Hong Kong's securities watchdog issues regulatory framework to license crypto exchanges

Hong Kong Securities and Futures Commission (SFC), the region's securities watchdog, has issued rules for licensing cryptocurrency exchanges. 

Ashley Alder, head of the SFC, announced the news at a forum on Wednesday. Alder said that the rules will "enable virtual asset trading platforms to be regulated by the SFC, a major development which builds on a way forward I outlined at the same time last year.”

The 61-page regulatory framework covers custody and know-your-customer (KYC) rules, among other issues. "The safe custody of a user’s crypto-assets and cybersecurity are major concerns. There have been many instances of platforms being hacked, with investors suffering substantial losses. Trading rules may not be transparent and fair, and crypto markets are vulnerable to manipulation," said Alder, adding:

"Our new regulatory framework covers all of the key investor protection concerns, including the safe custody of assets, know-your-client requirements, anti-money laundering and market manipulation. And it also zeros in on many of the new concepts we are getting used to, such as hot and cold wallets, forks, airdrops and the like. We will also set out the criteria for platforms to decide on the inclusion of a new virtual asset for trading."

Notably, the framework applies to "a centralized virtual asset trading platform operating in Hong Kong which trades virtual assets including at least one security token." The SFC said it has no power to grant a license to or supervise a platform that only trades non-security virtual assets or tokens.  "Only those platforms which enable clients to trade security virtual assets or tokens fall within the SFC’s regulatory remit," it said. 

Licensing requirements

Some of the key licensing requirements are that licensees must only provide services to "professional investors;" they must obtain the SFC’s prior written approval for any plan or proposal to add any product to its trading platform, and they must also provide monthly reports to the SFC on its business activities in a format as prescribed by the SFC.

BC Group, Hong Kong-listed technology and digital asset company, told The Block that the SFC issuing licenses for digital asset trading platforms in Hong Kong is a “watershed moment” for financial services in Asia. " With licensing, regulated and institutional players will gain direct access and exposure to digital assets with the assurance of full regulatory oversight and protection," BC Group added."

Custody - "cold" and "hot" wallets 

The SFC said a crypto custody platform operator should hold client assets through a company which (i) is an “associated entity” of the platform operator under the Securities and Futures Ordinance (SFO); (ii) is incorporated in Hong Kong; (iii) holds a “trust or company service provider licence” under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance; and (iv) is a wholly owned subsidiary of the platform operator (Associated Entity). "This should assist in the safekeeping of client virtual assets and ensure that they are properly segregated from those of the platform," said the SFC.

Regarding "cold" and "hot" wallets, the SFC said it will require a firm to ensure that it or its associated entity to store 98% of client virtual assets in cold wallets and limits holdings in hot wallets to not more than 2%. 

Insurance

The SFC said crypto custody providers must ensure that an insurance policy covering the risks of assets held in both hot storage (full coverage) and cold storage (a substantial coverage, eg, 95%) is in effect at all times.

KYC and AML

Crypto exchanges 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, said the SFC, adding: "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."

Crypto trading platforms should also regularly review the effectiveness of its Anti-Money Laundering/Countering Financing of Terrorism systems and introduce enhancements where appropriate, said the watchdog.

"The adoption of the new regulatory framework will enable the SFC to formulate its future regulatory strategy for virtual assets through close supervisory interactions with an evolving and dynamic industry," the SFC concluded. 

UPDATE: This story has been updated to include details from the regulatory framework document