Virtual Asset Regulation - Hong Kong

[Extracted from our Client Update on issues relating to the Money Laundering Reporting Officers (MLRO), Manager in Charge (MIC) for Anti-Money Laundering and Compliance responsibilities. It should not be treated or relied upon as legal advice. Please speak to your advisors for specific advice.]

Staking a claim on the regional hub for virtual assets

On 24th June 2022, the Hong Kong government issued a bill on proposed changes to CAP 615, the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (the "AMLO", or "the Ordinance") We would normally wait for bills to become law before providing an analysis on impact, we felt this change deserved some earlier attention as it has a strategic impact on the regulation of markets in Hong Kong. The changes implement FATF recommendations that require countries to either ban or regulate service providers who operate in this space.

The History

The SFC already owns oversight over licensed firms that provide services relating to securities and futures related products. In 2018, by circular they extended their oversight to firms that also provided services in tokenised instruments but they did so by requiring those firms to at least offer some form of securities or futures based product. The HKMA and the SFC issued a joint circular in January 2022 on its expectations with regards to virtual asset related services. The joint statement superseded the 2018 circular and focused on distribution of Virtual Asset related products. It recognised that some products were being distributed to a broader audience and wanted to ensure that such distribution remained aligned with their investor protection framework. Like most product innovations being offered into the market, they wanted to ensure complex products were being limited to professional investors only investor types by ensuring its suitability obligations were being met where this occurred. They also recognised that some Virtual Asset related products, such as listed futures or Virtual Assets Exchange Traded Funds fell outside some of those limitations as they were deemed non-complex instruments. The June 2022 Bill provides for the licensing of virtual asset service providers but limited the proposed scope of activities to professional investor only classes of investors.

Since its issue, there has been a flurry of industry action to help the regulator get more comfortable that the potential risks that exist are mitigatable by the adoption of existing investor protection mechanisms.

The recent update to the plan

Just as Fintech Week starts, in an opening day speech (Source SFC), the SFC's deputy CEO signalled clearly that Hong Kong is embracing innovation in this regard. The speech highlights why the SFC is now further opening the proposed regime to the potential of providing services to retail investors as it stakes its claim to cautiously capture a regional hub status for virtual asset servicing.

The speech also referred to other updates, including a circular allowing for the launch of Virtual Assets Futures Exchange Traded Funds (VA ETFs), (although initially limited to investing in Bitcoin Futures and Ether Futures traded on the Chicago Mercantile Exchange), and offered up some concrete updates on paving the way for Security Token Offerings to be detailed in the not too distant future. These interrelated building blocks are vital to allow for curate growth of the industry.

We have prepared a summary of the AMLO proposal below for those interested in the development of the market in Hong Kong where we believe the regulator has successfully found the inflection point about which both the traditional market and the new ones can mutually draw from eachother to create a better outcome for both.

The basis of the change has been that if virtual asset transactions were allowed to continue unregulated, there would be a risk that they could proliferate to support global money laundering activities. (See latest update on FATF Virtual Asset Recommendations here (Source: FATF)),

The SFC already has oversight of securities or future contracts that are issued in the form of tokens but, the proposed update to the AMLO will provide the SFC with similar oversight powers over relevant service providers that are facilitating the sale or exchange of cryptographically secured representations of value. (i.e. crypto or virtual assets - as defined in the new Bill - Anti-Money Laundering and Counter-Terrorist Financing (Amendment) Ordinance 2022 (Source: HK companies registry)).

Apart from government issued tokens or stored value facilities (e.g. loyalty reward programs), the amended ordinance will provide the SFC with recognised powers over firms that offer or facilitate the exchange of virtual assets. The framework looks very much like the powers that they have over those firms that are involved in similar services relating to securities and futures, so will follow a tried and test path to compliance and regulation. A path that we have worn well and understand.

In practice, we expect that the activity will become an additional license type and added to the SFC's list of regulated activities that they cover. The proposed framework is substantially similar to that which exists for securities licensing. Our experience in that area, in particular, as a result of the transition to online applications through WINGS (i.e. the system that is being used for securities license applications) should allow for a smooth process. However, the experience of the relatively recent transition to online applications has not been without its own challenges. We will have to wait and see whether they will be ready to accept these new application types closer to that time.

The progress of how quickly they will process an application is an unknown factor here, despite the fact they have indeed provided for a limited transition period. If permission is required to allow access to retail markets, subject to the proposed consultation, it is likely that those applications will be subjected to greater scrutiny. Expect some further guidance to emerge.

Key AMLO updates

The Bill proposes that the SFC will adopt similar processes to licensing and oversight that it has in place for securities activities but, in the case of virtual assets, it will be under the AMLO (Cap 615) instead of the Securities and Futures Ordinance (Cap 571).

For example, there are recognisable replications on various areas of the SFO;

• Fitness and properness requirements,

• Permanent place of business or registration status under Hong Kong companies ordinance,

• 7-day notification requirements,

• At least 2 responsible officers, with oversight and responsibility for Compliance,

• Regulated Functions to be performed by licensed representatives (including Responsible Officers)

• Competency requirements (as yet undefined),

• Professional investor only licensing restrictions, (and in some product cases unrestricted),

• Annual returns,

• Auditor appointment,

• Annual Report and Accounts obligations, and

• an ability for the SFC to impose conditions, codes and guidelines on licensees.

We are aware that the SFC has been preparing for the new regime through their exposure to the securities token space and that their ability to regulate such markets has been carefully reviewed and considered over the last 5 years.

Transition

An interesting transition process has been proposed for the first 9 months after the proposed implementation (March 2023) that will potentially allow applicants to operate while decisions are being made about their approval. As with the current licence application process, it will be an offence to make false representations during dealings with the SFC or undertake the activity without (for the first 9 months) having submitted an approved application for a license or having obtained a fully approved license. Please note that it is likely that such transitional applications will need to receive an initial acceptance to apply but the approach is likely to be confirmed nearer to commencement.

Ownership Requirements

One interesting nuance that we have noted, is that the AMLO diverges from the SFO with regards to substantial shareholders, adopting a less opaque definition, that is more aligned with ultimate beneficial ownership definitions included in the AMLO. This may be of interest to those who have struggled with the SFO definitions to date.

New Offences

Once in force, it will be an offence to market virtual asset services to/from Hong Kong without a license and to make fraudulent or reckless misstatements for the purpose of inducing persons to invest in such type of assets, whether the transaction is conducted within or outside a licensed exchange venue. This will therefore capture relevant activities by persons other than those licensed to provide virtual asset services (e.g. advisory or asset management firms who may provide an opinion on the market).

Recognising the unique opportunities for market misconduct, the bill also introduces a broad catch all offence called “Offence involving fraudulent or deceptive devices etc. in transactions in virtual assets” which has been defined to include activities in which a person, directly or indirectly:

This may be first time we have seen the word “etcetera” in an offence description, but it is well established that laws are designed to try to and capture the broadest definition of the offence so that it can future proof itself against criminal innovation. (Although we do expect some additional wordsmithing will take place)

While the bill may be amended before implementation, it is well developed and has benefited from over 4 years of industry and regulatory input. It may be said that Hong Kong has taken a while to get to the party, but it seems the cautious and considered approach has paid off, as it is just as important for traditional markets to adopt the technological opportunities that crypto and distributed finance offers, as it is for those innovative markets to mature into ones that can adopt traditional market control infrastructure.

As highlighted in the SFC forum, traditional finance will need to trust crypto service providers in order to allow both sides to engage in mutually meaningful relationships and the winter of crypto discontent has not completely endeared those who want to see better control environments therein.

Jurisdictions that have raced to the bottom will not do so well in helping to establish such trust in this market. We note with interest the approach that different jurisdictions will take with regards to opening to up retail investors as this develops. The comments in this weeks speech suggest that Hong Kong will be a hub for activity in near future and a viable centre for digital services. However, time and trust in the jurisdiction will tell as there are environmental and ecosystem requirements that will need to be aligned for this strategy to work.

A core element of delivering services in virtual assets is going to be market conduct and surveillance as trust will be paramount

Coincidentally, we have had the recent opportunity to discuss these proposed changes with Vince Turcotte, Director of Digital Assets, at Eventus on a recent industry educational seminar. Vince is an ex-trader with vast market experience, and extremely knowledgeable about market mechanics. He is also one of our co-lecturers on the Executive Hedge Fund Course provided by Inflection Point Intelligence which provides educational resources to persons interested in a career in finance. We often discuss technical trading matters with Vince. While neither the AMLO or the SFO definitions narrow the focus of concern due to their broad scope, the key control obligations are about being able to find and prevent activities that are not done for proper purposes or result in market impact due to reckless behaviour. Firms, and in particular those that seek retail permission, will need to be able to demonstrate that they can preserve the integrity of the market in order to meet threshold conditions.

The surveillance teams (inhouse, external, or at regulators) already know the patterns that they look for (spoofing, layering, ramp and dump, wash trades, front running and scaffolding, etc) and as with all potential regulatory issues, while you are generally considered innocent until proven guilty, if there is no evidence of proper motive, then suspicions will be aroused by recognised patterns of behaviour which would normally be considered abusive.

Training that focuses on the legal definitions will not be as practical as focusing on the behaviours that we all know to be wrong, and those behaviours are not always defined clearly in the legislation. It is left to the surveillance experts to help calibrate controls.

This is typically why it is vital to refer to cases in training, and why we are able to point to circumstances that have arisen in either local securities or futures markets, or indeed overseas markets where activities have been found to be sub-optimal to the level of behaviour that was expected. This is also going to provide direction with respect to acceptable behaviours on virtual asset markets. Often, by necessity regulators will refer to global market expectations and we have seen some recent market examples of regulatory leverage in this regard (i.e. instances where one regulator refers to the guidance produced by another on a particular matter - market sounding for example).

Market manipulation is already considered part of the AMLO, and there is a whole section on red flags that already exists in the current guidelines on Anti-Money Laundering (see appendix B page 143). The proposed new licensable activity represents a timely reminder that market misconduct, and indeed insider trading, which while considered to be something that occurs with respect to securities or exchange products, is in essence a fraud, or deception, which is a crime, resulting in proceeds being transferred to a criminal recipient. Where intent is identified, or at least reckless behaviour has occurred, it is wholly appropriate that it is covered by the AMLO in both the securities and non-securities space. We further note that while there is no insider dealing offence in the AMLO proposal, the general offence that has been created will capture the activities of those who have access to information that is not generally available to the broader market, due to having access to volume information, such as the operators of those exchange mechanisms. The SFC will have much broader powers to issue guidelines and codes under the AMLO. Therefore, it is likely that they will issue a code of conduct for virtual asset service providers and we also expect that firms seeking to be licensed for virtual service provision will be subjected to conditions that will require them to undertake appropriate and ongoing surveillance with regards to market misconduct.

Please reach out to us if you have any interest in pursuing a stand alone or additional licences in this regard. While the maths and technology may be interesting, the regulation is recognisable, and should be straight forward for those who understand the core concern relating to market misconduct risk. The processing time is at yet uncertain and there are other environmental barriers that will need to be addressed to ensure that Hong Kong stays ahead in a race that is not necessarily won by being first.

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