Following a consultation last year, the Hong Kong FSTB has released a proposal paper indicating the changes it thinks should be made to Hong Kong law as it applies to companies that deal with digital assets.
The changes include stricter regulations on digital assets, sidelining retail investors, and an emphasis on establishing parity of regulatory requirement between digital assets companies and the rest of the financial industry in Hong Kong.
Public Consultation on Legislative Proposals to Enhance Anti-Money Laundering and Counter-Terrorist Financing Regulation in Hong Kong: Consultation Conclusions
[See the paper here.]
In brief: what the proposals contain:
- License scheme for digital assets companies
- Serious fines and prison time for noncompliance
- Parity with the existing financial structure in terms of AML, KYC and CTF
- Exemption for P2P networks
- Professional investors only, companies may not sell to retail investors
The paper, published by Hong Kong’s Financial Services and the Treasury Bureau (FSTB), is the conclusion of an exercise designed to gather opinions on anti-money laundering and counter-terrorist financing from Hong Kong’s public, institutions and businesses.
The paper’s preamble states that “respondents came from a good mix of backgrounds, including industry associations and professional bodies, political party [sic], individual firms or companies, as well as individual members of the public”.
It goes on to note that most respondents “shared our view that a balanced approach to legislation should be adopted, complementing the need to have an effective system for addressing money laundering and terrorist financing (“ML/TF”) risks in the 3 concerned sectors, while minimizing regulatory burden and compliance costs on the businesses”.
In practice this is likely to mean a tighter regulatory regime, designed to exclude retail investors almost completely in the short term, and with serious penalties for unlicensed operations according to the Hong Kong arrangement. The paper’s recommendations aren’t law yet, but it is very likely to pass the Legislative Council in more or less its current form. It has implications for any business that deals in digital assets, as we’ll see. In particular it will tend to encourage consolidation of digital assets businesses and exclude smaller exchanges currently using Hong Kong as a base.
Currently, Hong Kong law regarding digital assets is based on the Securities and Futures Commission (SFC)’s 2018 “Statement on regulatory framework for virtual asset portfolios managers, fund distributors and trading platform operators”, amended by announcements from the Internal Revenue Department (IRD), the international Financial Action Task Force (FATF), and others.
The FSTB now proposes to change the laws regulating digital assets, creating significantly stricter standards of supervision for digital assets companies.
Companies classified as Virtual Assets Service Providers (VASPs) will have to seek licensing from the SFC within 180 days of beginning operations — regardless of whether they offer tokens classified as securities, or assets like BTC.
The FSTB proposes to designate “operating a VA exchange as a ‘regulated VA activity’ under the AMLO” (Anti-Money Laundering Ordinance), and defines both VASPs and exchanges extremely broadly.
The FSTB proposes to define VASPs as “any trading platform which is operated for the purpose of allowing an offer or invitation to be made to buy or sell any VA in exchange for any money or any VA, and which comes into custody, control, power or possession of, or over, any money or any VA at any point in time during its course of business”.
Hence, centralized exchanges and OTC desks will fall under this definition.
The proposal makes no direct mention of registered trust companies. It’s important to bear in mind that the paper is written to answer FATF AMLO questions, and to propose that SFC be the AML regulator for VA exchanges under AMLO, rather than under the Securities and Futures Ordinance (SFO) Schedule 5.
Peer-to-peer exchanges are explicitly exempted from this proposal. This means that registered trust companies that deal with digital assets clients, like First Digital Trust, will likely be allowed to continue acting as a clearer for peer-to-peer networks which have already been onboarded.
Decentralized exchanges that do not custody user tokens are explicitly exempted from the proposal, though the definition of P2P exchanges is drawn quite narrowly.
The FSTB says that an exchange is a P2P exchange “to the extent that the actual transaction is conducted outside the platform and the platform is not involved in the underlying transaction by coming into possession of any money or any VA at any point in time”. This seems to mean that an exchange offering P2P functionality but also has a conventional centralized exchange, would not be exempted.
The proposal notes “the view of prospective market players that a VA exchange should be allowed to offer its services to retail investors as well as professional investors”, and observes in the preamble that 40% of respondents held this view.
Nevertheless, the FSTB decided that “the requirement of confining the services of a VA exchange to professional investors only is necessary to ensure a proper degree of protection for the investing public, in line with the policy objective of promoting the healthy and orderly development of the market.”
Professional investors are defined as those with portfolios worth HK$8 million (about US$1 million).
This, combined with the consolidation of the market and the loss of easy on-ramps and centralized exchanges with easy UX, will likely mean a sharp drop in retail investment and a change in the shape of the market. Some retail-oriented VASPs currently calling Hong Kong home will likely move their base of operations, and retail investors who do want access to digital assets will be obliged to use purely P2P networks which are technically more secure, but can be less safe and a lot less easy to use.
However, there’s no reason to think this restriction will be permanent. The proposal authors “consider that the requirement is appropriate at least for the initial stage of the licensing regime. We will continue to monitor the evolving landscape and review the position as the market becomes more mature in future”, strongly suggesting that retail investment in digital assets could make a comeback after regulation has established a safer, less volatile market.
The stated purpose of these proposals is to “address the ML/TF [money-laundering and terrorism financing] risks of VA activities”. That’s why the FATF revised its Standards in 2019 to “impose on VASPs the full range of AML/CTF obligations that are currently applicable to financial institutions and designated non-financial businesses and professions (‘DNFBPs’)”.
This is partly about addressing a perceived issue with the digital assets market, which is more volatile and higher-risk than the traditional financial space. But it’s also about normalizing regulations across the whole of Hong Kong’s financial life.
In particular, the proposal would bring VASPs into line with other financial institutions by making them subject to the same Customer Due Diligence (CDD) and record-keeping requirements, under Schedule 2 of the AMLO, as well as the prescribed regulatory requirements relating to financial resources, knowledge and experience, risk management, segregation and management of client assets, financial reporting and disclosure, prevention of conflicts of interest, and prevention of market manipulation and abusive activities.
The SFC will be empowered to enter the place of business of a VASP to conduct routine inspections, request documents and other records, and to investigate non-compliance and impose administrative penalties including orders for remedial activity, reprimands and loss of license.
Licenses will be open-ended; once gained, a license will not expire. VASP license applicants will be subject to a fit-and-proper test under criteria consistent with those applied to DNFBPs and financial institutions by Schedule 9 of the AMLO.
Licensees will also have to appoint at least two responsible officers who are to be held personally accountable in case of contravention or non-compliance.
Licensed VASPs may only offer services to professional investors, and must “impose rigorous criteria for the inclusion of VAs to be traded on its platform.”
Punishments for noncompliance include delicensing and other lesser administrative actions. But the proposals also include these measures:
- Conducting a regulated VA activity without a license: a fine of $5,000,000 and imprisonment for seven years
- In the case of a continuing offence, a further fine of $100,000 for every day during which the offence continues
- Provision of a false, deceptive or misleading statement in a material particular in connection with a license application: a fine of $1,000,000 and imprisonment for two years
- Non-compliance with the statutory AML/CTF requirements: a fine of $1,000,000 and imprisonment for two years
- Fraudulent or reckless misrepresentation for the purpose of inducing another person to acquire or dispose of a VA: a fine of $1,000,000 and imprisonment for two years
These punishments apply to the responsible persons each licensee must appoint as officers, and include serious prison time as well as large fines.
These proposals will almost certainly pass with relatively little alteration and become law. From First Digital Trust’s perspective, we don’t see anything in this document that should directly disrupt or alter our business, though it might affect some of our clients and partners. But looking at the space as a whole, the effects will probably be ambivalent.
Like most operators in the digital assets space, we welcome sensible legislation and are aware of the dangers posed by money-laundering, terrorism finance and other financial crimes. But we are also sensitive to the role of retail investors in digital assets innovation, and although such investors form no part of our business we hope to see a regulated path to exposure to digital assets for retail investors secured by the Hong Kong authorities.
However, better regulation and clearer areas of personal responsibility, and the establishment of parity with existing financial institutions and with institutional, HNWI and professional investors in mind, clearly helps to bring positive attention to the digital assets space, reduce the number of potential bad actors and increase investor confidence in the space and the asset class. To that extent we very much welcome these proposals.