Quick Observations on the Outlook of Virtual Assets Retail Trading under SFC’s New Regime

The Securities and Futures Commission of Hong Kong (“SFC”) concluded its Consultation on the Proposed Regulatory Requirements for Virtual Asset Trading Platform Operator (“Platform Operators”).  The regulatory framework “aims to provide robust investor protection and manage key risks … [and] enable the industry to develop sustainably and support innovation”.  The guidelines will come into force on 1 June 2023 and the SFC will accept applications for Virtual Asset (“VA”) Trading Platform Licenses from that date onwards.

The Consultation Conclusion covered several key areas, including (among others):

1. Retail access to licensed VA trading platforms
2. The criteria for token admission
3. Compensation arrangements
4. Implementation details; and
5. The transitional arrangements

This note will focus on the first 3 areas.

First, in the proposed framework, the SFC will allow VA trading platforms to provide services to retail investors.  The Platform Operators are to be subject to a number of robust measures to protect retail investors, including ensuring suitability in the onboarding process, good governance, enhanced token due diligence, admission criteria and disclosure, etc.  Further, the Platform Operators must be sufficiently liquid, with assets (not VA) equivalent to at least 12 months of its actual operating expenses. They must also, at all times, maintain paid-up share capital of not less than HK$5,000,000.

General Token Admission Criteria

With the support of majority of the consultation respondents, it is concluded that a licensed VA trading platform should conduct due diligence on each token before admission.

The SFC explained the due diligence process as follows:

“A platform operator is expected to obtain information for each virtual asset – whether directly from the issuer or otherwise – which it can be reasonably satisfied is reliable and sufficient to base its token admission decision on”

The SFC further spelled out the due diligence measures:

• Platform Operators are required to consider the regulatory status of the VA in Hong Kong (status in other jurisdictions is not a must);
• Non-security token must have at least a 12-month track record
• With regards to smart contract audit, an independent assessor by the platform or another party
• SFC may request legal opinion on specific tokens based on the token’s development in other jurisdictions. However, it is not mandatory to submit legal advice on the regulatory status of each VA

Specific Tokens Admission Criteria

Platform Operators must conduct due diligence on each and every token.

they are only permitted to trade VAs which satisfy the specific token admission criteria, which only comprise “eligible large-cap” VAs included in at least two acceptable indices issued by at least two independent index provider.

The token being on two acceptable indices is merely the “minimum criterion”. The burden falls on the Platform Operator to conduct further due diligence, and to ensure the platform itself is highly liquid. The SFC also stressed that it would be inappropriate for the SFC to publish a list of eligible VA for retail trading.

Stablecoins

Under the guidelines, stablecoins are not to be admitted for retail trading until further regulations are rolled out in respect of stablecoins.

Compensation arrangements will be required for the purpose of investors protection.  Provided that 98% of the client VA are held in cold storage, the insurance coverage threshold has been lowered to 50%.  Meanwhile, client VA held in hot storage should be fully covered by the compensation arrangement.

The SFC has helpfully identified the types of assets that can form part of the compensation arrangement, such as bank guarantees, funds held in the form of demand deposits of fixed deposit with a maturity of 6 months or less, and reserve virtual assets that are the same as the client virtual assets

Licensed VA trading platforms should set aside the fund via an escrow arrangement or held in a segregated account with an authorised financial institutions.

The SFC’s consultation conclusions are significant in terms of investors protection and, perhaps more remarkably, a strong step towards legitimising retail trading of VA.

Under the guidelines, the SFC is seeking to provide robust protection to the retail investors in VA.  It is readily understandable why SFC would like to be cautious.  Given the number and scale of seismic events in the VA space since the beginning of 2022, a relatively stringent approach is clearly a sensible first step.  As one of the first comprehensive frameworks, the proposed regulatory regime even has the potential to lay down a major milestone in the global regulatory landscape for VA trading.

Meanwhile, whether the measures in place are sufficient for the purpose of protecting retail investors remains to be tested.

In terms of the range of selection for retail investors, a major drawback is that stablecoins cannot be traded by retail investors for the time being.  This may cause difficulties for retail investors to access a wider variety of cryptocurrencies and Platform Operators to access better liquidity.  The market awaits the further regulations to be issued by the SFC in respect of stablecoins.

Regarding the development of the crypto-space, the most interesting implication is whether Hong Kong could develop a more significant role as a hub given that, in mainland China, cryptocurrency still remains officially banned.  The legitimacy of VA trading platforms in Hong Kong could potentially attract more interest from the mainland to develop their businesses in this area and those cryptocurrency businesses which had previously moved away from Hong Kong to return.

This article was authored by Vincent Chiu.