The Hong Kong Securities and Futures Commission (SFC) published a new regulatory framework for crypto exchanges on Wednesday. CEO Ashley Alder explained that the commission met with a number of crypto exchange operators after unveiling a conceptual framework that could be used to regulate crypto exchanges last year. “After an in-depth examination of the unique technical and operational features of these platforms, we finally concluded that some could be regulated by us,” he remarked.
Hong Kong’s Securities and Futures Commission has established a new regulatory framework that allows crypto exchanges to opt-in to be licensed and regulated. Starting Wednesday, centralized trading platforms can apply for a license, providing they meet certain requirements including adequate measures for the safe custody of assets, insurance, hot and cold wallets, and private key management.
An Opt-In System
SFC CEO Ashley Alder
The commission has been focusing on whether to regulate crypto exchanges. Alder elaborated, “We saw this as a priority because this type of platform has proliferated in Hong Kong and up to now has largely escaped any form of regulation,” adding that it is largely because crypto assets fall outside the legal definition of securities and futures contracts. Since bitcoin and other cryptocurrencies are not securities and “nothing in our new framework alters this position,” he admitted that the SFC can only regulate those platforms that choose to include at least one security crypto asset or token for trading. “But once this happens our new rules will apply to all platform operations, even if the vast majority of other virtual assets traded on the platform are not securities.” The CEO clarified:
So this, essentially, is a framework allowing a platform operator to opt-in to regulation … Once licenses are granted to those platforms which choose to opt-in, investors will then be able to distinguish easily between properly regulated platforms, and all the rest.
What the Regulation Entails
The SFC detailed in its “Position Paper” published on Wednesday the rules and requirements for crypto trading platforms to be regulated. The commission also emphasized that only centralized platforms in Hong Kong that provide crypto trading, clearing, and settlement services will be considered for licensing. Applications from peer-to-peer marketplaces will not be accepted at this time. The SFC confirmed:
As from 6 November 2019, a firm which operates a centralized 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 license from the SFC for Types 1 and 7 regulated activities.
The Type 1 license is for dealing in securities and the Type 7 is for automated trading services (ATS) activities. The commission also requires all trading activities of its licensees, including those conducted by their group companies, to be carried out under a single, SFC-licensed legal entity. The regulator explained that not only will it allow for comprehensive oversight, but it also “minimizes any uncertainty about which parts of the business are licensed and supervised by the SFC.”
Further, licensees are required to obtain prior written approval from the SFC for any plan or proposal such as for introducing or offering a new or incidental product or service, or to make a material change to an existing service or activity. Licensees must also provide monthly reports to the commission and engage an independent professional firm to review their activities and operations annually.
The Position Paper also outlines licensing conditions, the first of which details who can trade on licensed platforms. The SFC noted:
The licensee must only provide services to professional investors.
The definition of a professional investor is extensive; it includes an individual, a partnership or a corporation with a portfolio of at least 8 million HKD (~$1 million) or equivalent, or a trust corporation with total assets of at least 40 million HKD or equivalent.
For the safe custody of assets, the SFC requires licensees “to ensure that 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, eg, 95%) is in effect at all times.” Licensed platform operators and their associated entities must also store 98% of client crypto assets in cold wallets and limit the amount stored in hot wallets to 2%. The commission also expects them “to set up and implement strong internal controls and governance procedures for private key management to ensure all cryptographic seeds and keys are securely generated, stored and backed up.” Moreover, the SFC added:
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.
There are many more conditions that must be met, including complying with the SFC code of conduct and having adequate measures for know-your-client (KYC), anti-money laundering and counter-financing of terrorism (AML/CFT), preventing market manipulation and abusive activities, accounting and auditing, and risk management.