On 15 January 2021, Charltons presented Webinar 2 of Charltons Online Crypto Regulation Forum

Hong Kong Crypto Regulation

Webinar 2 – 15 January 2021

IMPLEMENTATION OF REVISED RECOMMENDATIONS

35 implemented regimes for VASPs

19 no regimes for VASPs

13 intend to regulate VASPs

TRAVEL RULE IMPLEMENTATION

• development of technological standards for use by different travel rule solutions
• several different travel rule solutions are being developed
• lower implementation / adoption of the travel rule when compared to other AML/CTF requirements

A GLOBAL VASP LIST?

PEER-TO-PEER TRANSACTIONS VIA PRIVATE/UNHOSTED WALLETS

• peer-to-peer transactions of virtual assets, without the use or involvement of a VASP or financial institution, are not explicitly subject to AML/CTF obligations under the revised FATF Recommendations

BATCH AND POST FACTO SUBMISSION AND PAST TRANSFERS

1. extent to which the batched data submission of transfers of originator and beneficiary data is permissible
2. whether the originator and beneficiary data could be submitted on a post facto basis
3. the extent to which beneficiary and originator data should be collected on past virtual asset transfers

INTER-OPERABILITY OF SYSTEMS

• development of global messaging standards is necessary
• inter-operability of different travel rule solutions may be impacted unless (i) sufficient flexibility is built into the messaging standards or (ii) solutions are being developed to accommodate the requirements of particular jurisdictions

SUNRISE ISSUE

Lack of a global framework for travel rule compliance poses a challenge to VASPs

SPECIFIC WORDING ISSUES

“Legal Entity Identifier”

“Account number”

“Address of an originator”

IMPLEMENTATION OF OTHER AML/CFT OBLIGATIONS

• implementation of AML/CFT obligations globally is at an early stage
• many VASPs may be unfamiliar with the fundamentals of AML/CFT
• jurisdictions which have developed and imposed AML/CFT regimes on VASPs have reported improved overall compliance

HK CRYPTO REGULATION

• regulates entities conducting activities in cryptocurrencies where the relevant cryptocurrencies are “securities” or “futures contracts” as defined in the SFO
• intermediaries conducting regulated activities in relation to cryptocurrencies that are securities or futures contracts must be licensed or registered by the SFC and must comply with its AML/CFT requirements
• cryptocurrencies are not regulated by Hong Kong’s other financial regulators

FSTB CONSULTATION

• 3 NOV 2020 – proposal to introduce a new licensing regime under the AMLO for virtual asset exchanges that are not required to be licensed under the SFO
• licensed exchanges will be required to comply with the AML and CTF obligations in Sch.2 to the AMLO
• the new regime would fulfil FATF’s requirements for virtual asset exchanges

SFC REGULATORY STANDARDS

• NOV 2018 – SFC published new regulatory standards which apply to virtual asset portfolio managers and distributors of virtual asset funds that are already required to be licensed
• SFC invited virtual asset trading platforms and exchanges interested in becoming licensed to join the SFC Regulatory Sandbox

REGULATING AROUND THE EDGES

SFC REGULATORY REMIT -> CRYPTOCURRENCIES WHICH ARE “SECURITIES” OR “FUTURES” <- CRYPTOCURRENCIES

MANAGING ML/TF RISKS ASSOCIATED WITH VIRTUAL ASSETS AND VASPs

• HKMA Dec 2019 notice:
  • carry out appropriate risk assessments to differentiate the risks of each VASP
  • undertake additional customer due diligence
  • before introducing new banking or investment products, undertake ML/TF risk assessments and take appropriate measures to manage and mitigate the identified risks in accordance with the applicable legal and regulatory requirements

VA PORTFOLIO MANAGERS AND VA FUND DISTRIBUTORS

SFC imposes licensing on those already required to be licensed either because:

1. they also manage portfolios of traditional securities or futures contracts which requires an asset management licence; or
2. they distribute funds investing solely in non-SF virtual assets

firms distributing VA funds are required to comply with:

1. SFC regulatory framework for licensed corporations; and
2. additional requirements including extensive due diligence in relation to the virtual asset funds they distribute, their fund managers and counterparties

REGULATION OF MANAGERS OF FUNDS INVESTING IN CRYPTOCURRENCIES

• SFCs Regulatory Standards for Licensed Corporations Managing Virtual Asset Portfolios impose licensing conditions on Type 9 licensed fund managers which manage funds whose stated investment objective is to invest in crypto or which intend to invest 10%+ of their gross asset value in crypto
• conditions do not apply to:
  1. licensed corporations which only manage funds that invest in crypto funds (i.e. FoF); or
  2. licensed corporations managing portfolios whose mandate is to invest mainly in securities and/or futures contracts and investment in crypto exceeds 10% of their gross asset value only because of an increase in the prices of crypto held

(1) RESTRICTION TO PROFESSIONAL INVESTORS

• restricted to professional investors as defined in the SFO (including HNWs)
• must implement measures to ensure that the fund is only distributed to professional investors

(2) CUSTODIAN REQUIREMENT

• must assess and select the most appropriate custodial arrangement, considering:
  • ease of accessibility to crypto; and
  • security of the custodial facility
• must exercise due skill, care and diligence in selecting, appointing and conducting on-going monitoring of custodians by reference to:
  • experience and track record
  • regulatory status
  • corporate governance structure and background of senior management
  • financial resources and insurance coverage
  • operational capabilities and arrangements

CUSTODIAN REQUIREMENT (CONT.)

where held by licensed fund manager itself, must:

1. document reasons for self-custody and disclose risks to investors
2. implement appropriate measures to protect fund assets and segregate crypto from own assets in event of its insolvency
3. use best endeavours to acquire and maintain insurance cover over the crypto

(3) PORTFOLIO VALUATION

• must select valuation principles, methodologies, models and policies which are reasonably appropriate in the circumstances and in the best interests of investors
• these must be disclosed to investors

(4) RISK MANAGEMENT

• must set appropriate limits for each product or market the fund invests in
• should consider using more than one custodian to hold the fund’s assets
• periodic stress testing is required

(4) RISK MANAGEMENT (cont.)

before transacting with a crypto exchange, a licensed virtual fund manager must assess the reliability and integrity of the virtual asset exchange taking into account:

• experience and track record
• legal / regulatory status
• corporate governance structure
• operational capabilities
• mechanisms to guard against fraud and manipulation with respect to products traded on the exchange
• cybersecurity risk management measures
• financial resources and insurance cover

exposure to individual crypto exchanges must be capped

(5) AUDITORS

1. an independent auditor must be appointed to audit the financial statements of managed funds
2. must consider auditors’ experience and capability in checking the existence and ownership of cryptocurrencies, and ascertaining the reasonableness of their valuation, in their selection of an auditor

(6) LIQUID CAPITAL

• licensed fund manager which holds crypto on behalf of the funds it manages must maintain liquid capital equal to the higher of HK$3m or the amount of its variable required liquid capital

SFC LICENSED FIRMS

• Diginex
• Venture Smart
• Huobi Tech

Regulation of crypto fund distributors

• a fund manager which only manages funds investing in cryptocurrencies that are not securities does not need to be licensed for Type 9
• the distribution of a fund will require the distributor to be licensed for Type 1
• a Type 9 licensed asset manager which also distributes the funds it manages may rely on the incidental exemption from the Type 1 licensing requirement

CIRCULAR TO INTERMEDIARIES ON THE DISTRIBUTION OF VIRTUAL ASSET FUNDS

1. Licensed Corporations must: ensure the reasonable suitability of any recommendation or solicitation made to a client under para. 5.2 of the Code
2. Additional requirements for distributors of VA funds apply if: the distributor knows, or should reasonably know, at the time it distributes the fund that the fund has invested 10%+ of its GAV in crypto, unless the fund manager informed it that it intends to reduce the fund’s investment in crypto to below 10% in the near future

(1) SELLING RESTRICTIONS

• a distributor can only target professional investors as defined under the SFO
• distributor must assess whether its clients have knowledge of investing in cryptocurrencies or related products before effecting a transaction on their behalf
• transaction can only be executed for a client without such knowledge if it would be in the best interests of the client

(2) CONCENTRATION ASSESSMENTS

licensed corporations must consider the aggregate amount to be invested by a client in VA funds to be reasonable given the client’s net worth

(3) DUE DILIGENCE ON CRYPTO FUNDS

must conduct extensive DD on crypto funds, fund managers and parties providing trading and custodian services to the funds

DUE DILIGENCE: FUND MANAGER

1. background and relevant experience and track record of senior management
2. regulatory status, compliance history and internal controls and systems
3. IT infrastructure, risk management procedures, liquidity risk management policy and disaster recovery plan

DUE DILIGENCE: THE FUND

1. fund’s targeted investors
2. instruments fund intends to trade / invest in and any limitations on the size of its holding of ICO tokens, pre-ICO tokens or other illiquid or hard-to-value instruments
3. valuation policy
4. custody arrangement for the fund assets, including policy on allocation of assets to be kept at different host locations
5. use of leverage and derivatives
6. targeted risk and return per annum
7. key risks
8. auditors and audited financial statements

DUE DILIGENCE: FUND’S COUNTERPARTIES

1. legal and regulatory status
2. experience and track record in dealing in crypto
3. robustness of IT systems and contingency plans
4. financial soundness and insurance coverage

(4) PROVISION OF INFORMATION TO CLIENTS

• continuing evolution of cryptocurrencies and how this may be affected by global regulatory developments
• price volatility
• potential for price manipulation on crypto exchanges or trading platforms
• lack of secondary markets for certain cryptocurrencies
• that most exchanges, trading platforms and custodians of cryptocurrencies are currently unregulated
• counterparty risk when effecting transactions with issuers, private buyers/sellers or through exchanges or trading platforms
• risk of loss