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Crypto regulation becomes a balancing act

By Alex Liu

Hong Kong, 8 June 2021: Stricter regulation of cryptocurrency exchanges operating in Hong Kong is in the offing. If government proposals are passed by the Legislative Council, as is expected, these businesses will require a licence from the Securities and Futures Commission and will only be allowed to provide services to professional investors. There will be punitive sanctions for exchanges which fail to comply.

Dozens of cryptocurrency exchanges – including some of the world’s biggest – have operations in Hong Kong. Currently, there is an “opt in” arrangement under which they can voluntarily apply to be licensed by the SFC. The new regulations will make this mandatory.

Background

The fast-evolving cryptocurrency industry presents a challenge for governments and financial bodies around the world. Regulators need to strike a balance between harnessing the opportunities presented by financial innovation and ensuring orderly development of the market. The two major concerns regarding regulation are investor protection and money laundering.

With a few exceptions, cryptocurrencies are generally not accepted as legal tender as they do not have any backing from an issuer. Even so, they are considered a regulatory risk because of the anonymity associated with transactions. Hence the focus on cryptocurrency exchanges or “virtual asset services providers” (VASPs).

In February 2019, the Financial Action Task Force – the global money laundering and terrorist financing watchdog, of which Hong Kong is a member – began requiring governments to regulate VASPs for anti-money laundering (AML) and counter-terrorist financing (CTF) purposes and to supervise their compliance. It said VASPs should be subject to the same obligations as financial institutions and designated non-financial businesses and professions.

Hong Kong proposals

In November last year, the Financial Services and the Treasury Bureau (FSTB) launched a three-month public consultation exercise on proposals to enhance Hong Kong’s AML/CTF measures. While the draft document outlined a registration regime for dealers in precious metals and stones, and detailed various technical amendments to the Anti-Money Laundering and Counter-Terrorist Financing Ordinance, the main focus was on regulation of the cryptocurrency industry.

The FSTB published its conclusions last month, spelling out how the government intends to enforce and implement the new licensing regime for VASPs. It is expected an amendment bill will be put before the Legislative Council during its 2021-22 session. The main points are as follows:

  • Cryptocurrency exchanges operating in Hong Kong will have to be licensed by the SFC.
  • They will only be allowed to provide services to professional investors; serving retail investors will be forbidden.
  • The rules will apply to all VASPs registered in Hong Kong, whether or not they are incorporated here or elsewhere.
  • Applicants seeking a VASP licence will need to pass a fit-and-proper test, proving they have the necessary experience and qualifications, and are of good standing and financial integrity.
  • A licensed VASP must also meet prescribed regulatory requirements regarding financial resources, risk management, segregation and management of client assets, financial reporting and disclosure, prevention of manipulative activities and prevention of conflicts of interest.
  • Licences will be open-ended, so will remain valid until revoked by the SFC, for example, due to misconduct or cessation of operation.

The FSTB points out that the cryptocurrency industry operates largely in the virtual world and therefore brings a “high inherent risk” of money laundering, terrorist financing and other criminal activities such as fraud. Thus, to “achieve the necessary deterrent effects”, the proposals contain heavy maximum penalties for transgressors:

  • For conducting a regulated VASP activity without a licence: HK$5 million fine and seven years in prison; in the case of a continuing offence, a further fine of HK$100,000 for every day the offence continues.
  • For providing a false or misleading statement in connection with a licence application: HK$1 million fine and two years in prison.
  • Non-compliance with the statutory AML/CTF requirements: HK$1 million fine and two years in prison.
  • Fraudulent or reckless misrepresentation for the purpose of inducing another person to acquire or dispose of a virtual asset: HK$1 million fine and two years in prison.

Peer-to-peer trading platforms are exempted from the regulations. These are platforms that simply provide a forum where buyers and sellers of virtual assets can post their bids and offers, with or without automatic matching mechanisms, for them to trade at an outside venue.

Further, the proposed definition of a virtual asset does not cover stored value items – for example, air miles, credit card rewards, gift cards, customer loyalty programmes and the like – which are separately regulated under the Payment Systems and Stored Value Facilities Ordinance.

However, the FSTB says it will provide flexibility in the legislation by empowering the SFC to prescribe characteristics that constitute the definition of a virtual asset. It will be up to the Secretary for Financial Services and the Treasury to determine whether any digital representation of value is to be regarded as a virtual asset or not.

Comments

Perhaps the most contentious measure in the FSTB paper is the one limiting trading activities to professional investors only. (According to Hong Kong law, such persons must have a portfolio worth at least HK$8 million.) Yet the FSTB admits that more than 40% of the submissions it received during the public consultation were in favour of allowing retail investors to trade.

Industry figures here have opposed banning retail investors, warning it could drive exchanges out of the city, perhaps to regional rival Singapore, where such investors are allowed. They also warn the move could push Hong Kong’s retail investors to unregulated platforms. It remains to be seen if their fears are justified.

However, Hong Kong’s approach is in marked contrast to mainland China, which last month announced a ban on banks, other financial institutions and payment companies offering crypto-related services and warned investors against speculative crypto trading. While the authorities there have banned crypto exchanges and initial coin offerings, they have not barred individuals from holding cryptocurrencies.

The proposed new licensing regime demonstrates that the Hong Kong government is committed to supporting the burgeoning cryptocurrency and virtual asset industry with a clear regulatory framework. It levels the playing field for all involved, deters rogue players and offers greater protection to investors.

At the same time, the authorities have made it clear they are adopting a flexible and nimble approach so they can react quickly to the challenges of this complex and rapidly developing sector.

A Partner in BC&C since 2000, Alex Liu’s key areas of practice include commercial and corporate litigation, investigations by governmental bodies such as the SFC, ICAC and Commercial Crime Bureau, insolvency and debt restructuring, intellectual property, defamation, property and commercial contract drafting. He can be contacted at alex@boasecohencollins.com.

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