Hong Kong’s Proposed Licensing Regime for Over-the-Counter Virtual Asset Trading

Hong Kong’s Proposed Licensing Regime for Over-the-Counter Virtual Asset Trading

Hong Kong’s Proposed Licensing Regime for Over-the-Counter Virtual Asset Trading 1400 788 Hauzen LLP

On 8 February 2024, the Financial Services and the Treasury Bureau (“FSTB”) of Hong Kong released a consultation paper outlining proposed legislative changes to regulate over-the-counter (“OTC”) trading of virtual assets (“VA”). This proposal aims to address the growing concerns surrounding the potential for money laundering and terrorist financing (“ML/TF”) risks associated with VA activities, while also ensuring adequate investor protection.

The consultation paper proposes the introduction of a new licensing regime for providers of VA OTC services under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615) (“AMLO”).

The Need for Regulation

The paper highlights the increasing global consensus on the need for VA regulations to mitigate ML/TF risks. The inherent anonymity and decentralization of VA transactions make them susceptible to abuse by criminals. To address the ML/TF risks, the Financial Action Task Force revised its standards, under Recommendation 15, to mandate jurisdictions to regulate VA service providers for anti-money laundering and counter-terrorist financing (“AML/CTF”) purposes.

While Hong Kong already has a licensing regime for VA trading platforms (“VATPs”) under the Securities and Futures Ordinance (Cap. 571) (“SFO”), the consultation paper points to the emergence of unregulated VA OTC activities, particularly physical VA OTC shops, which pose significant risks to investors. These shops have been implicated in fraudulent schemes, channeling retail investors’ funds through deceptive means.

The well-known JP-EX crypto scandal of 2023 in Hong Kong comes to mind. We understand that this event and another similar crypto scandal in Hong Kong (the Hounax scandal) were largely behind this proposal to regulate VA OTC operations.

Scope of the Proposed Regime

Under the proposed regime, anyone offering spot trading of any VA in Hong Kong must obtain a licence from the Commissioner of Customs and Excise (“CCE”). The proposed licensing regime will cover all VA OTC services, regardless of whether they are provided through physical outlets or digital platforms. The scope of regulation will encompass:

  • Spot trading of VA: The regime will cover any business activity involving the spot trading of VA, excluding peer-to-peer trading between individuals unless it forms the business activity of either party.
  • Temporary custody/escrow service: The consultation paper seeks views on whether temporary custody/escrow services provided by VA OTC operators as part of the transaction process should be included in the regulatory remit and if dedicated requirements should be established for such services.

Eligibility and Regulatory Requirements

To be eligible for a licence, applicants must be:

  • A locally incorporated company with a permanent place of business in Hong Kong; or
  • A company incorporated elsewhere but registered in Hong Kong under the Companies Ordinance (Cap. 622).

Licensees will be subject to a fit-and-proper test and other regulatory requirements, including:

  • AML/CTF obligations: Licensees will be required to comply with the AML/CTF requirements stipulated in Schedule 2 to the AMLO, including customer due diligence and record-keeping.
  • Robust regulatory requirements: To mitigate risks associated with system failure or security breaches, licensees will need to meet specific requirements related to their operational capacity, know-how, and security measures. These requirements include, inter alia, the following:
    • Appointment of a competent Compliance Officer and a Money Laundering Reporting Officer;
    • Proper corporate governance structure staffed by personnel with the necessary knowledge of and experience with VA;
    • A licensee needs to operate its business in a prudent and sound manner, and ensure that clients and public interests will not be adversely affected;
    • A licensee needs to act honestly, fairly, with due skill, care and diligence, in the best interests of its clients and the integrity of the market, as well as comply with all statutory and regulatory requirements applicable to the conduct of its business activities;
    • A licensee is required to have in place appropriate risk management policies and procedures for managing ML/TF, cybersecurity and other risks arising from its activities that are commensurate with the scale and complexity of its business; and
    • Maintenance of proper records of transactions and fund flows, which will be accessible to CCE as and when CCE considers necessary.

In Scope and Out of Scope Activities

  • Restricted activities: Licensees will be restricted to providing VA-fiat (and vice versa) spot trading services and subsequent remittance of exchange proceeds or transfer of VA under specified conditions[1].
  • Prohibited activities: Licensees will not be permitted to provide VA-to-VA trading services, any form of VA advisory or referral services, offer VA derivatives, or engage in other financial product offerings like staking, lending, or margin trading. They will not be allowed to, directly or indirectly, provide custody/escrow service of clients’ VA unless the custody/escrow service is temporary in nature and is an indispensable part of the transaction process.
  • Limited VA offerings: Licensees will only be allowed to offer services in respect of VA available for retail trading on at least one SFC-licensed VATP and stablecoins issued by issuers licensed by the Hong Kong Monetary Authority (“HKMA”) (subject to the implementation of the stablecoin regime).

To avoid overlapping with existing licensing regimes, SFC-regulated VATPs, HKMA-regulated stablecoin issuers (subject to the implementation of the stablecoin regime), licensed corporations[2] and authorized institutions[3] are exempt from the VA OTC service provider licensing regime. The FSTB aims to facilitate a smooth transition for existing legitimate VA OTC operators into the new regime. To this end, it is considering two potential transitional arrangements, each with a six-month transition period.

The consultation paper sought public feedback on the proposed licensing regime before 12 April 2024, encouraging stakeholders to provide their views on the proposed framework. The FSTB intends to utilize the feedback to introduce a bill on the proposed regime into the Legislative Council as soon as practicable.

Response to the consultation has been overwhelming, and has prompted the CCE into a realization that VA OTC activities are far more pervasive, and relevant to Hong Kong’s overall economy, than simply being limited to corner-store exchange operators. It is therefore likely that a further consultation will be forthcoming.

Contact us today to find out more about cryptocurrency regulation and our cryptocurrency expertise.

 

[1] To provide services on remittance of fiat money, based on the “same activity, same risks, same regulation” principle, licensees will need to apply for a money service operators licence. To transfer VA after sale to clients, licensees will only be allowed to transfer the VA concerned from their registered wallets with CCE to a client wallet in respect of which the clients can provide proof of ownership and/or control. Use of a wallet not owned by the VA OTC client will not be allowed.

[2] A licensed corporation means a corporation (that is not an authorized institution) which is granted a licence to carry on one or more regulated activities under sections 116 and 117 of the SFO. When offering FRS, licensed corporations must hold a licence for Type 1 regulated activity (dealing in securities) and be permitted by the SFC to carry out dealing in virtual assets.

[3] An authorized institution means a licensed bank, a restricted licence bank or a deposit-taking company under the Banking Ordinance (Cap. 155).

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