurrency industry and will establish conduct of business standards for VASPs.
The new VASP Regulation enables Hong Kong to meet Financial Action Task Force ("FATF") recommendations, aiming to increase transparency, (ii) decrease hesitancy, and (iii) protect the cryptocurrency business and the public.
What is a Virtual Asset (VA)?
The VASP Regulation will apply to cryptocurrencies and other digital assets, which, in the language of the new regulation, are called "virtual assets". As proposed, the VASP Regulation will define a virtual asset as "a digital representation of value" that meets 3 criteria:
- Unit of Account or Store of Value – The asset must serve as a unit of account or a store of economic value;
- Medium of Exchange – The asset must function (or be intended to function) as a medium of exchange accepted by the public as payment for goods or services or for the discharge of a debt, or for investment purposes, and
- Electronic Dealing – The asset must be transferable, storable or tradeable electronically.
As proposed, the definition of a "virtual asset" is very broad and could capture a range of assets which are not regarded as cryptocurrencies. As a result, it is proposed that the VASP Regulation will create a number of exemptions from the definition of a virtual asset, including:
- Digital representations of fiat currencies
- Financial assets already regulated under the Securities and Futures Ordinance
- Stored value facilities regulated by the Payments Systems and Stored Value Facilities Ordinance
- Certain closed-loop, limited purpose items. Examples of closed-loop limited purpose items include credit card rewards, gift cards, and air miles.
The status of blockchain based digital assets which are traded but which are used to provide smart contract functionality is unclear. The proposed VASP Regulation will give the Secretary for Financial Services and the Treasury the power to determine either generally or in a particular case whether any digital representation of value is to be regarded as a VA or not.
What is a Virtual Asset Service Provider?
Under the proposed VASP Regulation, a VASP is person a carrying on a business in a regulated VA activity, meaning the business of operating a VA exchange. For this purpose, a "VA Exchange" will be any trading platform which:
- is operated for the purpose of allowing an offer or invitation to be made to buy or sell any VA in exchange for any money or any VA; and
- comes into custody, control, power or possession of, or over, any money or any VA at any point in time during its course of business.
Significantly, peer-to-peer trading platforms in which the platform is not involved in the underlying transaction by coming into possession of any money or any VA at any point in time fall outside the definition of VA exchange. It may be possible therefore that execution only platforms may be excluded from the scope of VASP regulation on the basis that transactions executed on those platforms are settled outside those platforms.
When Do Licensing Requirements Apply?
As proposed, the VASP licensing regime will apply when a VASP carries on a "VA regulated activity" in Hong Kong or when a VASP "actively markets" its services to the Hong Kong public. The AML Consultation does not propose any definition of the term "actively markets" and it is unclear what level of activity will trigger VASP licensing requirements. The comparable term in securities laws is notoriously difficult to construe.
A VASP which is licensed by the SFC under the Securities and Futures Ordinance under the opt-in regime will be exempt from VASP licensing under the new proposed VASP Regulation.
Who Is Eligible To Be Licensed as a VASP?
Fitness and Properness
To qualify for a license, a VASP must demonstrate that it is fit and proper. Fitness and properness will depend not only upon integrity but also on competency.
As regards integrity, the SFC will look at whether a person has been convicted anywhere of a money laundering offence or an offence involving fraud, corruption or dishonesty or has failed to observe AML/CTF regulatory requirements.
In regards competency, it appears that the SFC will look at the VASP's financial resources, its knowledge and experience, the soundness of its business, its risk management policies, how it segregates and manages client assets, its financial reporting and disclosure system, its ability to prevent market manipulation and abusive activities, and its ability to prevent conflicts of interests.
Each VASP license holder must have a minimum of two responsible officers who are intended to be personally responsible if the VASL licensee breaches any applicable regulations.
Corporate Presence in Hong Kong
A VASP licensee must be a body corporate either incorporated in Hong Kong or registered as an overseas company in Hong Kong. A VASP licensee must have a physical presence in Hong Kong. Individuals cannot apply for a VASP license.
What Conduct Of Business Requirements Apply to a VASP?
AML/CTF Customer Due Diligence
As proposed, a VASP must have in place systems and procedures to comply with AML/CTF requirements including customer due diligence ("CDD") and record-keeping requirements set out in Schedule 2 to the AMLO in common with money service operators ("MSOs") and trust and corporate service providers ("TCSPs").
A licensed VASP will only be able offer services to professional investors. In other words, licensed VASPs are not allowed to offer services to the retail public. The AML Consultation does not indicate what eligibility criteria would apply to a "professional investor" but, presumably, the definition would align with that under securities laws.
A VASP licensee must establish rigorous criteria for the inclusion of VAs to be traded on its platform.
VASP licenses will be open-ended but subject to revocation for disciplinary reasons. In contrast, licenses for TCSPs are issued for 2 year terms and must be renewed therefore every 2 years.
The SFC will regulate licensed VASPs. In addition to determining VASP licensing applications, the SFC will be given a number of regulatory powers, including the power to enter business premises to conduct inspections, to require production of documents and records, and to take enforcement action for non-compliance with regulatory requirements.
Once the VASP Regulation comes into force, it is expected that all VASPs must be licensed within 180 days. The VASP Regulation is expected to be introduced into the Legislative Council during the 2021-22 legislative session.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.