Virtual Asset Trading Platforms in Hong Kong

In this article, we look at some specific requirements under the Guidelines for Virtual Asset Trading Platform Operators (VATP Guidelines), and the Guideline on Anti-Money Laundering and Counter-Financing of Terrorism (For Licensed Corporations and SFC-licensed Virtual Asset Service Providers) (AML Guideline) published in June 2023.

Retail Access And Protection

Under the VATP Guidelines, licenced VATPs may provide trading services in respect of certain virtual assets to retail investors, subject to complying with a suite of investor protection measures before providing such services. Key measures cover areas such as client onboarding, governance, disclosure obligations, token due diligence, and admission criteria.

Client Onboarding And Suitability Assessment

VATPs should assess whether it is suitable for a client to trade virtual assets, for example by assessing a client’s risk tolerance and conducting a holistic assessment of an investor’s understanding of the nature and risks of virtual assets.

Governance

A VATP should set up a token admission and review committee responsible for establishing, implementing, and enforcing the criteria for a virtual asset to be admitted, suspended, and withdrawn from trading, and making the final decision as to whether to admit, suspend, or withdraw a virtual asset for clients based on such criteria. The committee should also be responsible for establishing, implementing, and enforcing the rules, which set out the obligations of and restrictions on virtual asset issuers, and reviewing regularly both the foregoing criteria, as well as the virtual assets admitted for trading, to ensure they continue to satisfy the token admission criteria.

Disclosure Obligations

When posting information or materials on its platform or providing information to clients, a VATP should act with due skill, care, and diligence to ensure that all information is accurate. A VATP should also ensure all information is presented in a clear and fair manner, communicated in an easily understood way, and not misleading.

Token Due Diligence And Admission Criteria

The VATP Guidelines outline a non-exhaustive list of factors for VATPs to consider when admitting virtual assets for trading, which include the background of the management or development team of a virtual asset; regulatory status of the virtual asset in Hong Kong; supply, demand, maturity and liquidity of the virtual asset, including its track record (a non-security token should have been issued for at least 12 months); technical aspects and development of the virtual asset; market, governance, and legal risks of the virtual asset; and the money laundering and terrorist financing risk associated with the virtual asset.

These are general due diligence requirements that VATPs should always adhere to and apply, irrespective of whether the virtual asset in question is made available to retail clients or not.

For tokens for trading by retail clients, in addition to the above, the VATP should ensure that the virtual asset does not fall within the definition of “securities” under the SFO (unless the offering of the virtual asset complies with a relevant exemption and does not breach the restrictions on offers of investments under the SFO), and is of high liquidity. When assessing the liquidity of a specific virtual asset for retail trading, a VATP should, at minimum, ensure that the virtual asset is an eligible large-cap virtual asset (ie a virtual asset that has been included in a minimum of two acceptable indices issued by at least two different index providers). Amongst other matters, the SFC requires at least one of the indices to be issued by an index provider that complies with the International Organization of Securities Commissions (IOSCO) Principles for Financial Benchmarks, and will not publish a whitelist of acceptable tokens or indices.

Additionally, before admitting any virtual asset for trading, a VATP must exercise due skill, care, and diligence in selecting and appointing an independent assessor to conduct a smart contract audit for smart-contract-based virtual assets, unless the VATP demonstrates that it would be reasonable to rely on a smart contract audit conducted by an independent assessor engaged by a third party.

VATPs must also implement appropriate monitoring procedures to keep track of any changes to a virtual asset being traded by clients through the VATP that may cause the virtual asset’s legal status to change. The VATP should regularly submit review reports to the token admission and review committee that it is required to establish.

Stablecoins

Stablecoins will not be available for retail trading until a full regulatory regime on stablecoins has been implemented by the Hong Kong Monetary Authority (HKMA), which is expected in the near future.

Algorithmic Trading

Whilst a VATP is prohibited under the VATP Guidelines from providing algorithmic trading services to its clients, the SFC has clarified that clients can use their own algorithmic trading systems in connection with trading via a VATP.

Provision Of Other Common Services

The SFC has emphasised that a VATP’s primary business is to act as an agent and provide an avenue for the matching of orders between clients. Hence, VATPs are not permitted to provide such businesses as earning, deposit-taking, lending, and borrowing.

Offers Of Gifts

A VATP should not offer any gift, other than a discount of fees or charges, to its client for the trading of a specific virtual asset.

Insurance And Compensation Arrangements

A compensation arrangement, as approved by the SFC, should be in place for clients’ virtual assets held by a VATP. Where a client’s virtual assets are held in hot and other similar storage facilities (with such types of virtual assets being, preferably, less than two per cent of all the client’s virtual assets), those types of virtual assets must be 100 per cent covered by the compensation arrangement of the VATP. Conversely, a client’s virtual assets held in cold storage (which should be at least 98 per cent of a client’s virtual assets) has a reduced coverage threshold of 50 per cent.

The compensation arrangement should include any or a combination of the options below:

• Third-party insurance.
• Funds (held in the form of a demand deposit or time deposit that will mature in six months or less) of the VATP or its group companies, which are set aside on trust and designated for such a purpose, provided that where the funds are held in a manner controlled by the VATP or its associated entity, the funds so set aside should be held in a segregated account with an authorised financial institution and segregated from any assets of, amongst others, the VATP, its associated entity, its group companies and client assets.
• Virtual assets of the VATP or its group companies, which are set aside on trust and designated for such a purpose, provided that the virtual assets set aside should be the same as those client virtual assets covered under the compensation arrangement, and be held by the VATP’s associated entity in cold storage and segregated from any virtual assets of the VATP, its associated entity, its group companies and client virtual assets; and
• Bank guarantee(s) provided by an authorised financial institution in Hong Kong.

Travel Rule

Under the AML Guideline, licenced VATPs are required to comply with various requirements known as the ‘Travel Rule’ including:

• When acting as the ordering institution, obtain, hold, and submit required information about the originator and recipient to the beneficiary institution immediately and securely.
• When acting as the beneficiary institution, obtain from the ordering institution and hold the required information.

The SFC echoed the view of the Financial Action Task Force that the Travel Rule should be implemented as soon as possible in light of the fact that other major jurisdictions have already implemented, or will shortly implement, their own travel rules. If there is a delay in implementing the Travel Rule in Hong Kong, that may deter VATPs and financial institutions operating in other major jurisdictions from entering transactions with VATPs in Hong Kong in light of risk management concerns.

However, acknowledging that VATPs may require more time to develop systems for the immediate submission of the required information, the SFC has been accepting submissions on an “as soon as practicable” basis during a transitionary period from 1 June 2023 to 1 January, 2024. VATPs have still been required to comply with all other Travel Rule requirements with effect from 1 June, 2023, including submitting the required information to the beneficiary institution securely whilst adopting the foregoing transitionary arrangements.

Both obtaining a licence and ensuring continuous compliance with the new regime will be critically important for those VATPs wanting to provide virtual asset services in Hong Kong, including to retail investors, as monetary and criminal penalties can be imposed where there are violations of the requirements imposed by the new regime.

However, it appears clear that the Hong Kong government wishes to continue to support the growth of the virtual asset industries, and that the framework implemented should help to promote the growth, both of the virtual asset industries and more traditional businesses assisting those industries.

Gavin Cumming
Mr. Cumming joined the firm in 2005 and has day-to-day responsibility for the firm’s non-contentious financial services practice. He is recognized by AsiaLaw Leading Lawyers as a leading lawyer in financial services regulation. Mr. Cumming has broad and deep experience in corporate, commercial and tax matters with a particular focus on strategic and operational initiatives of asset managers, investment banks, private banks and other wealth managers, insurance companies, broker-dealers and market infrastructure operators. He has a wealth of experience in electronic trading and clearing systems, the formation of private funds, including hedge funds and private equity funds, capital raising for funds, the authorization of public funds for sale to the retail public, private equity portfolio transactions, change of control transactions involving regulated financial institutions, and ongoing compliance issues for regulated financial institutions.