SFC Opens Sandbox to Crypto Exchanges

Posted 2021-04-29 Charltons HK

SFC Opens Sandbox to Crypto Exchanges

Hong Kong’s securities regulator, the Securities and Futures Commission (SFC), issued its “Statement on regulatory framework for virtual asset portfolio managers, fund distributors and trading platform operators” on 1 November 2018 setting out its regulatory approach for virtual assets.  This includes proposals for the potential regulation of virtual asset trading platforms (commonly known as cryptocurrency exchanges) in the SFC Regulatory Sandbox.

The statement follows FATF’s amendment of its recommendations on anti-money laundering and terrorist financing standards on 19 October 2018 to require countries to regulate virtual asset service providers, including crypto exchanges, for AML and CTF purposes.  In common with other securities regulators, the SFC is keen to address the significant investor protection concerns it associates with trading virtual assets.  Apart from the risks inherent in virtual assets themselves, the SFC notes particular risks associated with cryptocurrency exchanges such as their vulnerability to hacking and theft.

What are virtual assets?

Virtual assets are digital representations of value and include digital tokens such as cryptocurrencies, utility tokens, security or asset-backed tokens.  They can act as a means of payment, provide access to a product or service, confer rights to a financial return, or offer a combination of these features.

Existing regulatory regime

The SFC’s regulatory remit under Hong Kong’s Securities and Futures Ordinance (SFO) is limited to activities involving “securities” or “futures contracts”. Activities related to virtual assets are thus only regulated if the virtual asset in question is either a security or futures contract within the SFO definition.

Whether or not a virtual asset constitutes a security must be assessed on a case-by-case basis. Depending on the nature and rights attached to a particular virtual asset, it may constitute a “share”, “debenture” or interest in a collective investment scheme, all of which are “securities” under the SFO.

Cryptocurrency-related futures contracts which are traded on and subject to the rules of a futures exchange, such as Bitcoin futures contracts trading on the Chicago Board Options Exchange and Chicago Mercantile Exchange, are futures contracts under the SFO and parties dealing in these contracts for Hong Kong investors need to be licensed by the SFC. This is the case notwithstanding that the underlying asset, e.g. Bitcoin, is not considered to be a “security” and is not regulated under the SFO.

However many virtual assets are not securities or futures contracts. Operators of trading platforms which only provide trading in virtual assets that are not securities are not regulated by the SFC. None of the cryptocurrency exchanges operating in Hong Kong are currently licensed by the SFC.

Exploring Hong Kong regulation of cryptocurrency exchanges

The SFC’s proposals for the potential regulation of cryptocurrency exchanges are set out in its “Conceptual framework for the potential regulation of virtual asset trading platform operators” in Appendix 2 of its “Statement on regulatory framework for virtual asset portfolio managers, fund distributors and trading platform operators“.

The SFC is proposing to work with virtual asset trading platform operators (Platform Operators) by placing them in the SFC Regulatory Sandbox (SFC Sandbox). Participation in the SFC Sandbox will be entirely voluntary. In order to join the SFC Sandbox, a Platform Operator needs to be within the scope of the SFC’s jurisdiction and must:

• operate an online trading platform in Hong Kong;

• offer trading of at least one virtual asset that constitutes a “security” under the SFO; and

• provide trading, clearing and settlement services for virtual assets and have control of investors’ assets.

  
  

A two-stage approach will be implemented. In the initial exploratory stage, the SFC will not grant a licence to Platform Operators. Instead, it will discuss with Platform Operators its expected standards of regulation, observe their live operations, and assess whether its proposed regulations are effective to address risks and adequately protect investors. To avoid public confusion about Platform Operators’ regulatory status, the SFC will keep Sandbox applicants’ identity confidential.  This exploratory stage is intended also to provide learning opportunities for the SFC.  It acknowledges, for example, that it is currently unsure whether Platform Operators will be able to meet the SFC’s expected AML standards given the anonymity of virtual asset transactions. At the end of the exploratory stage, the SFC may decide not to regulate Platform Operators if it considers that investor protection concerns cannot be properly addressed. If, however, the SFC determines that Platform Operators are appropriate to be regulated, it will consider granting licences for Type 1 (dealing in securities) and Type 7 (providing automated trading services) to a qualified Platform Operator subject to stipulated licensing conditions.  The Platform Operator will then move to the second stage of the Sandbox when it will be subject to closer SFC supervision.

Core Principles – Proposed Licensing Conditions

If the SFC grants a licence to a qualified Platform Operator, it will impose licensing conditions which are likely to include the following core principles:

1. All virtual asset trading activities must be conducted under a single legal entity.

   All virtual asset trading activities conducted by the Platform Operator’s group which are: (a) conducted in Hong Kong; or (b) actively marketed to Hong Kong investors, will need to be carried out by a single SFC-licensed entity. Virtual asset trading activities include all virtual asset trading activities on and off the platform, and any activities that are wholly incidental to the provision of trading services.

   
   

2. All virtual asset trading activities must comply with all applicable regulatory requirements (including any licensing conditions imposed by the SFC).

   A Platform Operator will be required to comply with all regulatory requirements and licensing conditions in relation to all virtual asset trading, irrespective of whether they are “securities”.

   
   

3. Services must be provided only to “professional investors”.

   
   

4. Prohibition on trading ICO tokens in initial 12 months.

   A virtual asset issued by way of an initial coin offering (ICO) must only be accepted for trading at least 12 months after completion of the ICO, or when the ICO project has begun to generate profit, whichever is earlier.

   
   

5. Transactions must be pre-funded and no leverage or virtual asset-related futures contracts or other derivatives are allowed.

   A Platform Operator must only execute a trade for a client if there are sufficient fiat currencies or virtual assets in the client’s account with the platform to cover the trade.  Platform Operators may not provide financial accommodation for clients to acquire virtual assets.  No trading of virtual assets which are futures contracts or other derivatives is allowed.

   
   

Applicable Regulatory Standards

If a Platform Operator is granted a licence, it will be required to comply with the 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.

Proposed Terms and Conditions

Where the existing requirements under the SFO, its subsidiary legislation and the SFC’s codes and guidelines do not apply directly to a Platform Operator, or where enhanced investor protection measures are considered necessary, the SFC has set out, in the terms and conditions, the regulatory standards it would generally expect to apply to licensed Platform Operators. These terms and conditions will be subject to variation depending on a Platform Operator’s business nature, size and model and the outcome of discussions with the SFC. The following are the examples of key terms and conditions given by the SFC in the Conceptual Framework:

1. Maintaining financial resources commensurate with the role and functions the Platform Operator performs and the level of risk it undertakes;

   
   

2. Taking out insurance for risks associated with the custody of virtual assets, such as theft or hacking;

   
   

3. Except for institutional professional investors, assessing 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;

   
   

4. Establishing adequate and effective anti-money laundering and counter-financing of terrorism systems complying with the detailed requirements set out in the Conceptual Framework.  These include, among others, requirements to:

1. 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;

2. 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;

   
   

5. Disclosing the risks of trading virtual assets and the Platform Operator’s fees and charges;

   
   

6. Performing all reasonable due diligence on virtual assets before listing them on trading platforms.  Platform Operators should also 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);

   
   

7. Publishing comprehensive trading rules governing its platform operations on the Platform Operator’s website;

   
   

8. Preventing market manipulative and abusive activities;

   
   

9. Implementing written policies and procedures governing employees’ dealings in virtual assets;

   
   

10. 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;

    
    

11. Holding clients’ money and virtual assets in a segregated account; and

    
    

12. Reporting to the SFC on a regular basis (as specified by the SFC).

    
    

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.

After a minimum period of 12 months, a Platform Operator will be able to apply to the SFC for the removal or variation of some licensing conditions and exit the SFC Sandbox.

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