SFC Regulation of Virtual Asset Trading Platforms
The Emerging Hong Kong Framework

Platforms which facilitate trading of virtual assets (also known as digital and crypto assets) such as Bitcoin, Ethereum and other cryptocurrencies, normally fall outside the regulatory framework of the Securities and Futures Commission (“SFC”). However, the SFC has expressed concerns that some of the largest operators of such trading platforms have been operating from Hong Kong. At the same time, based on our work with some of these operators, it is clear that many of these operators see regulation as a path to enhanced credibility.

THE SFC’S NEW INITIATIVE

Given these considerations, on November 1, 2018, the SFC issued a “Statement on regulatory framework for virtual asset portfolios managers, fund distributors and trading platform operators” (“Virtual Asset Statement”). In an appendix therein (“Platform Circular”) entitled “Conceptual framework for the potential regulation of virtual asset trading platform operators” and dated November 1, 2018, the SFC launched an innovative initiative to bring willing operators into the regulatory framework. Under this initiative, it appears that operators will be undergo a 2 stage vetting process:

• Exploratory and Assessment Stage - At the first stage, operators meeting certain prescribed qualifications would be placed under the SFC FinTech Sandbox, where they would work under the informal supervision of the SFC. At this stage, they would not be licensed, registered or authorized under the Securities and Futures Ordinance (“SFO”). The SFC would assess whether a particular operator is suitable for formal regulation and supervision. If the SFC considers the operator suitable, the operator would move to the second stage.

• Conditional Licensing Stage – In the second stage, the SFC would require the operator to offer a product that would constitute “securities” or “futures contracts” so that the operator would fall within the ambit of the SFO. Before the operator launches that product, the operator would then apply to the SFC for a license either for Type 1 (dealing in securities) or Type 7 (providing automated trading services) regulated activity. If so minded, the SFC would then grant a conditional license to the operator. The SFC would impose licensing conditions to reflect certain prescribed conduct of business requirements and address specific risks associated with the operator’s operations. At this stage, the operator would be subject to closer supervision by the SFC with more frequent reporting, monitoring and reviews. After a minimum period of 12 months, the operator may apply to the SFC to remove (or vary) these licensing conditions and exit and Sandbox.

It is important to emphasize that the initiative would be a voluntary scheme for operators on the basis that the virtual assets being traded by those operators do not constitute “securities” or “futures contracts”. Operators of platforms which trade virtual assets which fall outside the remit of the SFO have no obligation to opt-in to the SFC initiative. As will be seen below, the requirements of the SFC initiative may prove too burdensome for some operators and they may wish on this basis to opt-out to continue to build market share.

Background

In broad terms, operators of trading platforms may be subject to regulation by the SFC through the provisions of the SFO regulating offers of investment products or by the provisions of the SFO regulating investment services.

Regulation of Investment Offers

The provisions of the SFO governing the offers of investment products regulate “securities”, “regulated investment agreements”, “structured products” and “collective investment schemes”. To the extent that virtual assets fall outside the scope of these terms, as defined in the SFO, these provisions would not apply.

In its Virtual Asset Statement, the SFC itself acknowledges that virtual assets may not be “securities” as defined under the SFO. Whilst it seems less likely that a virtual asset could be considered to be a “regulated investment agreement”, “structured product” or “collective investment scheme”, the SFC has made no statement to clarify its position.

It is notable that the Platform Circular was issued by the Intermediaries Division of the SFC and did not appear to be endorsed by the Investment Products Division of the SFC. The latter is responsible for supervising offers of investment products.

Whilst the application of the SFO provisions governing investment offers will depend upon the specific characteristics of a particular virtual asset and there can be no assurance that any given virtual asset will fall outside those provisions, we can confirm that having acted on a number of regulatory investigations initiated by the Hong Kong Monetary Authority (“HKMA”) as well as the SFC, we have yet to see any investigation focused on a possible breach of the investment offer provisions of the SFO.

Regulation of Investment Services

The provisions of the SFO governing investment services broadly fall into requirements for SFC licensing and registration where a person carries on a business in a regulated activity and requirements for authorization where a person provides an automated trading service (“ATS”).

In broad terms, an ATS is an electronic facility which, on the trading side, enables buyers and sellers to conclude binding contracts in accordance with “established methods”. The provision of ATS is itself a regulated activity (Type 7).

Other regulated activities include “dealing in securities” (Type 1), “dealing in futures contracts” (Type 2) and “leveraged foreign exchange trading” (Type 3).

In its Virtual Asset Statement, the SFC appears to acknowledge that virtual assets often will fall outside the ambit of the terms “securities” and “futures contracts” under the SFO. It is for this reason that the Platform Circular requires that operators at stage 2 include in their product offering a product which falls within the ambit of the term “securities”. It has made no statement as to its position of whether the trading of virtual assets in the form of digital currencies would constitute “leveraged foreign exchange trading”.

Whilst each virtual asset will need to be scrutinized separately, it appears to be less likely that such virtual assets would be foreign exchange - the HKMA has recognized that crypto assets are not “currencies”.

Regulatory Approach

The SFC initiative works on the basis that once a firm is licensed by the SFC to offer a particular product, the entire firm is licensed and thus, the entire firm’s operations, even those which do not involve “securities” or “futures contracts” fall within the regulatory purview of the SFC. This is not a novel approach. For many years, SFC licensed firms engaged in OTC derivatives activities were regulated in this way even though those activities did not fall within the SFC’s regulatory purview.

The result of this approach is that licensed operators of virtual asset trading platforms will need to comply with all regulatory obligations which apply to other licensed firms. However, in addition to these obligations, the SFC has added a number of additional requirements on the businesses of these operators.

Single Entity

Under the Platform Circular, the SFC will expect an operator of a virtual asset trading platform to consolidate all its activities into a single legal entity so as to afford the SFC a holistic view of the full scope of the operator’s activities. It is not clear whether operators can split their operations into 2 distinct but fully functional groups, one to be regulated by the SFC and the other outside the SFC’s regulation.

Professional Investors

The SFC will require operators of virtual asset trading platforms to limit trading activities to “professional investors” as defined under the SFO. Individuals, for example, may qualify as professional investors if they hold a portfolio of securities and cash valued at HK$8 million or more.

Given that many platforms are currently available to a wide range of investors, many of whom will not qualify as professional investors, the professional investor limitation will be an important consideration for operators in deciding whether to join the initiative.

No Leverage

All trades on a platform should be pre-funded with fiat currencies or virtual assets. The platform should not offer any leverage to acquire virtual assets and should not provide trading in respect of futures contracts or derivatives on the basis that such leverage would magnify the already significant risks of trading in virtual assets.

Financial Resources

Quite apart from the usual obligation to maintain minimum regulatory capital, the SFC may require, on a case-by-case basis, the operator to maintain a reserve equivalent to 12 months operating expenses.

Risk Disclosure

The SFC expects an operator to make risk disclosures specific to the trading of virtual assets. These disclosures include the following:

• the fact that the Investor Compensation Fund will not be available to investors,

• virtual assets are not legal tender and they may lose their value completely if the market for the market for them disappears; and

• transactions in virtual assets may be irreversible.

Potential Areas of Concern

Assuming that the special limitations described above are acceptable, operators considering whether to apply for a license will need to consider whether the regulatory obligations normally applicable to licensed firms are acceptable.

Know Your Client

The SFC will expect operators of virtual asset trading platforms to comply with Know-Your-Client (“KYC”) obligations. This is a matter of particular sensitivity given the SFC’s emphasis on the ability of licensed firms to comply with anti-money laundering obligations and the traditional anonymity associated with virtual asset, particularly, cryptocurrency trading.

To comply with KYC obligations, operators will need to ascertain the true and full legal identity of each person who stands to gain or lose the economic benefit of a trade or who originates a trading instruction.

In this regard, where identity of a person is verified other than on a face-to-face basis (as will normally be the case for online transactions), the SFC will normally expect that either the person’s identity be certified by a professional (e.g. a lawyer or an accountant) or that the person issue a cheque drawn on a Hong Kong bank account in the person’s own name.

Moreover, the SFC will expect that all deposits and withdrawals of fiat currency by conducted through an account in the name of the person either with a Hong Kong bank or a bank in a jurisdiction acceptable to the SFC.

Suitability

Like other licensed firms, operators of virtual asset trading platforms will be expected to determine the financial situation and investment objectives of each person who trades on the platform and to assess whether trading would be suitable for the person.

This suitability obligation may pose implementation difficulties for platform operators as the SFC has indicated that where a person does not possess sufficient knowledge of virtual assets, the operator may only allow the person to trade if it would be in the best interest of the person.

The SFC does not indicate generally or in the context of specific virtual assets what type of knowledge would be sufficient or in what circumstances a trade would be in the best interest of a person but, in the context of derivatives, it is common to look to the length and quality of experience of persons seeking to trade derivatives as well as their overall net worth and ability to absorb losses.

Custody

An operator must comply with statutory rules in respect of custody of assets, including the requirement to deposit all funds into a segregated account with a bank in Hong Kong and must maintain insurance in respect of risks associated with custody, including theft or hacking.

The requirement to open a bank account in Hong Kong may pose significant practical difficulties in the pre-licensing stage as banks in Hong Kong may be reluctant to open an account handling funds from a platform where the source of trader funds is unknown.

Conflicts of Interest

Operators must take steps to minimize conflicts of interest which may arise from dealings by their employees or dealings for their own account and which may be prejudicial to platform traders.

Applying to the SFC

It is notable that the Platform Circular was issued by the Intermediaries Division rather than the Supervision of Markets Division, the latter of which is normally responsible for regulating market infrastructure, including exchanges, clearing houses and ATS providers. The division of responsibility suggests that the main focus of the SFC at this stage is investor protection rather than systemic stability as the Intermediaries Division is generally responsible for ensuring that investors are protected in their dealings with intermediaries and Supervision of Markets is generally responsible for managing risks in the market infrastructure. As a result, we may surmise that the emphasis in the supervisory process will focus less on systemic issues and more on investor protection issues. This is not to say that systemic issues will be unimportant. There is clear potential for cooperation between the Intermediaries Division and the Supervision of Markets Division.

The SFC expects the operator:

• Rule Making - to publish rules in respect of trading, custody, funding, suspensions and dispute resolution and to have in place safeguards against market manipulation.

• Market Surveillance - to conduct appropriate due diligence to ensure the quality of the virtual assets to be traded on the platform.

• Admission of Virtual Assets - to disclose criteria for admission of virtual assets to be traded.

In this final regard, an operator cannot admit an initial coin offering (“ICO”) token to the platform for at least 12 months after the completion of the ICO or when the ICO project has started to generate profit, whichever is earlier.

Forward Action

Based on our experience representing clients in licensing applications as well as applications for authorization of ATS, it appears that operators of virtual asset trading platforms face an uphill battle transitioning into entities regulated by the SFC.

The typical operator at this time likely not only falls short of meeting requirements applicable to licensed entities but also falls short of the much higher requirements applicable to operators of market infrastructure even if such latter requirements are “lite” versions of what would normally be required.

As the SFC’s initiative will likely require significant changes in how operators structure their operations and conduct themselves, operators will need to carefully consider whether the long-term benefits of being regulated by the SFC outweigh the possible substantial short-term losses in their trading base.