To put it simply: virtual assets move fast, but legislation doesn’t. Hong Kong’s securities regulator (SFC) knows this, and in recent weeks has put in a lot of effort to show that regulation is better than legislation at keeping up with the breakneck speed of virtual asset developments. There have been major developments in both:
(1) the management and distribution of virtual asset funds – as the SFC last month imposed T&Cs on virtual assets fund managers; and now
(2) the regulation of virtual asset trading platforms (VA Platforms) – as a new regulatory framework was announced last week.
Short of new legislation to put virtual assets on a clear legal footing in Hong Kong, these developments are being seen as the best response to the industry’s calls for greater certainty, and could help pave the way for more institutional money to flow into the virtual asset market.
1. An “opt-in” licensing regime
When announcing the new regime, Ashley Alder (SFC CEO) described it as an “opt-in” regime, although as written the new framework requires certain VA Platforms to apply for licenses to deal in securities and to run an automated trading platform (in SFC parlance – Type 1 and Type 7 licences). The reality is somewhere in the middle.
Affected VA Platforms are those that (1) trade at least one security token (ie virtual assets or tokens which are legally “securities” or “futures contracts”); (2) have control over investors’ assets; and (3) operate in Hong Kong. As existing VA Platforms typically trade non-security tokens (primarily “exchange tokens” such as bitcoin), platform operators can essentially choose whether or not to offer to trade security tokens.
In other words, if platform operators think the SFC’s regulatory expectations are too difficult or costly, they can decide not to fall within the regulatory remit by ensuring that no virtual asset traded on their VA Platforms is a “security”.
2. Should VA Platforms opt in? Some pros and cons to consider
Why opt in?
- Many consider a regulatory licence to be a “seal of approval” and as a factor that will attract institutional investors. Licensed status could therefore boost trade volume and liquidity.
- Licensed VA Platforms will be able to better monitor and manage potential risks, by having in place effective and robust infrastructure and systems in compliance with the regulatory standards.
Why opt out?
- The broad scope of regulatory standards – covering both the usual investor protection concerns (eg safe custody of assets, KYC, AML and market manipulation) and issues specific to virtual assets (eg hot and cold wallets, forks, airdrops) – means they are bound to have a significant compliance cost, especially for new VA Platforms.
- All aspects of the VA Platform’s operations will be regulated, even if the vast majority of trading is in non-security tokens.
- Restructuring may be needed, as the SFC requires all virtual asset trading activities in Hong Kong (including actively marketing to Hong Kong investors from outside Hong Kong) to be carried out under a single licensed entity.
3. A band-aid solution…
An “opt-in” regime for the willing and the capable is perhaps not ideal from an investor protection perspective, but the SFC acknowledges that this is the maximum it can offer at the moment. As existing securities legislation was designed without virtual assets in mind, the SFC admits that there are “inevitable gaps and limitations” with the new framework, in particular:
- VA Platforms hosted in Hong Kong may decide not to seek an SFC licence;
- the SFC has no power to regulate VA Platforms that only trade non-security tokens;
- licensed VA Platforms will not be subject to the same kind of regulation which applies to traditional offerings of “securities” or investment funds (eg no disclosure requirements for an offer of virtual assets which are not legally “securities”); and
- the SFC does not have the authority to take legal action against misconduct, because VA Platforms are not recognised stock exchanges or futures markets.
Mr. Alder mentioned in his keynote speech at last week’s Hong Kong Fintech Week that this new framework “can only be an interim measure”, and that “the rapid evolution of the virtual asset sector cries out for new, comprehensive legislation which enables innovation benefiting investors and economies to flourish in an environment where new risks are addressed properly”. Looking ahead, legislative changes appear to be the answer, but it remains uncertain as to if and when they will happen.