The inaugural Hong Kong framework for licensing virtual asset trading platform (VATP) operators was launched on June 1, 2023. The Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO) is the statutory instrument that brought this licensing system to life. The administrative duties and responsibilities for overseeing this licensing system fall under the Securities and Futures Commission (SFC) purview.
Who falls under the purview of the AMLO licensing structure?
The licensing framework extends its jurisdiction to operators of virtual asset trading platforms (VATPs) both within Hong Kong and abroad. A VATP operator with a physical business location in Hong Kong must acquire a license. Similarly, an overseas VATP operator actively promoting its services to Hong Kong's public also requires a license.
However, the licensing structure is tailored explicitly for VATPs operating an automated system to pair up sellers and buyers and those handling virtual assets on behalf of their clients, either directly or indirectly. It does not encapsulate peer-to-peer platforms facilitating transactions outside their platforms or platforms that don't manage clients' virtual assets.
Furthermore, the licensing regulations do not cover service providers related to other virtual asset facets, such as custody or payment systems.
Who qualifies for the transitional licensing terms?
Transitional licensing provisions only extend to international VATP operators with a physical establishment in Hong Kong. VATP operators delivering virtual asset (VA) services (as outlined in the AMLO) in Hong Kong before June 1, 2023, may be considered for the transitional licensing terms. The SFC plans to implement stringent criteria for this purpose and will only entertain VATP operators with a significant presence in Hong Kong before June 1, 2023.
In assessing whether a VATP operator has a substantial and meaningful presence, the SFC will consider factors such as:
The VATP operator's incorporation status in Hong Kong.
The existence of a physical office of the VATP operator in Hong Kong.
Whether the Hong Kong staff of the VATP operator exercise central management and control over operations.
Whether key personnel operating the trading system are stationed in Hong Kong.
The extent of the VATP operator's live operations, considering the number of clients and trading activity volume in Hong Kong.
A VATP operator qualifying for the transitional licensing terms and lodging an application to the SFC before February 29, 2024, is considered licensed until the SFC formally decides to either grant or refuse the license application.
What steps must be taken to adhere to the AMLO licensing structure?
Before lodging a license application, a VATP operator aspiring to be a licensee needs to:
(a) Conduct an extensive gap analysis covering the organization's existing structure, governance, operations, systems, and controls to pinpoint areas requiring improvements to align with regulatory obligations;
(b) Carry out the necessary upgrades, which might include changes to financial resources, custody arrangements, personnel, policies, documentation, etc.;
(c) Create a fully owned subsidiary to serve as the VATP operator's associated entity with the intent to manage client assets and apply for a license from the Registrar of Companies for this subsidiary to operate as a trust or company services provider (TCSP) under AMLO;
(d) Hire an independent external assessor to compile a Phase 1 Report (detailed in the section below).
Some of the key requirements include:
Necessary Financial Resources
A licensed VATP operator should maintain a minimum of HK$5 million in paid-up share capital and HK$3 million in liquid assets.
Responsible Officers and Executive Directors
Applicants must appoint at least two responsible officers (ROs) for VATP services. Each RO must qualify as "fit and proper" and fulfill the requisite experience stipulations.
At least one RO should hold a position on the corporation's board of directors and be actively involved in or directly oversee the VATP service (commonly referred to as an executive director). Every individual executive director needs to be approved by the SFC as an RO. Due to their seniority, board members cannot choose to be approved only as licensed representatives.
At least one RO must be continually available to supervise the VATP operator's business, meaning one RO must ordinarily reside in Hong Kong.
Formation of a Token Admission and Review Committee
A licensed VATP operator is obliged to establish a token admission and review committee. This committee sets the criteria for admitting virtual assets to trading, suspending and withdrawing virtual assets from trading, imposing requirements on virtual asset issuers listed on the VATP, and conducting regular reviews of these criteria and requirements.
Deployment of a Market Surveillance System
A licensed VATP operator must implement a market surveillance system, provided by a reputable and independent provider, to identify, monitor, and prevent any market manipulative or abusive activities on its VATP.
Custody Stipulations
A licensed VATP operator must set up an "associated entity" for holding client assets. This associated entity must:
(a) Be incorporated in Hong Kong;
(b) Be wholly owned by the VATP operator;
(c) Hold a TCSP license from the Registrar of Companies;
(d) Retain client assets in trust;
(e) Conduct no other business besides receiving or retaining client assets on behalf of the VATP operator.
A minimum of 98% of client virtual assets must always be maintained in cold storage unless the SFC approves otherwise in specific instances. All seeds and private keys (and their backups) must be securely stored in Hong Kong.
Insurance or Compensation Provisions for Potential Losses
A licensed VATP operator must implement a compensation mechanism to offset potential losses resulting from hacking incidents, theft, fraud, or default. This mechanism should cover possible losses of 50% of client virtual assets in cold storage and 100% in hot and other storage.
The compensation provision could comprise one or a mix of:
(a) Third-party insurance;
(b) Designated funds (held as a demand deposit or time deposit maturing in six months or less) or virtual assets of the VATP operator or any corporation within the same group of companies as the VATP operator that are held in trust for this purpose;
(c) Bank guarantee issued by an authorized financial institution in Hong Kong.
The SFC must greenlight the compensation provision and any modifications to it.
What is the procedure for applying for a license?
Required Data
An applicant seeking a license must provide comprehensive information to the SFC regarding its business proposition, ultimate owners, directors, proposed responsible officers, and the associated entity created to hold client assets. Suppose the applicant is utilizing the transitional licensing provisions. In that case, confirmations of having operated the VATP in Hong Kong immediately before June 1, 2023, and adherence to regulatory requirements from the date the license is issued must also be provided.
Method of Application
Applications must be submitted digitally through the SFC's WINGS platform.
Application Charges
The applicant must pay application fees to the SFC. Currently, these fees are HK$4,740 for the VATP operator, HK$2,950 for each proposed responsible officer, and HK$1,790 for each licensed representative. Additional charges will apply if the applicant seeks to be licensed under the SFO.
Submission of External Assessor Reports Along with the Application
The license applicant must appoint an external assessor to evaluate its prospective business and submit the assessor's reports to the SFC during the license application (Phase 1 Report) and after the SFC has provisionally approved the application (Phase 2 Report) but before final approval. Allocating up to six months to finalize the Phase 1 Report is advised.
Different external assessors may be appointed to review varying aspects of the applicant's business. The chosen assessor(s) must be independent, with the requisite expertise and technical knowledge to conduct the necessary assessments. The SFC clarified that the same service provider for a specific system could not also function as the external assessor. The SFC retains the right to object to the appointment of any external assessor.
The SFC has released its Scope of External Assessment Reports, outlining its expectations for the Phase 1 and Phase 2 Reports.
The Phase 1 Report should examine the proposed structure, governance, operations, systems, and controls of the VATP, concentrating on key areas like governance and staffing, token admission, virtual asset custody, client identification, anti-money laundering, market surveillance, risk management, and cybersecurity. The assessor should evaluate whether the VATP operator's policies and procedures comply with legal and regulatory requirements and are clearly documented. The Phase 2 Report should provide the assessor's evaluation of the actual adoption and effectiveness of the planned policies, procedures, systems, and controls.
Only after being satisfied with the findings of the Phase 2 Report will the SFC give the final approval for a license application.
External assessment reports are necessary to facilitate the SFC's processing of license applications. However, this requirement implies a further commitment of time and costs for license applicants in terms of identifying and appointing an external assessor and coordinating with the external assessor to review the VATP's proposed structure, governance, operations, systems, controls, and the final reports.
What activities does a license authorize?
Activities Allowed
A licensed VATP operator can conduct virtual asset trading with "professional investors" (as the SFO outlines). A licensed VATP operator may also provide certain virtual asset trading services to retail investors.
Activities Not Allowed
The activities prohibited for a licensed VATP operator include the following:
Offering financial aid to its clients for virtual asset acquisition (e.g., margin trading is not allowed)
Providing, trading, or dealing in virtual asset futures contracts or related derivatives
Offering algorithmic trading services to its clients
Arranging with clients to utilize client virtual assets held by the VATP for generating returns for clients or any other parties (e.g., lending, borrowing, staking, etc.)
Engaging in proprietary trading or market making on a proprietary basis
Possibility to offer virtual assets to retail investors
A licensed VATP operator can trade in eligible large-cap virtual assets with retail investors. Eligible large-cap virtual assets appear in at least two "acceptable indices" issued by two independent index providers. An index provider is deemed independent if it isn't part of the same group of companies as the virtual asset issuer or the licensed VATP operator.
An "acceptable index" is defined as one that measures the performance of the largest virtual assets globally and satisfies the following criteria:
(a) The index should be investible with sufficiently liquid constituent virtual assets
(b) The index should be objectively calculated and abide by established rules
(c) The index provider should have the required expertise and resources to construct, maintain, and review the index's methodology and rules
(d) The methodology and rules of the index should be well-documented, consistent, and transparent
At least one of the indices should be issued by an index provider in compliance with the IOSCO Principles for Financial Benchmarks, with experience publishing indices for conventional securities markets.
The SFC may allow a licensed VATP operator to offer trading in other virtual assets to retail investors on a case-by-case basis.
What are the ongoing license requirements?
A licensed VATP operator must:
(a) maintain consistent compliance with regulatory requirements under the AMLO
(b) always meet financial resource requirements for minimum paid-up share capital and minimum liquid capital
(c) periodically make regulatory filings to the SFC, including financial resources returns, annual returns, and annual business risk management questionnaire
(d) make various ad hoc regulatory filings and applications to the SFC, for example, due to changes to personnel, ultimate owners, and scope of business activities
(e) ensure continuous training for its representatives
(f) promptly report to the SFC any significant breaches or non-compliance with regulatory requirements
Is compliance with the SFO licensing regime necessary?
The SFC recommends that a VATP operator obtain licenses under the AMLO and the SFO, even if the operator plans to list tokens not classified as "securities" under the SFO. The SFC will concurrently process applications under the AMLO and SFO using a streamlined approach.
The SFC suggests dual licenses because the characteristics and features of virtual assets may change over time, and a token's classification may shift from a non-security token to a security token, and vice versa. Having licenses under both the AMLO and the SFO ensures that any changes in a token's nature would not result in a licensing regime breach.
If an applicant applies for a license under the AMLO only, it will likely need to justify to the SFC why it doesn't need a license under the SFO.
If the SFO and AMLO requirements differ, a dual-licensed VATP operator must comply with the stricter requirement.
Can an existing SFC-licensed corporation apply for a dual license under the AMLO?
A VATP operator licensed under the SFO is required to conduct VATP operations solely. As a result, existing SFC-licensed corporations that want to operate a VATP must establish a new entity for this purpose.
What alternatives exist if you wish to avoid applying for a license?
If you operate a VATP in Hong Kong and don't want to apply for a license under the AMLO, you must either:
(a) Restructure your operations to avoid triggering a license obligation under the AMLO, as much as possible, or
(b) Cease your business in Hong Kong – the deadline for winding down your business is May 31 2024. If you operate a VATP outside Hong Kong, you must stop actively promoting your services to the public in Hong Kong.
At Prokopiev Law Group, we have established partnerships with leading legal firms worldwide to ensure a seamless and integrated service for your business, no matter where you operate. Our global reach allows us to navigate international regulations and complexities efficiently, ensuring your company's compliance with local and international laws.
Link to the SFC website.
The information provided is not legal, tax, investment, or accounting advice and should not be used as such. It is for discussion purposes only. Seek guidance from your own legal counsel and advisors on any matters. The views presented are those of the author and not any other individual or organization. Some parts of the text may be automatically generated. The author of this material makes no guarantees or warranties about the accuracy or completeness of the information.
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