Cryptocurrency

Hong Kong Proposes Regulation of Over-the-Counter Crypto Trading – JD Supra


The requirements in the proposed framework are more extensive in scope and reach than what many virtual asset industry stakeholders anticipated.

On 8 February 2024, the Financial Services and the Treasury Bureau (FSTB) released a consultation paper on its legislative proposal to introduce a regulatory regime governing over-the-counter (OTC) trading of virtual assets (VA) in Hong Kong (Consultation Paper).

This blog post summarises the proposed regulatory framework set out in the Consultation Paper.

Background

A number of VA exchange platforms allegedly engaged in fraudulent trading activities in Hong Kong in 2023, causing significant losses to the public. Some VA OTC dealers made false or misleading statements to retail customers about the regulatory status of those exchanges and channeled their funds onto those exchanges.

In June 2023, Hong Kong introduced a comprehensive regime to regulate VA service providers operating a virtual asset trading platform (VATP) (see this Latham blog post) through an amendment to the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO). VATPs are supervised by the Securities and Futures Commission (SFC). When consulting on the VATP regime, the SFC and FSTB concluded that regulating VA exchanges was a priority whereas OTC trading activity was omitted on the basis that it was not a material consumer protection risk at that time.

Therefore, VA OTC dealers — including brokers, VA ATMs, and other digital platforms that facilitate VA trading but are not exchanges — are still unregulated in Hong Kong, meaning they are not subject to customer due diligence, conduct, and other regulatory requirements.

The FSTB now proposes to close that regulatory gap by amending the AMLO to introduce a new licensing regime for VA OTC service providers (VA OTC Providers) with reference to the existing regime for money service operators (MSOs), i.e., those who provide remittance and money changing services). Under the proposal, the Hong Kong Customs and Excise Department (CED), which supervises the MSO regime, would also supervise the new regime.

Proposed Regulatory Regime for VA OTC Providers

The key aspects of the proposed regime in the Consultation Paper are as follows:

  • VA spot trading services would be covered. Any person who conducts a business of “provision of service of spot trade of any VA” in Hong Kong (or who actively markets such services to the Hong Kong public) would need to be licensed, irrespective of whether such services are provided through a physical outlet or on a digital platform.

    The proposal is unclear on whether “service” is intended to cover both “intermediary” services (e.g., assisting a customer to purchase VAs on licensed VATPs and/or offering to sell VAs to customers), and “proprietary trading” activities (e.g., crypto trading firms dealing with institutional and sophisticated counterparties, market makers, or funds). We also expect the industry to seek (i) clarification on whether exemptions apply when dealing as principal and/or dealing with institutional professional investors (similar to the licensing exemptions for securities dealers under the current securities framework), and (ii) confirmation the regime is not intended to cover other VA services such as VA custody, staking, and lending.

  • Extraterritorial application. The scope of the licensing obligation would cover VA OTC Providers who operate in Hong Kong and those who “actively market” to the Hong Kong public from overseas. The term “active marketing” is seen in other Hong Kong regulatory regimes and refers to activity such as unsolicited communications with Hong Kong investors, mass media programmes targeting the Hong Kong public, and internet activities targeting Hong Kong investors.
  • Local presence requirement. An applicant for a VA OTC Provider licence would need to be a Hong Kong-incorporated company or a company with a branch registered in Hong Kong. It would also need to have a suitable premise in Hong Kong for its operations.
  • Prohibited activities for licensed VA OTC Providers. Licensees would be permitted to perform spot trades of any VA for money (or vice versa) but would not be permitted to convert VA to another VA (so providers of those services would need to operate as an exchange and apply for a VATP licence).

Providing other services, including any form of VA advisory or referral services, offering of VA derivatives, or other financial products (including staking, lending, and margin trading), would also not be permitted for VA OTC Provider licensees.

The initial thinking is that direct or indirect custody/escrow service of clients’ VA by licensees would not be allowed unless it is temporary in nature and is an indispensable part of the transaction process.

  • Remittance services to require a separate licence. Licensees would only be allowed to perform remittance of VA OTC transaction proceeds on specified conditions. To provide services for remittance of money, licensees would need to apply for a separate MSO licence (although there may be a streamlined licence process).

Licensees would only be allowed to transfer VA from their registered wallets to a client wallet for which the clients can provide proof of ownership and/or control.

  • Restricted token access: VA OTC Providers would only be able to offer services with respect to tokens that may be accessed by retail investors on at least one SFC-licensed VATP (i.e., large-cap VA) and stablecoins issued by HKMA-licensed stablecoin issuers under their forthcoming regime (see this Latham blog post).  This proposal significantly limits the universe of VAs in which VA OTC Providers could transact and, taken together with the requirement for each spot transaction to include a fiat currency leg and prohibiting VA for VA transactions, means that current OTC broker business models will need to be modified.    
  • Conduct of business requirements. VA OTC Providers would be required to appoint a compliance officer and money laundering reporting officer, have knowledge and experience in VAs, carry out their business in a sound and prudent manner and comply with conduct obligations, and have appropriate risk management. They would be subject to substantive anti-money laundering and counter-financing of terrorism obligations similar to other regulated financial institutions.
  • Certain regulated entities exempted. Banks, SFC-licensed corporations, VATPs, and (likely) stablecoin issuers would be exempt from the licensing regime. This will likely be welcomed by traditional financial services institutions interested in providing VA-related products and services to their customers.
  • Powers of the CED. The CED would be granted licensing and supervision powers, as well as sanctioning power against unlicensed or non-compliant activity.
  • Licence period. A successful applicant would be granted a licence for two years, renewable for another two years on application, consistent with the licensing regime for MSOs.
  • Transitional arrangement. The FSTB is proposing a transitional period of six months once the licensing regime commences. Existing providers would be allowed to continue their operations during that period, on condition that they have to submit a licence application to CED within three months from the start of the licensing regime.

The FSTB has asked for comments on whether there should be a “deeming arrangement” so that the CED can grant a “deemed licence” for a period until the CED can make a final decision on the application.

Pre-existing VA OTC service providers that do not submit a licence to CED within the first three months of the transitional period would need to close down their business in an orderly manner by the end of the fourth month.

Next Steps

Comments on the proposals should be submitted by 12 April 2024.

The VA industry has been expecting stricter guardrails to be imposed for VA spot dealing activities following the high-profile fraud cases in 2023. Still, the FSTB’s proposal is more far-reaching than many market participants anticipated. We expect many questions and comments from the industry around the intended scope of the licensing regime (including whether custody, market making, and proprietary trading are intended to be caught). Some of the more onerous restrictions (including incorporation or registration in Hong Kong and the restrictions on eligible VAs) may cause firms to rethink their Hong Kong presence or strategy.

Notably, the proposed regime would be supervised by the CED, which has not historically had oversight of VAs or trading activities (unlike the SFC and the Hong Kong Monetary Authority). The CED will likely need time and additional resources to properly understand the rapidly developing VA industry and business models, and put in place a suitable supervisory team.

In the meantime, existing VA OTC Providers should consider whether they could fall within scope of the licensing framework, the extent of their active marketing, and user base in Hong Kong.

The FSTB proposes to introduce the new regulatory regime as an amendment to the AMLO, which will need to pass through the Hong Kong Legislative Council before it is enacted. The FSTB aims to introduce a bill into the Legislative Council as soon as practicable.

Latham & Watkins will continue to analyse and report on the new developments to the proposed Hong Kong VA OTC Provider regulatory framework.



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