Hong Kong’s keenly-awaited Virtual Asset Licensing Regime (VASP) is one of the first major market in-depth licensing regimes to be developed following the turbulent events of 2022, which continue to reverberate the crypto industry.
The VASP Licensing Regime commences on 1 June 2023.
In this article we explore why it matters to those in and out of Hong Kong, what you need to know about it. However, first some background on the proposed licensing regime.
What is the Hong Kong VASP Licensing Regime?
The core aspect of the VASP Licensing Regime is that it requires certain centralised cryptocurrency exchanges to obtain a licence to carry on business in Hong Kong. Failure to obtain a licence is an offence.
The key triggers relating to the VASP Licensing Regime are as follows:
1. The regime captures virtual asset exchanges only: the VASP Licensing Regime only applies to persons operating a virtual asset exchange, which in turn means the provision of services via an electronic facility:
i. where:
a. offers to sell or purchase virtual assets are regularly made or accepted in a way that forms or results in a binding transaction; or
b. persons are regularly introduced, or identified to other persons in order that they may negotiate or conclude, or with the reasonable expectation that they will negotiate or conclude sales or purchases of virtual assets in a way that forms or results in a binding transaction; and
ii. where client money or client virtual assets come into the direct or indirect possession of the person providing such service.
There are several observations on the scope of this definition: it does not capture brokers or persons who deal in virtual asset transactions – it only captures those providers that provide matching-related services. This means that certain bulletin boards, OTC trade desks and DeFi protocols where execution occurs off-platform will not be captured. Similarly, the requirement for possession may mean some OTC decks or P2P protocols will not be captured.
2. Utility-type virtual assets captured: the VASP Licensing Regime only applies to “virtual assets” as defined in the legislation. Broadly speaking, the definition captures utilities tokens, payment tokens and governance tokens. It also captures unregulated stablecoins. It does not cover in-game assets, loyalty type tokens, and any financial products (eg securities or futures contracts). The legislation does not specifically call out NFTs as their own asset class – whether an NFT falls within the definition will depend on the specific NFT’s functionality.
3. The VASP Licensing Regime applies to exchanges with retail and professional investor clients: interestingly, the VASP Licensing Regime was originally only intended to regulate exchanges that had professional investor clients. Any exchange offering retail services would not be granted a licence; their operation would remain an offence. This position has since changed, with the ability for licensed exchanges to provide retail services, subject to satisfying additional measures (several of which are described below).
For those exchanges captured by the VASP Licensing Regime, there are several key licensing requirements. At a high level, these includes the following:
Why is this important?
From a macro perspective, the most interesting and important aspect of the VASP Licensing Regime is that it is one of the first in-depth licensing regimes in a major market to be developed following the turbulent events of 2022 that shook (and still are shaking) the crypto industry. Some of the key shortfalls in consumer protections or regulation related to:
- service providers freely using client assets for their own purposes, without restriction;
- the opaqueness between exchanges and their seemingly independent affiliates – this included sharing of confidential, market information;
- lack of consumer protection and protection of assets in the event of insolvency; and
- the ability to affect market integrity and engage in market misconduct.
Other regulators and industry participants will inevitably be looking at the VASP Licensing Regime to see if and how the lessons of 2022 are addressed, and if the proposed controls / measures are effective, practical and workable.
So how does the VASP Licensing Regime address the events of 2022 and their related risks, and how is it different to other licensing regimes?
The VASP Licensing Regime has a greater depth of regulation than other licensing regimes. To understand this, we need to look at the Financial Action Task Force (FATF) and its recommendations. In 2019, FATF, the global transnational body responsible setting AML/CTF standards, released guidance that recommended each country implement licensing regimes to regulate “virtual asset service providers”. These virtual asset services providers included custodians, exchanges, advisors, and those responsibility for the transfer of virtual assets. In light of these recommendations, countries went off and developed licensing / registration regimes to satisfy the FATF recommendations. As expected, those regimes were AML/CTF focussed.
However, the VASP Licensing Regime is different: while the immediate aim of the VASP Licensing Regime is to comply with FATF recommendations and impose AML/CTF specific controls and requirements, the VASP Licensing Regime goes further. One of the key pillars of the VASP Licensing Regime is to provide strong consumer protection and prudential controls – a point made clear in the initial consultation papers introducing the VASP Licensing Regime. This is often missing in many VASP licensing regimes outside of Hong Kong.
Further, unlike many other jurisdictions, the VASP Licensing Regime only covers exchanges. It does not cover other “virtual asset service providers” like custodians, advisors or transferors of virtual assets. In this way, the VASP Licensing Regime is narrower in scope. The rationale for this has been that exchanges pose the greatest systemic risk in Hong Kong, and regulation should focus on this area first. We expect that Hong Kong will in time seek to regulate other types of virtual asset providers to ensure it complies with FATF recommendations.
Let’s look at some of the specific investor-focussed protections and those that are likely to be influenced by the events of 2022:
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Focus area
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Further detail
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Example
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Asset protection |
The VASP Licensing Regime seeks to ensure that client assets are kept safe, without the risk of theft or loss, including if the licensed exchange becomes insolvent. Much of this has been shaped by the large-scale collapses that occurred over 2022. Such measures include:
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Intra-group dealings |
The VASP Licensing Regime imposes several restrictions that limit exchange activities, but also impose restrictions on intra-group arrangements to ensure they occur at arm’s length and so as to reduce the risk of misconduct:
In particular, the VASP Licensing Regime expects that the licensed exchange impose information barriers in cases where such measures are necessary to carefully manage sensitive confidential information within the group. This is to minimise the risk of conflicts of interest, unauthorised disclosure of confidential information and to reduce the risk of market misconduct. |
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Restriction on risky activities |
The VASP Licensing Regime seeks to prevent licensed exchanges from carrying on higher risk activities. For example:
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Retail specific controls |
The VASP Licensing Regime imposes additional requirements in respect of services provided to retail – this reflects the additional investor protections that retail warrants. Several of the additional measures include:
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What else do I need to know about it?
As we approach the commencement date of 1 June 2023, we’ve put together a quick list of non-exhaustive items you may want to think about:
1. Does the VASP Licensing Regime directly affect me, and my business?
This involves assessing whether you are captured by the VASP Licensing Regime, having regard to the trigger items mentioned above and if you have a Hong Kong connection. Importantly, the VASP Licensing Regime can apply to a virtual asset exchange even if it does not have a physical presence in Hong Kong. For example, persons who actively market from abroad to the Hong Kong public will be captured by the VASP Licensing Regime.
There are other ancillary offences as part of the VASP Licensing Regime, so if you have a Hong Kong connection, we recommend you consider the applicability of the VASP Licensing Regime.
2. If the answer to (1) is “yes”, then consider your options.
In a nutshell, there are two options: either (i) transition to wind-down your Hong Kong activities, or (ii) get ready to comply and apply for a licence.
The VASP Licensing Regime provides for a transition arrangement to allow for an orderly wind-down or ramp up to get licensed. If you propose to get a licence, there are specific steps needed before 1 June 2023 so that you can get the benefit of the transition arrangements. See our alert for more details on the transition arrangement.
3. Keep an eye on developments.
While the underlying law governing the VASP Licensing Regime is settled, the regulatory guidance may still change as the SFC is reviewing public feedback to the draft guidelines. Requirements may change so it is worth staying on top of developments in the lead in to 1 June 2023.
