Detailed interpretation of the Hong Kong Virtual Asset Service Provider Licensing Regime (VASP Regime).

Original Title: "Breaking News | Countdown to the Run! In-depth Interpretation of Hong Kong Virtual Asset VASP Issuance System (June 1, 2023)"

Original Author: Liao Wang, Lawyer at Beijing Deheng (Hangzhou) Law Firm; Gu Jining, Senior Legal Advisor at Shanghai Mankun Law Firm

* This article was jointly written by lawyers Liao Wang and Gu Jiening, invited by Beosin.

In response to the Policy Statement on the Development of Virtual Assets in Hong Kong in October 2022, and to promote Hong Kong as an international center for virtual assets, the Hong Kong Legislative Council passed the latest revision of the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLCO) on December 7, 2022. This means that the new Virtual Asset Service Providers (VASP) licensing regime will be officially implemented on June 1, 2023.

On February 20, 2023, the Securities and Futures Commission (SFC) of Hong Kong released the "VASP Consultation Paper" and on May 23, it published the "VASP Consultation Summary", clarifying that the "Guideline for Virtual Asset Trading Platform Operators" (VASP Guideline) will officially take effect on June 1, 2023. This marks the Hong Kong government's open attitude towards the virtual asset market and its active embrace of the new VASP system.

All centralized virtual asset exchanges that operate in Hong Kong or actively promote their services to Hong Kong investors, regardless of whether they provide security token trading services, must obtain a license from the SFC and be regulated by it.

SFC will implement allowing licensed virtual asset exchanges to provide services to retail investors in the second half of the year, but only tokens that are non-securities and have high liquidity in one of the traditional financial indices can be provided to retail investors.

Regarding stablecoins, regulatory arrangements for stablecoins will be implemented in 2023/24, and a licensing system for activities related to stablecoins will be established. Before stablecoins are regulated, the SFC believes that stablecoins should not be included for retail trading.

This article will help readers better understand the upcoming Hong Kong Virtual Asset Service Provider (VASP) licensing system, including the background of the revision of the VASP system, what virtual assets and virtual asset services are, the requirements for applying for a VASP license, compliance requirements for exchanges, the dual licensing system, and transitional arrangements.

One, Background of VASP System Revision

In the "VASP Consultation Paper," the SFC clearly explained the background of revising the establishment of a new VASP system: in the continuous winter of encryption, a series of collapse events have occurred, which has intensified the risk of the virtual asset market, especially the collapse of FTX, causing millions of investors to suffer significant losses. The increasing connection between the virtual asset market and the traditional financial market has highlighted the importance and necessity of effective regulation in the virtual asset industry. Major global jurisdictions are shifting their regulatory policies from lenient (i.e., regulating from the perspective of combating money laundering and payments) to comprehensive (i.e., regulating from the perspective of protecting investors).

SFC is ahead of other jurisdictions and has gradually established a "voluntary licensing" system for securities-type token virtual assets as early as 2018. It is clearly stipulated that SFC has no authority to regulate platforms that only trade non-securities virtual assets or tokens. Under the "voluntary licensing" system, if a virtual asset trading platform deals with non-securities tokens, it does not need to be licensed. Only two virtual asset exchanges, OSL Digital Securities Limited under BC Technology Group and Hash Blockchain Limited under HashKey Group, have obtained licenses for exchange business (License No. 1) and automated trading services (License No. 7) under the "voluntary licensing" system.

Until today, the virtual asset industry has undergone a huge transformation. The original "voluntary licensing" system can no longer cover the market, which is mainly composed of retail investors and non-securities tokens. In order to comprehensively regulate all centralized virtual asset trading platforms in Hong Kong and implement the latest standards of the Financial Action Task Force on Money Laundering (FATF), the Hong Kong government has revised the Anti-Money Laundering Ordinance and established a new VASP "mandatory licensing" system to achieve a more suitable balance between investor protection and market development. After the VASP system is officially implemented, all centralized virtual asset exchanges that operate in Hong Kong or actively promote their services to Hong Kong investors, regardless of whether they provide securities token trading services, will need to obtain a license from the SFC and be regulated by it.

二、Virtual Assets and Virtual Asset Services

It is crucial to clarify what virtual assets are and what virtual asset services are in the context of the "mandatory licensing" system in VASP.

2.1 What is virtual assets

According to Article 53 of the Anti-Money Laundering Regulations and the VASP Guidelines, virtual assets (VA) are widely defined as "Virtual Asset" (VA).

(a) The value representation of cryptographic protection in digital form that meets the following description:

(1) Expressed in the form of storage of computing units or economic value;

(2) Meets one of the following:

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, , , and

, will not be translated. If there are English characters in the HTML tags, they will be omitted and returned as is. The content in an a tag will be preserved and not translated. All Chinese characters will be translated. The following is the translation of the content: As or intended to be a publicly accepted medium of exchange, used for one or more of the following purposes: (I) payment for goods or services; (II) debt settlement; (III) investment; or

B. Provide rights, qualifications, or avenues to vote on the management, operation, or governance of any matters related to the encryption of digital forms of value, or any changes to the terms applicable to arrangements for the encryption of digital forms of value.

(3) Can be transferred, stored or traded electronically;

(4) Possess other characteristics as specified in the announcement published by SFC in the constitutional newspaper from time to time;

(b) The digital representation of value that is designated as virtual assets in the form of a constitutional announcement published by the Hong Kong Financial and Treasury Bureau.

(c) Any security-type token refers to the cryptographic protected digital form of value that constitutes a "security" as defined in Part 1, Article 1 of Schedule 1 of the Securities and Futures Ordinance.

According to Article 53 of the Anti-Money Laundering Regulations, the following items are excluded from the definition of VA:

(1) Digital currency (CBDC) issued by the central bank or entities that perform central bank functions, or authorized by the central bank to issue digital currency.

(2) Limited-purpose digital tokens (which are non-transferable, non-exchangeable, and non-substitutable in nature, such as gift cards, customer loyalty reward programs, and electronic payment services);

(3) Stored value payment instruments (regulated by the Payment System and Stored Value Payment Instrument Regulations).

(4) Securities or futures contracts (regulated by the Securities and Futures Ordinance).

The definition of VA in the "Anti-Money Laundering Regulations" will cover most of the virtual currencies on the market, including BTC, ETH, stablecoins, utility tokens, and governance tokens. Regarding stablecoins, the SFC also clearly stated in the "Consultation Summary" that: The Hong Kong Monetary Authority has issued a "Consultation Summary on Cryptocurrencies and Stablecoins" in January 2023, indicating that regulatory arrangements for stablecoins will be implemented in 2023/24, and a licensing system for activities related to stablecoins will be established. Before stablecoins are regulated, the SFC believes that stablecoins should not be included for retail trading.

NFT's attributes are linked to the underlying asset properties, and there is currently no clear definition under the VASP system. When SFC issued a reminder to investors to pay attention to NFT risks on June 6, 2022, it stated that if NFT is a true digital representation of collectibles (art, music, or film), activities related to it are not within the scope of SFC's regulation. However, some NFTs cross the boundary between collectibles and financial assets and may have the attributes of "securities" regulated by the Securities and Futures Ordinance, and therefore will be subject to regulation.

2.2 What is Virtual Asset Service

According to the "Anti-Money Laundering Regulations" Appendix 3B and VASP guidelines, activities related to Virtual Asset Services (VA Service) are defined as operating virtual asset exchanges, that is:

(a) Provide services that meet the following description through electronic means:

(1) This service:

A. Offers to buy or sell virtual assets are often made or accepted in a certain way, and by making or accepting such offers, binding transactions are formed or may be generated.

B. People often introduce or identify each other in order to negotiate or complete the buying and selling of virtual assets, or frequently introduce or identify each other in situations where they are expected to negotiate or complete the buying and selling of virtual assets in a reasonable manner, and negotiate or complete such transactions in a binding manner, or lead to the creation of binding transactions.

(2) In this service, the customer's funds or virtual assets are directly or indirectly controlled by the person providing the service;

(b) Any virtual asset trading activities and related services provided by the platform operator to its customers outside the platform, as well as any activities related to virtual asset trading conducted outside the platform.

Therefore, both (1) centralized virtual asset exchanges operating in Hong Kong and (2) offshore centralized virtual asset exchanges actively promoting their services to Hong Kong investors, engaging in the aforementioned activities, fall within the scope of virtual asset services. According to section 53 of the Anti-Money Laundering Ordinance, any entity operating virtual asset services must obtain a VASP license from the SFC.

Currently, in addition to the aforementioned virtual asset services, other businesses such as market making, proprietary trading, futures contracts, and derivatives are not allowed to be conducted. However, it is not ruled out that the Hong Kong Financial and Treasury Bureau may include other virtual asset services through announcements published in the Gazette in the future.

Three, VASP License Application

Under the new VASP system, the SFC issues licenses and conducts supervision to applicants based on the Anti-Money Laundering Ordinance and VASP guidelines. Applying for a VASP license requires very high standards for the company and its personnel.

A. Company: 1. There is a company established in Hong Kong with a fixed office location; 2. It is required to have a registered capital of not less than HKD 5 million, and the liquid capital needs to reach HKD 3 million or above; 3. Subsidiaries or affiliated companies must have a Hong Kong trust TCSP license for virtual asset custody.

B. Personnel: 1. The applicant, responsible personnel, licensed representative, director, and ultimate owner of VASP must pass the appropriate person test of SFC; 2. At least two responsible officers (RO) with virtual asset service experience must be appointed, and the following conditions must be met: at least one RO must be an executive director of VASP, at least one RO must be a permanent resident of Hong Kong, and there must always be at least one RO supervising the business; 3. At least one RO must be a licensed representative; 4. An auditor with virtual asset business experience is required.

C. Compliance Requirements: In addition to meeting the company's qualifications and personnel requirements, it is also necessary to comply with a series of compliance regulations such as the virtual asset trading business evaluation report, AML/CTF, and customer asset management. According to the VASP guidelines, these detailed requirements for application also include provisions for appropriate personnel, competency, continuous training, business conduct principles, financial soundness, virtual asset operation on the platform, prevention of market manipulation and illegal activities, transactions with customers, protection of customer assets, management, supervision and internal control, network security, avoidance of conflicts of interest, record keeping, auditor audit, continuous reporting and notification responsibilities, etc.

 

4. Compliance Requirements for Exchanges

According to the VASP guidelines, and the compliance requirements for the operation of centralized virtual asset exchanges, the following requirements must be met:

A. Safeguarding Customer Assets

The platform operator should hold customer funds and virtual assets in trust through a wholly-owned subsidiary (i.e. "related entity") with a TCSP trust license. The platform operator should ensure that customer virtual assets stored in online wallets do not exceed 2%.

In addition, since accessing virtual assets requires the use of private keys, the safe management of private keys is essential for the storage of virtual assets. Platform operators should establish and implement written internal policies and governance procedures for private key management to ensure the secure generation, storage, and backup of all encryption seeds and keys.

In addition, platform operators should not deposit, transfer, lend, pledge, re-pledge, or buy and sell customer virtual assets in any way, or create any property rights burden on customer virtual assets. They must also have insurance, and their coverage should include the risks involved in storing customer virtual assets.

B. Know Your Customer (KYC)

Platform operators should take all reasonable steps to establish the true and complete identity, financial status, investment experience, and investment objectives of each of their customers. In addition, platform operators must ensure that customers have sufficient knowledge of virtual assets (including awareness of the risks involved) before providing any services.

C. Combating Money Laundering / Terrorist Financing

Platform operators should establish and implement sufficient and appropriate policies, procedures, and monitoring measures to combat money laundering/terrorist financing. Platform operators can use virtual asset tracking tools to trace the records of specific virtual assets on the blockchain.

D. Prevention of conflicts of interest

The platform operator should not engage in self-operated trading or self-operated dealer activities, and should have policies in place to manage internal employees trading virtual assets to eliminate, avoid, manage or disclose actual or potential conflicts of interest.

E. Inclusion of virtual assets for buying and selling

The platform operator should establish a function responsible for formulating, implementing, and enforcing guidelines related to the inclusion of virtual assets, guidelines for suspending, pausing, and revoking virtual asset transactions, along with the options available to customers.

In addition, before incorporating any virtual assets for trading, platform operators should conduct a reasonable due diligence on such virtual assets and ensure that they continue to comply with all guidelines.

F. Prevention of Market Manipulation and Violations

Platform operators should establish and implement written policies and monitoring measures to identify, prevent, and report any market manipulation or non-compliant trading activities that occur on their platforms. The monitoring measures should include restrictions or suspensions of trading upon discovery of manipulation or non-compliant activities. Platform operators should adopt effective market surveillance systems provided by reputable independent vendors to identify, monitor, detect, and prevent such manipulation or non-compliant trading activities, and provide SFC with access to this system.

G. Accounting and Auditing

Platform operators must select auditors with appropriate skills, carefulness, and diligence, and consider their experience, track record, and ability to audit virtual asset-related businesses and platform operations. In addition, platform operators should submit an auditor's report for each fiscal year, which should include a statement on whether there has been a violation of applicable regulatory requirements. Furthermore, the SFC requires platform operators to provide reports to the SFC on their business activities every month within two weeks after the end of each month and when requested by the SFC.

H. Risk Management

Platform operators should establish a robust risk management framework that enables them to identify, measure, monitor, and manage all risks arising from their business and operations. Platform operators should also require customers to deposit funds into their accounts in advance and not provide any financial leverage to customers for the purchase of virtual assets.

5. Dual License System

According to different regulatory authorizations, SFC will regulate security token transactions on virtual asset exchanges (1+7 licenses) based on the Securities and Futures Ordinance. At the same time, SFC will also regulate non-security token transactions on virtual asset exchanges (VASP license) based on the Anti-Money Laundering Ordinance.

 

Considering that the nature of virtual assets may evolve over time, such as from non-security tokens to security tokens, in order to avoid any violation of the issuance regime, virtual asset exchanges should apply for dual licenses and approvals (i.e. apply for both VASP license and No.1 and No.7 licenses) from the SFC in accordance with the Securities and Futures Ordinance and the Anti-Money Laundering Ordinance.

To simplify the application process for dual licenses, applicants who wish to apply for licenses under both the current Securities and Futures Ordinance system and the virtual asset service provider system under the Anti-Money Laundering Ordinance can submit a comprehensive application form online and indicate that they are applying for both licenses at the same time.

SFC expects that platform operators who have obtained dual licenses only need to submit a report once to comply with the current system under the Securities and Futures Ordinance and the licensing or notification requirements under the virtual asset service provider system under the Anti-Money Laundering Ordinance.

Sixth, Transitional Arrangements

The "Anti-Money Laundering Regulations" provide transitional arrangements for "existing virtual asset exchanges", which stipulate that the transitional period will be before June 1, 2024. For exchanges that have operated in Hong Kong before June 1, 2023 and have meaningful and substantive businesses, including (1) exchanges that have obtained or are applying for licenses under the "Securities and Futures Ordinance", and (2) unlicensed exchanges that conduct business in non-securities tokens under the "Securities and Futures Ordinance", are eligible to participate in the transitional arrangements.

Qualified exchanges participating in the transitional arrangement must meet the conditions listed in Annex 3G of the Anti-Money Laundering Ordinance in order to continue operating in Hong Kong from June 1, 2023 to May 31, 2024, and will be subject to the VASP licensing regime from June 1, 2024 onwards.

 

If the operator submits an application to SFC within 9 months after June 1, 2023 and confirms that they will comply with the regulatory requirements set by SFC, the operator may be deemed to have been licensed until SFC makes a decision on their license application. During this period, the operator will be able to continue providing services until (i) the first 12 months end, (ii) the application is withdrawn, (iii) the application is rejected by SFC, or (iv) the license is granted by SFC, whichever is earlier.

If the application for a virtual asset service provider license is rejected by the SFC, the operator must terminate its virtual asset service business within 3 months after receiving the rejection notice or before June 1, 2024 (whichever is later). During this period, the operator can only take actions purely for the purpose of closing its services. The operator may apply to the SFC for an extension of the closing period, which shall be a period deemed appropriate by the SFC in consideration of the operator's business and activities.For "non-original virtual asset exchanges" that plan to provide virtual asset services in Hong Kong after June 1, 2023, they must apply to the SFC in advance and obtain a VASP license.

Seven, "Regulatory Arbitrage" is Gradually Fading Away

According to the "Anti-Money Laundering Regulations", relevant sanctions will be taken against illegal and non-compliant behaviors, including providing virtual asset services without obtaining a license and not meeting AML/CTF requirements. In addition, any act of actively promoting services to the Hong Kong public will be regarded as providing virtual asset services, regardless of the location or provider of the services.

After June 1, 2023, operating and providing virtual asset services without a VASP license is considered a criminal offense. If convicted through a public prosecution process, a fine of HKD 5 million and 7 years imprisonment may be imposed. If it is a continuous offense, a fine of HKD 100,000 may be imposed for each day of the offense. If convicted through a summary conviction process, a fine of HKD 5 million and 2 years imprisonment may be imposed. If it is a continuous offense, a fine of HKD 10,000 may be imposed for each day of the offense.

If licensed service providers and their responsible personnel do not comply with the statutory AML/CTF regulations, they will be considered criminals. Once convicted, each person can be fined HKD 1 million and sentenced to 2 years imprisonment. In addition to criminal liability, they will also be subject to disciplinary action by the SFC, including suspension or revocation of their license, condemnation, orders to take remedial action, and fines.

In addition, various "improper behaviors" in the operation of virtual asset exchanges may also face disciplinary penalties and fines from the SFC.

Compared to other jurisdictions, especially in other parts of East Asia, Hong Kong's regulatory environment for virtual asset trading was previously very relaxed. This is why there are numerous companies that have set up their headquarters or operational centers in Hong Kong. However, with the introduction of the "VASP Crypto New Policy", Hong Kong is gradually moving away from "regulatory arbitrage".

 

Eight, Conclusion

VASP regulations are about to be implemented. Regardless of the situation, whether it is (1) a virtual asset exchange that is already operating in Hong Kong, (2) an offshore virtual asset exchange that actively promotes its services to Hong Kong investors, (3) a virtual asset exchange that plans to operate in Hong Kong, or (4) a traditional financial institution that plans to venture into virtual asset exchanges, VASP license applicants should prepare in advance for business compliance and related license applications.

VASP system is what the Hong Kong government is currently working on through licensed exchanges to "channel water into the canal". Against this backdrop, KYC and AML compliance are of paramount importance. After the first step of "channeling water into the canal", we will see a series of detailed regulations on the investment of retail investors and how to protect them in the second half of the year. To wear the crown, one must bear its weight. Only by meeting regulatory requirements can exchanges participate in the distribution of this huge cake and promote the long-term development of the market.

We can foresee that "the rise of the East and the fall of the West" has become inevitable. In the context of FTX's decline, tightening US regulation, and political games, Hong Kong, relying on its own traditional financial foundation and sound legal system, as well as the solid resources backed by the mainland, will surely regain its past glory as a "cryptocurrency center".

Reference:

https://www.elegislation.gov.hk/hk/cap571!zh-Hant-HK

https://www.sfc.hk/TC/Regulatory-functions/Intermediaries/Licensing/Do-you-need-a-licence-or-registration

https://apps.sfc.hk/edistributionWeb/API/consultation/openFile?lang=TC&refNo=23CP1

https://apps.sfc.hk/publicreg/Terms-and-Conditions-for-VATP_10Dec20.PDF

https://www.hkex.com.hk/-/media/HKEX-Market/News/Research-Reports/HKEx-Research-Papers/2023/CCEO_CryptoETF_202304_c.PDF

https://apps.sfc.hk/edistributionWeb/gateway/TC/news-and-announcements/news/doc?refNo=23PR5

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