Cryptocurrency Regulations in Hong Kong

ByClark

Laney Zhang Foreign Law Specialist

SUMMARY

In Hong Kong, virtual currencies are not considered legal tender but are virtual commodities. Hong Kong’s Securities and Futures Commission (SFC) has clarified that virtual assets falling under the definition of “securities” are subject to the SFC’s regulation.

More recently, in November 2018, the SFC issued guidance on a new regulatory approach to bring more virtual asset portfolio managers and distributors of virtual asset funds under its regulatory net. The SFC will impose licensing conditions on corporations that manage or intend to manage portfolios investing in virtual assets, where 10% or more of the gross asset value of the portfolio is invested in virtual assets, irrespective of whether the virtual assets meet the definition of “securities” or “futures contracts.”

Under the new regulatory framework, the SFC will allow licensed corporations that manage virtual asset portfolios to select the most appropriate custodial arrangement. For example, the assets may be held by the licensed corporation itself, with a third-party custodian, or by an exchange.

The SFC is also exploring the potential regulation of virtual asset trading platform operators. Such platform operators would be required to provide services only to professional investors. Virtual assets issued through an initial coin offering (ICO) would only be admitted for trading on the platform at least twelve months after the completion of the ICO or when the ICO project has started to generate profit.

Approach to Assets Created Through Blockchain

On January 8, 2014, in replying to a question raised at the meeting of the Legislative Council on the use of bitcoin, the Secretary for Financial Services and the Treasury said virtual currencies such as bitcoin are not considered legal tender but are virtual commodities in Hong Kong, and warned about the risks of using virtual currencies.1

More recently, in a speech made on September 21, 2018, the Chief Executive of the Hong Kong Monetary Authority (HKMA) reiterated that cryptoassets are not money or currencies, and warned that “people wishing to invest or speculate in crypto-assets should do so without harboring the unrealistic expectation that they would one day become money or currencies that can be used as a means of exchange.”2

In a circular issued on March 18, 2019, the HKMA asked banks and other authorized institutions planning to engage in activities relating to cryptoassets to discuss with the HKMA and demonstrate that they have put in place appropriate systems and controls to identify and manage any risks associated with such activities. The circular was issued after the Basel Committee on Banking Supervision (BCBS) issued a statement on cryptoassets. The BCBS statement sets out its “prudential expectations regarding banks’ exposures to crypto-assets and related services in jurisdictions where banks are involved in such business activities.”3

Financial Regulation

Hong Kong’s Securities and Futures Commission (SFC) has issued a number of circulars clarifying its regulatory stance on virtual assets. According to the SFC, where virtual assets fall under the definition of “securities” as defined in the Securities and Futures Ordinance, these products and related activities fall within the SFC’s ambit.4

More recently, however, the SFC realized that many virtual assets do not amount to “securities.” By using the conventional regulatory approach, many investors in virtual assets are left unprotected. Having identified significant risks associated with investing in virtual assets, on November 1, 2018, the SFC issued its guidance on regulatory standards expected of virtual asset portfolio managers and fund distributors, aiming to bring virtual asset portfolio managers and distributors of virtual asset funds under its regulatory net. The SFC also stated that it was exploring the potential regulation of virtual asset trading platform operators, commonly known as crypotocurrency exchanges, and issued a conceptual framework with this regard. 5

The SFC’s Statement on Regulatory Framework for Virtual Asset Portfolios Managers, Fund Distributors and Trading Platform Operators contains two appendixes, and an accompanying circular was also issued on the same day:

  1. Appendix 1: Regulatory Standards for Licensed Corporations Managing Virtual Asset Portfolios;6
  1. Appendix 2: Conceptual Framework for the Potential Regulation of Virtual Asset Trading Platform Operators;7
  1. Circular to Intermediaries Distribution of Virtual Asset Funds.8
  1. Background

In the statement, the SFC explained the background of its new regulatory approach on virtual assets as follows:

Under existing regulatory remits in Hong Kong, markets for virtual assets may not be subject to the oversight of the SFC if the virtual assets involved fall outside the legal definition of “securities” or “futures contracts” (or equivalent financial instruments). Therefore, investors who trade in virtual assets through unregulated trading platforms or invest in virtual asset portfolios which are managed by unregulated portfolio managers do not enjoy the protections afforded under the Securities and Futures Ordinance (SFO), such as requirements which ensure safe custody of assets and fair and open markets. If platform operators and portfolio managers are not regulated, their fitness and properness, including their financial soundness and competence, have not been assessed, and their operations are not subject to any supervision.9

Definition of Virtual Assets

According to the SFC statement, a “virtual asset” is a digital representation of value, which is also known as “cryptocurrency,” “crypto-asset,” or “digital token.” Virtual assets “may be or claim to be, a means of payment, may confer a right to present or future earnings or enable a token holder to access a product or service, or a combination of any of these functions.”10

Virtual Asset Portfolio Managers

The SFC will impose licensing conditions on corporations that manage or intend to manage portfolios investing in virtual assets, where 10% or more of the gross asset value of the portfolio is invested in virtual assets, irrespective of whether the virtual assets meet the definition of “securities” or “futures contracts.”11 Only professional investors as defined by the Securities and Futures Ordinance are allowed to invest into virtual asset portfolio managed by these licensed corporations.12

Virtual Asset Fund Distributors

In the Circular to Intermediaries Distribution of Virtual Asset Funds, the SFC provided detailed guidance and reminded firms that distribute funds investing in virtual assets that they should be registered with or regulated by the SFC and comply with its regulatory requirements, including the suitability obligations, when distributing these funds.13 Such funds should only be distributed to professional investors as defined by the Securities and Futures Ordinance, according to the Circular.14

Virtual Asset Trading Platform Operators

For virtual asset trading platform operators, the SFC will explore whether they are suitable for regulation in the SFC Regulatory Sandbox:

The SFC will observe the operations of interested trading platform operators and their compliance with proposed regulatory requirements in the Sandbox environment. If it

is decided at the end of this stage that it is appropriate to regulate platform operators, the SFC would then consider granting a licence and putting them under its close supervision. Alternatively, it may take the view that the risks involved cannot be sufficiently addressed and no licence shall be granted as protection for investors cannot be ensured.15

Under the conceptual framework, a platform operator would also be required to provide its services only to professional investors.16 Furthermore, a platform operator should only admit a virtual asset issued through an initial coin offering (ICO) for trading on its platform at least twelve months after the completion of the ICO, or when the ICO project has started to generate profit, whichever is earlier.17

Anti-Money Laundering Law

Under the conceptual framework for the potential regulation of virtual asset trading platform operators issued in November 2018, a virtual asset platform operator would be required to ensure that its anti-money laundering and countering financing of terrorism (AML/CFT) systems can adequately manage the money laundering and terrorist financing risks relating to the relevant activities. The conceptual framework also contains specific measures to be taken by a platform operator with this regard, such as obtaining sufficient contact information of the client, and suspending or terminating the account of any client who provides incomplete or suspicious contact information.18

Previously, on March 25, 2015, the Secretary for Financial Services and the Treasury responded to a question on the regulation of bitcoin trading activities raised at the meeting of the Legislative Council.19 The Secretary stated that the existing laws of Hong Kong provide for sanctions against unlawful acts such as money laundering, terrorist financing, fraud, pyramid schemes, and cybercrimes, with or without virtual commodities being involved. The Hong Kong Government and financial regulators would also keep a close watch on the development of bitcoin and other virtual commodities, he said 20

Taxation

Hong Kong’s Inland Revenue Department does not appear to have issued any specific guidelines on how it would treat cryptocurrencies for the purpose of tax assessment. In general, there is no capital gains tax payable from the sale of financial instruments in Hong Kong, but the income tax and profits tax may apply on the income from cryptocurrency trading.21

Custodianship of Cryptocurrencies by Financial Institutions

The SFC will allow licensed corporations that manage virtual asset portfolios to select the most appropriate custodial arrangement. For example, the assets may be held by the licensed corporation itself, with a third-party custodian, or by an exchange.22

The following factors, among other matters, should be considered in the selection, appointment, and ongoing monitoring of custodians:

  1. the experience and track record of the custodian in providing custodial services for virtual assets;
  1. the regulatory status of the custodian, in particular, whether it is subject to any regulatory oversight over its virtual asset custodial business;
  1. the corporate governance structure and background of the senior management of the custodian;
  1. the financial resources and insurance cover of the custodian for the purpose of compensating its customers in the event of loss of customers’ assets; and
  1. the operational capabilities and arrangements of the custodian, for example, the “wallet” arrangements and cybersecurity risk management measures.23

Regulation of Cryptocurrencies as Financial Securities

As indicated above, under the new SFC regulatory approach announced in November 2018, the SFC will impose licensing conditions on firms that manage or intend to manage portfolios investing in virtual assets, irrespective of whether the virtual assets meet the definition of “securities” or “futures contracts.”24

Previously, in a statement on ICOs dated September 5, 2017, the SFC explained that, depending on the facts and circumstances of an ICO, digital tokens that are offered or sold may be “securities” as defined in the Securities and Futures Ordinance, and therefore subject to the securities laws of Hong Kong.25 According to the statement, where the digital tokens involved in an ICO fall under the definition of “securities,” dealing in or advising on the digital tokens, or managing or marketing a fund investing in such digital tokens, may constitute a “regulated activity.” Parties engaging in a “regulated activity” are required to be licensed by or registered with the SFC irrespective of whether the parties involved are located in Hong Kong, so long as such business activities target the Hong Kong public.26

In another statement, dated February 9, 2018, the SFC alerted investors to the potential risks of dealing with cryptocurrency exchanges and investing in ICOs.27 In the alert, the SFC said it has taken regulatory action against a number of cryptocurrency exchanges and issuers of ICOs. The SFC had warned cryptocurrency exchanges in Hong Kong or with connections to Hong Kong that they should not trade cryptocurrencies that are “securities” as defined in the Securities and Futures Ordinance without a license. The SFC had written to ICO issuers and most of them confirmed compliance with the SFC’s regulatory regime or immediately ceased to offer tokens to Hong Kong investors. The SFC stated it would continue to police the market and engage in enforcement actions when necessary, and also urged market professionals to do proper gatekeeping to prevent fraud or dubious fundraising, and to assist the SFC in ensuring compliance with the law.28

Treatment of Cryptoassets Not Considered Securities

As mentioned above, the Secretary for Financial Services and the Treasury made a statement in 2015, indicating that the existing laws of Hong Kong provide for sanctions against unlawful acts such as money laundering, terrorist financing, fraud, pyramid schemes, and cybercrimes, with or without virtual commodities being involved.29 In that statement, the Secretary said the police would take enforcement action if they find criminal conduct involving virtual commodities by conducting patrols, including searching for relevant information via public platforms on the Internet, the Secretary said.30

Cryptoassets not considered securities would be subject to the regulation of Hong Kong’s Customs and Excise Department (Customs) as virtual commodities. On January 30, 2014, the Hong Kong’s Customs issued a circular to money service operators, warning about the money laundering and terrorist financing risks associated with “virtual commodities such as Bitcoin.”31 Virtual commodities which are transacted or held on the basis of anonymity by their nature pose significantly higher inherent ML/TF risks,” the circular states.32


1 Press Release, Government of Hong Kong, LCQ1: Monitoring the Use of Bitcoins (Jan. 8, 2014), source link, archived at source link.
2 Norman T.L. Chan, Chief Executive, Hong Kong Monetary Authority, Keynote Speech at Treasury Markets Summit 2018: “Crypto-assets and Money” (Sept. 21, 2018), Source Link, archived at source link.
3 Hong Kong Monetary Authority, BCBS Statement on Crypto-Assets (Mar. 18, 2019), Source Link archived at Source Link.
4 Securities and Futures Commission (SFC), Statement on Regulatory Framework for Virtual Asset Portfolios Managers, Fund Distributors and Trading Platform Operators (Nov. 1, 2018) (Statement), Source Link, archived at Source Link. 5 Id.
6 SFC, Regulatory Standards for Licensed Corporations Managing Virtual Asset Portfolios (Nov. 1, 2018) (Regulatory Standards), Source Link, archived at Source Link.
7 SFC, Conceptual Framework for the Potential Regulation of Virtual Asset Trading Platform Operators (Nov. 1, 2018) (Conceptual Framework), Source Link, archived at Source Link.
8 SFC, Circular to Intermediaries Distribution of Virtual Asset Funds (Nov. 1, 2018) (Circular to Intermediaries), Source Link, archived at Source Link.
9 Statement, supra note 4. 10 Id.
11 Press Release, SFC, SFC Sets out New Regulatory Approach for Virtual Assets (Nov. 1, 2018), Source Link, archived at Source Link; Regulatory Standards, supra note 6, at 2.
12 Regulatory Standards, supra note 6, at 3.
13 Press Release, SFC, SFC Sets out New Regulatory Approach for Virtual Assets (Nov. 1, 2018), supra note 11; Circular to Intermediaries, supra note 8.
14 Circular to Intermediaries, supra note 8.
15 Press Release, SFC, SFC Sets out New Regulatory Approach for Virtual Assets (Nov. 1, 2018), supra note 11;
16 Conceptual Framework, supra note 7, at 4. 17 Id. 18 Id. at 6–7.
19 Press Release, Government of Hong Kong, LCQ4: Regulation of Trading Activities of Bitcoins (Mar. 25, 2015), Source Link, archived at Source Link.
20 Id. 21 Henry Yu, Hong Kong, in BLOCKCHAIN LAWS AND REGULATIONS 2019 (Global Legal Insights, Sept. 17, 2018), Source Link, archived at Source Link.
22 Regulatory Standards, supra note 6, at 3. 23 Id. at 4.
24 Press Release, SFC Sets out New Regulatory Approach for Virtual Assets (Nov. 1, 2018), supra note 11.
25 SFC, Statement on Initial Coin Offerings (Sept. 5, 2017), Source Link, archived at Source Link. 26 Id.
27 Press Release, SFC, SFC Warns of Cryptocurrency Risks (Feb. 9, 2018), Source Link, archived at Source Link. 28 Id.
29 Press Release, Government of Hong Kong, LCQ4: Regulation of Trading Activities of Bitcoins (Mar. 25, 2015), supra note 19. 30 Id.
31 Customs and Excise Department, Circular to Money Service Operators, Anti-Money Laundering/Counter- Terrorist Financing, Money Laundering and Terrorist Financing Risks Associated with Virtual Commodities (Jan. 30, 2014), Source Link, archived at Source Link.

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Clark

Head of the technology.

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