Hong Kong's proposed crypto exchange rules could hamper volume, trigger consolidation say industry players

The Hong Kong government has said in a policy proposal that it intends to require crypto exchanges operating in the city to obtain a license within 180 days after the policy takes effect, after which they can offer services to  "professional investors only."

On November 3, the Hong Kong Securities and Futures Commission (SFC) announced it will put all crypto exchanges operating in the city under its regulatory oversight as part of its obligation to follow the Financial Action Task Force's requirement on anti-money laundering rules.

While the news of the government announcing the plan was widely covered following the SFC's note, some of the specifics of the actual proposal have gone under-noticed. For instance, some media reported that the new regulation would ban retail investors from trading. But in fact, under the proposed scheme, they could still participate via over-the-counter trading platforms. 

The Hong Kong Financial Services and the Treasury Bureau (FSTB) published the policy proposal late last week. The bureau is seeking public input until January 31, 2021. The policy proposal will then need to be considered and passed by the Hong Kong Legislative Council before it can take effect. 

The FSTB has laid out several regulatory requirements for giving out licenses to crypto exchanges in the city, with the top criteria being "professional investors only" – at least in the very beginning.

"At the initial stage, the licensed virtual assets service provider (VASP) should only offer services to professional investors. The SFC will continue to monitor the market and reconsider its position as the market becomes more mature in [the] future," the FSTB said.

The proposal would empower the SFC as the key regulatory body overseeing the licensing scheme. The SFC's definition for "professional investor" is an individual who has a portfolio of at least $1.03 million or any corporation or partnership with either a portfolio of more than $1.03 million or total assets of over $5 million. 

The FSTB also aims to put in place a deadline for when crypto exchanges operating in Hong Kong or targeting at Hong Kong investors must obtain a license.

"With effect from a future date to be determined, which we propose to be 180 days upon commencement of operation of the licensing regime, any operators carrying on the regulated activity of operating a virtual asset exchange will be required to possess a valid license issued by the SFC," the FSTB said. The proposed penalty for anyone that fails to comply — which would constitute a criminal offense — includes a fine of as much as $640,000 and imprisonment for seven years. 

Market participants offered varied takes on the proposal's prospects and the eventual impact it could have on the ecosystem of firms that offer services to investors. But those who spoke with The Block indicated that it could have an overall negative effect on companies that work in the Hong Kong market.

"While safe digital exchange platforms are essential, restricting access to professional investors may suffocate critical trade volume, and worse, pigeonholes virtual assets as speculative instrument rather than the building blocks of next generation digital infrastructure that they are," Jehan Chu, co-founder and managing partner at Hong Kong-based investment and trading firm Kenetic, told The Block in a message.

Sam Bankman-Fried, founder and CEO of Hong Kong-based exchange FTX, said he "doesn't think it is clear right now how things will shake out in the end but there's certainly a chance" that the proposed professional investor restriction, if takes effect as-is, will push some crypto exchanges away from Hong Kong.

Others say the policy proposal, if implemented, could raise compliance costs — and, ultimately, lead to consolidation among investor services.

"As a result of regulation, there will be a consolidation of players in the space as not all existing firms will be able to absorb the costs of compliance — and so the market itself will go through what we call a ‘changing of the guard’ with institutional-ready firms gaining more market share as non-compliant entities exit," said Wayne Trench, CEO of Hong Kong-based exchange OSL.

The FSTB said in the proposal that any person or business that involves any of the five types of crypto-related activities will fall under its scope, such as centralized fiat-to-crypto exchanges, centralized crypto-to-crypto exchanges, transfers of crypto assets, safekeeping crypto assets or tools enabling control over crypto assets, as well as initial coin offerings. 

However, over-the-counter trading platforms are not covered under the FSTB's definition for crypto exchanges — so long as they only provide the forum for advertising bids and offers while the actual trades are conducted outside the platform.

The FSTB also proposed the so-called fit-and-proper test that applicants must pass in order to be granted a license. Under the scheme, only "locally incorporated companies with a permanent place of business in Hong Kong" will be considered for licensure.

The test will also vet the backgrounds of all responsible officers and owners of the applying entity. Further, it will require an applicant to appoint at least two compliance officers responsible for ensuring compliance with AML rules and "be held personally accountable in case of contravention or non-compliance of the requirements."