Ready for Your Exam? A Refined Illustration on the SFC’s Stance III & IV

How hard is it to become a licensee?

Well, read this article, and you’ll find out

Get to know the policy and embrace regulation!

Once after the Position Paper became publicised, the SFC has been carrying out “the most challenging exam” for virtual asset exchanges.

I, again, will persist on my hardcore spirit of “never palaver, never slander, never betray readers and research comes the first”. This time, I will interpret SFC’s announcement in a full range. Avoiding any subjective and misleading guessing, I’ll prove myself, Seon, to be the one capable and liable in helping readers penetrate the essentials of “the exam rules”.

The Position Paper has four sections and an appendix (Licensing Conditions and Terms and Conditions for Virtual Asset Trading Platform Operators). The four sections are:

Part I: the SFC’s Regulatory Approach to Virtual Asset Trading Platforms

Part II: Background:

A. Global Landscape;

B. The SFC’s Regulatory Approach to Virtual Assets.

Part III: Framework for the Regulation of Virtual Asset Trading Platforms

A. Licensing and Supervision;

B. Regulatory Standards.

Part IV: Way Forward.

In the last chapter Ready for Your Exam? — — A Refined Illustration on the SFC’s Stance I & II, we interpreted the Position Paper’s Part I and Part II.

Today, we’ll come to Part III and IV. Let’s move ahead!

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Licensing and Supervision

Licensing Regime (To optimise the article’s readability, I, the author of this article, categorised the exchanges into Type A and Type B)

o Type A: a centralised exchange where at least one type of security token is offered for trade. To operate legally, this sort of exchange, confined to the SFC’s regulation, needs to apply for and obtain the Type 1 (security exchange) and Type 7 (providing automated trading services(ATS)).

o Type B: an exchange that only does not offer any security tokens for trade, even if it is a centralised exchange, is not confined to SFC’s regulatory regime.

o The SFC is empowered to grant licences to regulated persons who are capable of complying with the licensing criteria (i.e., to be a fit and proper licence applicant) as operators of the Type A platform according to the definition of the SFO. Such approval means the applicants become licensees that may operate and manage virtual asset exchange businesses.

o In the following conditions, SFC will not accept an application:

a. The operator only providing Peer-to-Peer trading services;

b. The investor retains the control over their own assets (be them fiat currencies or virtual currencies);

c. No ATS is provided on the platform.

The Regulatory Regime

o Non-security token trading and security token trading may associate and collectively constitute a comprehensive business. Owing to this, once the licence issued, the regulation will cover all the relevant issues of the licensed platform even if the business consists of only a small portion of security tokens. SFC will conduct a holistic assessment in terms of the platform’s infrastructure, applicants’ qualifications and the conditions of virtual asset trading activities.

o A platform operator applying for a licence should be aware that it would be expected to comply with all the relevant regulatory requirements when conducting its virtual asset trading business, whether this involves security tokens or non-security tokens and whether occurring on or off its platform. To ensure the enforcement, under section 116, 129 and 180 of the Securities and Futures Ordinance, the SFC must refuse to grant a licence unless it is satisfied and examined that a licence applicant is fit and proper.

o A platform operator should ensure that all virtual asset trading business activities (Relevant Activities) are actively marketed to Hong Kong investors or are conducted in Hong Kong are carried out under a single legal entity. Isolating all Relevant Activities within a single legal entity allows the SFC to exercise comprehensive oversight. This also minimises any uncertainty about which parts of the business are licensed and supervised by the SFC.

Regulatory Standards: Licensing Condition

o The licensee must only provide services to professional investors.

o The licensee must comply with the attached “Terms and Conditions for Virtual Asset Trading Platform Operators”.

o The licensee must obtain the SFC’s prior written approval for any plan or proposal to make a material change to an existing service or activity.

o The licensee must obtain the SFC’s prior written approval for any plan or proposal to add any product to its trading platform.

o The licensee must provide monthly reports to the SFC on its business activities in a format as prescribed by the SFC. The report must be submitted to the SFC within two weeks after the end of each calendar month.

o The licensee must engage an independent professional firm acceptable to the SFC to conduct an annual review of its activities and operations and prepare a report confirming that it has complied with the licensing conditions and all relevant legal and regulatory requirements. The first report must be submitted to the SFC within 18 months of the date of approval of the licence. Subsequent reports should be submitted to the SFC within four months after the end of each financial year and additionally upon the SFC’s request.

o The licensee must engage an independent professional firm acceptable to the SFC to conduct an annual review of its activities and operations and prepare a report confirming that it has complied with the licensing conditions and all relevant legal and regulatory requirements. The first report must be submitted to the SFC within 18 months of the date of approval of the licence. Subsequent reports should be submitted to the SFC within four months after the end of each financial year and additionally upon the SFC’s request.

In addition to these existing requirements, the SFC has included additional requirements which are responsive to the unique features of virtual assets and the technology associated with them.

Safe Custody of Assets:

The platform should have an “associated entity” incorporated in Hong Kong and wholly own a subsidiary that holds a “trust or company service provider licence”(TSCP).

Hot and Cold Wallets:

o The SFC will require a platform operator to ensure that it (or its Associated Entity)

o Stores 98%of client virtual assets in cold wallets and limits its holdings of client virtual assets in hot wallets to not more than 2%.

o Has detailed procedures to deal with events such as hard forks or air drops from an operational and technical point of view, given the unique characteristics of virtual assets.

o Takes on an insurance policy covering the risks associated with the custody of virtual assets held in both hot storage (full coverage) and cold storage (a substantial coverage, e.g.,95%) is in effect at all times.

o Sets up and implements strong internal controls and governance procedures for private key management to ensure all cryptographic seeds and keys are securely generated, stored and backed up.

Know-Your-Client (KYC):

o A platform operator should comply with the KYC requirements applicable to a licensed corporation. It should take all reasonable steps to establish the true and full identity of each of its clients, and of each client’s financial situation, investment experience and investment objectives.

o The platform provides the clients with sufficient knowledge of virtual assets, including knowledge of the relevant risks associated with virtual assets, before providing any services to the client. Where a client does not possess such knowledge, a platform operator may only provide training and inspection services to the client. A platform operator should enquire into every client’s personal circumstance to ensure that the provision of its services is suitable for that client.

o A platform operator should also assess concentration risks by setting a trading limit, position limit or both with reference to the client’s financial situation to ensure that the client has sufficient net worth to assume the risks and bear the potential trading losses.

Anti-money laundering and counter-financing of terrorism (AML/CFT):

o The SFC expects a platform operator to establish and implement adequate and appropriate AML/CFT policies, procedures and controls (collectively referred to as AML/CFT systems) so that it can adequately manage risks of anonymity.

o A platform operator should also regularly review the effectiveness of its AML/CFT systems and introduce enhancements where appropriate, taking into account any new guidance.

o A platform operator may deploy virtual asset tracking tools which enable platforms to trace the on-chain history of specific virtual assets and flag identified transactions. In such cases, platforms may refuse to on-board the persons involved as clients. These flagged items may include addresses used in ransomware attacks, money laundering or dark web transactions.

Prevention of market manipulative and abusive activities

The SFC expects a platform operator to establish and implement written policies and controls for the proper surveillance of activities on its platform in order to identify, prevent and report any market manipulative or abusive trading activities. The policies and controls should cover the misconducts include:

o Spoofing: this can be described as a trader places a large order to buy or sell a financial asset with no intention of executing. Such a trader is called “the spoofer”, by doing so, the spoofer creates an artificial impression of high demand for the asset.

o Layering: it is a strategy in high-frequency trading where a trader makes orders in hopes of influencing the asset price and then cancels orders before reaching a deal.

o Pump-and-Dump Scheme: it is an illegal scheme used to artificially boost the price of an asset by making false and misleading claims about a company’s business prospects. Then, the assets are sold before the fraud becomes known, at which the stock price usually plummets and the unsuspecting investors lose their money.

o Facing these misconducts, a platform operator should immediately restrict or pause trading by adopting the measures including freezing some accounts.

o Market surveillance tools developed to detect market manipulation in conventional asset classes, often used by global exchanges and regulators, can also be deployed to monitor virtual asset classes with some adjustments.

o The platform operator should adopt an effective market surveillance system provided by a reputable and independent provider to identify, monitor, detect and prevent any market manipulative or abusive activities on its platform, and provide access to this system for the SFC to perform its own surveillance functions when required.

Accounting and Auditing:

The SFC will require a platform operator to exercise due skill, care and diligence in the selection and appointment of auditors for its financial statements, and should have regard to their experience and track record in auditing virtual asset-related businesses and their capability to audit a platform operator.

Risk Management

o A platform operator and its Associated Entity will need to have a sound risk management framework which enables them to identify, measure, monitor and manage the full range of risks arising from their businesses and operations.

o A platform operator should also require customers to pre-fund their accounts. A platform operator is prohibited from providing any financial accommodation for clients to acquire virtual assets.

Conflicts of Interest

A platform operator, if licensed, should not engage in proprietary trading or market-making activities on a proprietary basis. Should a platform plan to use market-making services to enhance liquidity in its market, the SFC generally expects this to be done at arm’s length and to be provided by an independent external party using normal user access channels.

Virtual Assets for Trading

o A platform should set out and enforce the following factors: the obligations of and restrictions on virtual asset issuers; the criteria for a virtual asset to be included on its platform and the application procedures, taking into account the criteria contained in the Terms and Conditions; the criteria for halting, suspending and withdrawing a virtual asset from trading on its platform, the options available to clients holding that virtual asset and any notification periods.

o A platform operator should perform all reasonable due diligence on all virtual assets before including them on its platform for trading, and ensure that they continue to satisfy all application criteria. Set out below is a non-exhaustive list of factors which a platform operator must consider, where applicable:

a. the background of the management or development team of the issuer of a virtual asset;

b. the jurisdictive condition in which the platform operator provides trading services;

c. the market condition analysis, including the supply, demand, maturity, liquidity and trading volume;

d. the technical aspects of a virtual asset, including the security assessment in the dimensions of the blockchain protocol’s algorithm and infrastructure;

e. the level of activity within the development community;

f. the level of adoption across the ecosystem;

g. the marketing materials of a virtual asset provided by the issuer, which should be accurate and not misleading;

h. the development evaluation of a virtual asset, including the outcomes of any projects associated with it as set out in its Whitepaper (if any) and any previous major incidents associated with its history and development;

i. in relation to virtual assets, they must be asset-backed, approved or qualified by, or registered with, regulators in comparable jurisdictions, and with a post-issuance track record of 12 months.

o As from 6 November 2019, a firm which operates a centralised virtual asset trading platform in Hong Kong and intends to offer trading of at least one security token on this platform may apply for a licence from the SFC for Types 1 and 7 regulated activities.

o Applicants must demonstrate that they are willing and able to comply with the expected standards under the regulatory framework described in this paper.

o In light of the intensive assessment process and to meet the expected regulatory standards, the time required for processing a licensing application from a virtual asset trading platform may be longer than for a standard licensing application.

o A virtual asset trading platform operator, upon becoming licensed, will be placed in the SFC Regulatory Sandbox. This would typically mean more frequent reporting, monitoring and reviews. Through close supervision, the SFC will be able to highlight areas where operators should improve their internal controls and risk management.

o The SFC will continue to monitor the evolution of crypto-assets and work with the Hong Kong Government to explore the need for legislative changes in the longer term.

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I must say, virtual assets, owing to their peculiarity, constitute a significant regulatory challenge to regulatory agencies around the world. Such a regulatory framework of the HKSFC deserves the reputation of a textbook-level exemplar.

Such an exemplar will help the whole industry develop on a stable track and provide an instructive reference for other regulatory agencies. Such a framework is likely to harbinger a sped-up security tokenisation.

The previous passage: Ready for Your Exam? — — A Refined Illustration on the SFC’s Stance I & II

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