Hong Kong’s Securities and Futures Commission introduces new licensing regime to regulate previously unregulated markets and restates expectations regarding security token offerings.

By Simon Hawkins, Kieran Donovan, and Kenneth Y.F. Hui

The second day of Hong Kong Fintech Week again brought together regulators and market participants from across the fintech industry for a range of insightful discussions.

Ashley Alder, Chief Executive Officer of the Securities and Futures Commission (SFC), delivered the day’s biggest headline in his keynote speech, announcing that the Financial Services and Treasury Bureau (FSTB) would be issuing a consultation paper proposing a new licensing regime for virtual asset service providers (VASPs), effectively creating a legal framework that brings previously unregulated activities within the SFC’s regulatory perimeter. (Further analysis is available in Latham’s Client Alert on the proposed framework.)

Alder also reminded the market of certain regulatory requirements pertaining to security token offerings (STOs) as the first wave of security token trading platforms start to receive their SFC licences.

Existing “opt-in” licensing regime for virtual asset trading platforms

In November 2019, the SFC issued a position paper setting out a new regulatory framework for virtual asset trading platforms (VATPs) (see Latham’s 2019 blog post on this topic). The regulatory framework was based on the SFC’s power to regulate virtual assets that fall under the definition of “securities” under the Securities and Futures Ordinance.

Under this regime, a VATP offering trading of at least one virtual asset that is a security is able to “opt in” to be licensed and regulated by the SFC. Once licensed, all of the VATP’s business (including trading of non-security virtual assets, like Bitcoin) would fall under the supervision of the SFC.

The SFC acknowledged the limitations of this opt-in regime, noting that virtual asset exchanges that only facilitate trading in non-security cryptocurrencies would not need to be licensed by the SFC and could continue to operate as unregulated businesses. However, the SFC also stated that it would continue to monitor the development of the crypto industry and hinted that changes in law may be required in the future to enhance regulation of virtual assets.

Proposed new regime for VASPs operating virtual asset exchanges

Against this background, the FSTB is proposing a new licensing regime (New Regime) under the Anti-Money Laundering Ordinance for VASPs that operate a virtual asset exchange (VA Exchange), which means allowing an offer or invitation to be made to buy or sell any virtual asset in exchange for any money or any virtual asset (whether of the same or different type), and which comes into custody, control, power or possession of, or over, any money or any virtual asset at any point in time during its course of business. VASPs that operate VA Exchanges in Hong Kong or target Hong Kong customers will need to apply for an SFC licence — failure to do so will be a criminal offence.

The key takeaways are as follows:

  • The New Regime implements the Financial Action Task Force’s requirement to regulate VA Exchanges for anti-money laundering and counter-terrorist financing purposes and to supervise their compliance.
  • The New Regime will enable the SFC to engage its whole range of regulatory functions, including assessing VA Exchange applicants through their licence applications, monitoring VA Exchanges’ daily operations, conducting investigations, and, if necessary, enforcing rules.
  • The New Regime will only apply to centralised VA Exchanges; decentralised virtual asset exchanges will continue to fall outside of the regulatory licensing perimeter (consistent with the opt-in licensing framework for VATPs).
  • Licensed VA Exchanges, at least initially, will only be permitted to offer their services to customers that qualify as “professional investors” (e.g., high net-worth individuals with a portfolio of at least HK$8 million (around US$1 million), corporations with portfolios of at least HK$8 million (around US$1 million) or total assets of at least HK$40 million (around US$5.16 million), or institutional investors such as licensed banks, broker-dealers, and asset managers). This limited permission means that once the New Regime comes into effect, retail investors in Hong Kong may find themselves unable to trade virtual assets on exchange (though they could still access decentralised exchanges and transact with over-the-counter brokers).
  • Under the New Regime, licensed VA Exchanges will be required to segregate client assets, ensure keys are properly managed, and implement measures to deal with market manipulation activities. They also will be subject to requirements regarding financial resources, management experience, soundness of business, and risk management.
  • Once the New Regime is in place, all providers of virtual asset exchanges will either be licensed as VATPs under the current opt-in regime (for exchanges that facilitate trading in security virtual assets or a mixture of security and non-security virtual assets) or as VA Exchanges under the New Regime (for exchanges that exclusively trade in non-security virtual assets).
  • The SFC has made clear that both the opt-in regime and the New Regime will have the same regulatory standards, thereby creating a level playing field for all market participants, whether they are VATPs or VA Exchanges. Both regimes benchmark regulatory and supervisory principles that apply to traditional financial services intermediaries (e.g., securities brokers) and other trading venues.

Security Token Offerings

In his speech, Alder also advised firms planning to engage in activities relating to securities tokens and STOs should first discuss their plans with the SFC.

  • STOs have features of traditional securities offerings but are digital representations of ownership of assets (such as real estate or economic rights), and can be issued directly on a blockchain or can be a paper interest converted into digital form.
  • There is already a legal and regulatory framework in place for the primary distribution and secondary trading of security tokens:
    • If security tokens are offered to professional investors only in a primary distribution, the SFC’s authorisation process and prospectus registration regime are not triggered. However, any person who markets or distributes security tokens is required to apply to the SFC for a Type 1 licence for “dealing in securities.”
    • Secondary trading of securities tokens is subject to the opt-in licensing regime for VATPs, and any platform that facilitates trading in at least one security virtual asset must be licensed for Type 1 regulated activity (dealing in securities) and Type 7 regulated activity (providing automated trading services). Licensed VATPs may only deal with customers that qualify as professional investors.

Other areas of regulatory focus

Alder also noted that the SFC and other regulators are focusing on new groundbreaking changes, all of which relate to fintech innovations.

Specifically, regulators are increasingly focusing on digital central bank currencies, cross-border payments, cloud computing, artificial intelligence, machine learning, sophisticated algorithms, and outsourcing of crucial aspects of financial services to unregulated technology firms.

Latham & Watkins will continue to analyse this new regime.