Response to SFC's Consultation Paper on the Proposed Regulatory Requirements for Virtual Asset Trading Platform Operators Licensed by the Securities and Futures Commission
Release Date: 2023-03-31
March 31, 2023.
To the Securities and Futures Commission ("SFC"),
Regarding the SFC's Consultation Paper on the Proposed Regulatory Requirements for Virtual Asset Trading Platform Operators Licensed by the Securities and Futures Commission (the "Consultation Paper"), our association would like to provide the following comments.
Question 1:
Do you agree that licensed platform operators should be allowed to provide their services to retail investors, subject to the robust investor protection measures proposed? Please explain your views.
We support the proposal. Currently, investors in Hong Kong have the opportunity to engage in virtual asset investments in both regulated and unregulated international markets, while foreign governments permit retail investors to partake in these investments as well. As a global financial hub, it is essential for Hong Kong to adapt to evolving trends and proactively broaden its market. Failing to do so in this rapidly transforming financial landscape could lead to Hong Kong's decline, resulting in accelerated capital outflows to other jurisdictions, which would adversely affect the sustainable growth of the financial sector in the region.
Moreover, as we welcome new technological assets, it is crucial to implement robust and effective measures that ensure compliance with anti-money laundering and regulatory standards while safeguarding investor interests. This approach will provide a strong foundation for Hong Kong's ongoing development.
Question 2:
Do you have any comments on the proposals regarding the general token admission criteria and specific token admission criteria?
Regarding the recommendation that the Token Inclusion and Review Committee should primarily consist of senior management responsible for key functions such as core business, compliance, risk management, and information technology, our association believes that this approach may potentially devolve into mere formalism in practice.
Among the four core function heads (MICs) - core business (KBL), compliance, risk management, and information technology - only the head of core business is required to be approved by the Securities and Futures Commission (SFC) as the Responsible Officer (RO), while the other MICs only need to notify the SFC temporarily. These MICs may not possess sufficient relevant knowledge and expertise pertaining to token inclusion and review.
While the responsibility of establishing appropriate senior management lies with licensed entities, the SFC should consider implementing stricter qualification assessment measures to evaluate the capabilities of the MICs, particularly for emerging products like virtual assets. Furthermore, if the individuals responsible for the four MICs within licensed operators overlap, they may face challenges in contributing effectively to collaborative decision-making.
To address these concerns, the SFC should consider requiring virtual asset operators to have independent personnel for each MIC, prohibiting individuals from serving multiple MIC functions simultaneously. This would help ensure that the Token Inclusion and Review Committee is comprised of individuals with the necessary expertise and independence to make informed and effective decisions.
Concerning the "General Token Inclusion Criteria," our association supports the proposed guidelines. However, we recommend that the Securities and Futures Commission (SFC) contemplate the inclusion of frequently asked questions or educational resources for the market in the future. This addition would provide practical examples that could enhance retail investors' understanding of the criteria, thereby safeguarding their interests.
With regard to the "Specific Token Inclusion Criteria," we suggest that the initial implementation phase be restricted to professional investors. Once retail investors and virtual asset operators gain a better understanding of the "General Token Inclusion Criteria," the SFC might then evaluate an appropriate timeframe to ease the requirements.
Question 3
What other requirements do you think should be implemented from an investor protection perspective if the SFC is minded to allow retail access to licensed VA trading platforms?
Our association believes that the current regulations for virtual asset service providers serve as a sufficient starting point. Just as a skyscraper is built from the ground up, the financial market will continuously evolve and never stand still, which is characteristic of Hong Kong as an international financial center. However, we recommend that the Securities and Futures Commission or government departments invest resources to provide retail investors with continuous professional training (CPT) similar to that offered to licensed professionals. Additionally, offering questionnaire-based examinations could enhance retail investors' relevant knowledge and help protect their interests.
Question 4:
Do you have any comments on the proposal to allow a combination of third-party insurance and funds set aside by the licensed platform operator or a corporation within its same group of companies? Do you propose other options?
Segregation of Assets and Operational Responsibilities within Corporate Groups
In the financial services industry, it is common for a single corporate group to encompass multiple licensed entities, each engaged in regulated activities. To ensure effective risk management and mitigate potential conflicts of interest, it is crucial that the assets and operational responsibilities of these licensed entities be maintained separately and independently.
Consistent with the "Risk Management Guidelines for Licensed Persons Engaging in Futures Contract Trading," the assets of each licensed entity within a corporate group must be calculated and managed independently. The operating capital of each licensed entity must also be kept separate to facilitate effective risk management.
The rationale behind this approach is to create a clear delineation of individual risks within the same economic ecosystem. By segregating the assets and operations of related entities, the potential for conflicts of interest is reduced, allowing for more transparent and accountable risk management practices.
In cases where third-party insurance is utilized in conjunction with the funds of virtual asset service providers, it is essential that these funds be held in a trust structure by an independent third-party trust company with the relevant licensing qualifications. These trust companies should adhere to reporting requirements similar to the Financial Resources Rules (FRR) applicable to licensed entities, regularly providing relevant data to the Securities and Futures Commission. This ensures proactive oversight and monitoring of the safeguarding of client assets.
By adhering to these principles of asset segregation and operational independence, corporate groups can foster a more robust and transparent financial ecosystem, effectively managing risks and protecting the interests of clients and stakeholders.
Question 5:
Do you have any suggestions as to how funds should be set aside by the licensed platform operators (for instance, under house account of the licensed platform operator or under an escrow arrangement)? Please explain in detail the proposed arrangement and how it may provide the same level of comfort as third-party insurance.
The Association believes that licensed institutions should have effective mechanisms in place for handling client assets, client funds, and Financial Resources Requirements (FRR). It is essential that the company's management accounts and client custodian accounts be kept separate.
Regarding third-party insurance, insurers can decide on the level of coverage they are willing to provide. However, due to the lack of historical data and understanding of marginal risks, insurers may initially be reluctant to underwrite or can only raise premiums. Nevertheless, as time and the market evolve, and as the compliance data of virtual asset operators increases, there will be room for premium reductions, similar to the evolution of traditional financial institutions' liability insurance (including directors' and senior management's liability insurance).
As mentioned in paragraph 55, if virtual asset operators are unable to obtain insurance, the Securities and Futures Commission must significantly modify the insurance requirements, which could lead to unfairness for other licensed institutions.
Furthermore, as mentioned in question 4, an independent third-party trust company with the relevant licensing qualifications must establish the trust. This trust company should also provide relevant data to the Securities and Futures Commission on a regular basis, in line with the FRR reporting requirements for licensed institutions, to facilitate proactive management.
Question 6:
Do you have any suggestions for technical solutions which could effectively mitigate risks associated with the custody of client virtual assets, particularly in hot storage?
To ensure regulatory authorities and investors have continuous access to the financial status of virtual asset operators, the Association recommends the adoption of several measures:
1. Independent Audits and Custody: Virtual asset operators should undergo independent audits and utilize independent custodians to safeguard their assets.
2. Proof of Reserve (POR): Operators should implement POR mechanisms, which allow regulatory authorities and investors to directly verify the financial standing of the virtual asset operators at any given time.
3. Blockchain Audits and Compliance Certificates: Virtual asset operators should regularly commission qualified professionals to conduct independent blockchain audits (Chain Audit) and obtain compliance certificates. These should be included in the annual independent audit reports submitted to the Securities and Futures Commission.
Furthermore, in alignment with the development of Central Bank Digital Currency (CBDC), the Association proposes that a portion of virtual asset operators' funds be held in the form of CBDC, deposited with the designated locations or institutions of the Securities and Futures Commission.
These comprehensive measures are designed to enhance transparency, accountability, and regulatory oversight of the virtual asset industry, thereby instilling greater confidence among investors and regulatory authorities.
Question 7:
If licensed platform operators could provide trading services in VA derivatives, what type of business model would you propose to adopt? What type of VA derivatives would you propose to offer for trading? What types of investors would be targeted?
In reference to the globally regulated market for virtual asset trading, it is evident that the venues permitting virtual asset derivative transactions are limited. This scarcity is largely due to the inherently volatile nature of these assets. Beyond their hedging capabilities, they are prone to speculative behavior, which can escalate into excessive speculation, ultimately posing risks to retail investors rather than providing benefits.
In light of this, we recommend implementing a phased regulatory strategy:
1. Initially, limit virtual asset derivative transactions to professional and institutional investors. For these categories of investors, we can draw upon current securities regulatory frameworks, including metrics for concentration, maximum risk exposure, and derivative leverage ratios, to effectively manage the risk associated with virtual asset derivatives.
2. Concurrently, it is essential to establish quantitative criteria for the types of virtual assets eligible for trading. These criteria should encompass indicators such as liquidity, trading volume, and the market share held by institutional investors. It is advisable to conduct monthly reviews of these indicators to maintain oversight of investment risks.
3. Once the Securities and Futures Commission has gathered sufficient data and developed adequate risk management expertise, it may consider gradually easing restrictions to include other investor categories. This would support the structured advancement of the virtual asset derivative market.
Through a phased approach, grounded in quantitative indicators and ongoing risk management, we aim to safeguard investor interests while fostering the sustainable growth of the virtual asset derivative market.
Question 8:
Do you have any comments on how to enhance the other requirements in the VATP Terms and Conditions when they are incorporated into the VATP Guidelines?
The document formerly known as the "Terms and Conditions for Operators of Virtual Asset Trading Platforms," is now titled the "Terms and Conditions for Virtual Asset Trading Platforms," and was established in December 2020. Our organization asserts that at that time, the Securities and Futures Commission focused solely on permitting professional investors to engage in virtual asset trading, neglecting the interests of retail investors, despite the occurrence of several adverse incidents in the past. Should future considerations allow retail investors to participate in trading, the regulatory framework will require substantial modifications. Hence, our organization strongly urges the Securities and Futures Commission to undertake a thorough and systematic review, with the aim of potentially integrating these considerations into the "Guidelines for Virtual Asset Trading Platforms."
Question 9:
Do you have any comments on the requirements for virtual asset transfers or any other requirements in Chapter 12 of the AML Guideline for LCs and SFC-licensed VASPs?
Please explain your views.
We assert that rigorous compliance with the transfer regulations established by the Financial Action Task Force (FATF), commonly referred to as the Travel Rule, is crucial. A lack of adherence to these requirements could jeopardize the virtual asset industry's ability to engage with international business partners who uphold regulatory standards.
Question 10:
Do you have any comments on the Disciplinary Fining Guidelines? Please explain your views.
We express no objections to the proposed guidelines. However, given the extensive geographical reach of the virtual asset trading market, we advise the Securities and Futures Commission to thoroughly evaluate the applicability of these measures across different countries and regions.
Should you have any questions regarding this correspondence, please do not hesitate to reach out to me at (Phone: _____ / Email: _____) or to Mr. Wong Hoi Lok Ivan, Director of the Industrial Relations Department, at (Phone: _____ / Email: _____).
Wishing you continued good health.
Sincerely,
Mofiz Chan
Chairman
Hong Kong Securities and Futures Professionals Association
To the Securities and Futures Commission ("SFC"),
Regarding the SFC's Consultation Paper on the Proposed Regulatory Requirements for Virtual Asset Trading Platform Operators Licensed by the Securities and Futures Commission (the "Consultation Paper"), our association would like to provide the following comments.
Question 1:
Do you agree that licensed platform operators should be allowed to provide their services to retail investors, subject to the robust investor protection measures proposed? Please explain your views.
We support the proposal. Currently, investors in Hong Kong have the opportunity to engage in virtual asset investments in both regulated and unregulated international markets, while foreign governments permit retail investors to partake in these investments as well. As a global financial hub, it is essential for Hong Kong to adapt to evolving trends and proactively broaden its market. Failing to do so in this rapidly transforming financial landscape could lead to Hong Kong's decline, resulting in accelerated capital outflows to other jurisdictions, which would adversely affect the sustainable growth of the financial sector in the region.
Moreover, as we welcome new technological assets, it is crucial to implement robust and effective measures that ensure compliance with anti-money laundering and regulatory standards while safeguarding investor interests. This approach will provide a strong foundation for Hong Kong's ongoing development.
Question 2:
Do you have any comments on the proposals regarding the general token admission criteria and specific token admission criteria?
Regarding the recommendation that the Token Inclusion and Review Committee should primarily consist of senior management responsible for key functions such as core business, compliance, risk management, and information technology, our association believes that this approach may potentially devolve into mere formalism in practice.
Among the four core function heads (MICs) - core business (KBL), compliance, risk management, and information technology - only the head of core business is required to be approved by the Securities and Futures Commission (SFC) as the Responsible Officer (RO), while the other MICs only need to notify the SFC temporarily. These MICs may not possess sufficient relevant knowledge and expertise pertaining to token inclusion and review.
While the responsibility of establishing appropriate senior management lies with licensed entities, the SFC should consider implementing stricter qualification assessment measures to evaluate the capabilities of the MICs, particularly for emerging products like virtual assets. Furthermore, if the individuals responsible for the four MICs within licensed operators overlap, they may face challenges in contributing effectively to collaborative decision-making.
To address these concerns, the SFC should consider requiring virtual asset operators to have independent personnel for each MIC, prohibiting individuals from serving multiple MIC functions simultaneously. This would help ensure that the Token Inclusion and Review Committee is comprised of individuals with the necessary expertise and independence to make informed and effective decisions.
Concerning the "General Token Inclusion Criteria," our association supports the proposed guidelines. However, we recommend that the Securities and Futures Commission (SFC) contemplate the inclusion of frequently asked questions or educational resources for the market in the future. This addition would provide practical examples that could enhance retail investors' understanding of the criteria, thereby safeguarding their interests.
With regard to the "Specific Token Inclusion Criteria," we suggest that the initial implementation phase be restricted to professional investors. Once retail investors and virtual asset operators gain a better understanding of the "General Token Inclusion Criteria," the SFC might then evaluate an appropriate timeframe to ease the requirements.
Question 3
What other requirements do you think should be implemented from an investor protection perspective if the SFC is minded to allow retail access to licensed VA trading platforms?
Our association believes that the current regulations for virtual asset service providers serve as a sufficient starting point. Just as a skyscraper is built from the ground up, the financial market will continuously evolve and never stand still, which is characteristic of Hong Kong as an international financial center. However, we recommend that the Securities and Futures Commission or government departments invest resources to provide retail investors with continuous professional training (CPT) similar to that offered to licensed professionals. Additionally, offering questionnaire-based examinations could enhance retail investors' relevant knowledge and help protect their interests.
Question 4:
Do you have any comments on the proposal to allow a combination of third-party insurance and funds set aside by the licensed platform operator or a corporation within its same group of companies? Do you propose other options?
Segregation of Assets and Operational Responsibilities within Corporate Groups
In the financial services industry, it is common for a single corporate group to encompass multiple licensed entities, each engaged in regulated activities. To ensure effective risk management and mitigate potential conflicts of interest, it is crucial that the assets and operational responsibilities of these licensed entities be maintained separately and independently.
Consistent with the "Risk Management Guidelines for Licensed Persons Engaging in Futures Contract Trading," the assets of each licensed entity within a corporate group must be calculated and managed independently. The operating capital of each licensed entity must also be kept separate to facilitate effective risk management.
The rationale behind this approach is to create a clear delineation of individual risks within the same economic ecosystem. By segregating the assets and operations of related entities, the potential for conflicts of interest is reduced, allowing for more transparent and accountable risk management practices.
In cases where third-party insurance is utilized in conjunction with the funds of virtual asset service providers, it is essential that these funds be held in a trust structure by an independent third-party trust company with the relevant licensing qualifications. These trust companies should adhere to reporting requirements similar to the Financial Resources Rules (FRR) applicable to licensed entities, regularly providing relevant data to the Securities and Futures Commission. This ensures proactive oversight and monitoring of the safeguarding of client assets.
By adhering to these principles of asset segregation and operational independence, corporate groups can foster a more robust and transparent financial ecosystem, effectively managing risks and protecting the interests of clients and stakeholders.
Question 5:
Do you have any suggestions as to how funds should be set aside by the licensed platform operators (for instance, under house account of the licensed platform operator or under an escrow arrangement)? Please explain in detail the proposed arrangement and how it may provide the same level of comfort as third-party insurance.
The Association believes that licensed institutions should have effective mechanisms in place for handling client assets, client funds, and Financial Resources Requirements (FRR). It is essential that the company's management accounts and client custodian accounts be kept separate.
Regarding third-party insurance, insurers can decide on the level of coverage they are willing to provide. However, due to the lack of historical data and understanding of marginal risks, insurers may initially be reluctant to underwrite or can only raise premiums. Nevertheless, as time and the market evolve, and as the compliance data of virtual asset operators increases, there will be room for premium reductions, similar to the evolution of traditional financial institutions' liability insurance (including directors' and senior management's liability insurance).
As mentioned in paragraph 55, if virtual asset operators are unable to obtain insurance, the Securities and Futures Commission must significantly modify the insurance requirements, which could lead to unfairness for other licensed institutions.
Furthermore, as mentioned in question 4, an independent third-party trust company with the relevant licensing qualifications must establish the trust. This trust company should also provide relevant data to the Securities and Futures Commission on a regular basis, in line with the FRR reporting requirements for licensed institutions, to facilitate proactive management.
Question 6:
Do you have any suggestions for technical solutions which could effectively mitigate risks associated with the custody of client virtual assets, particularly in hot storage?
To ensure regulatory authorities and investors have continuous access to the financial status of virtual asset operators, the Association recommends the adoption of several measures:
1. Independent Audits and Custody: Virtual asset operators should undergo independent audits and utilize independent custodians to safeguard their assets.
2. Proof of Reserve (POR): Operators should implement POR mechanisms, which allow regulatory authorities and investors to directly verify the financial standing of the virtual asset operators at any given time.
3. Blockchain Audits and Compliance Certificates: Virtual asset operators should regularly commission qualified professionals to conduct independent blockchain audits (Chain Audit) and obtain compliance certificates. These should be included in the annual independent audit reports submitted to the Securities and Futures Commission.
Furthermore, in alignment with the development of Central Bank Digital Currency (CBDC), the Association proposes that a portion of virtual asset operators' funds be held in the form of CBDC, deposited with the designated locations or institutions of the Securities and Futures Commission.
These comprehensive measures are designed to enhance transparency, accountability, and regulatory oversight of the virtual asset industry, thereby instilling greater confidence among investors and regulatory authorities.
Question 7:
If licensed platform operators could provide trading services in VA derivatives, what type of business model would you propose to adopt? What type of VA derivatives would you propose to offer for trading? What types of investors would be targeted?
In reference to the globally regulated market for virtual asset trading, it is evident that the venues permitting virtual asset derivative transactions are limited. This scarcity is largely due to the inherently volatile nature of these assets. Beyond their hedging capabilities, they are prone to speculative behavior, which can escalate into excessive speculation, ultimately posing risks to retail investors rather than providing benefits.
In light of this, we recommend implementing a phased regulatory strategy:
1. Initially, limit virtual asset derivative transactions to professional and institutional investors. For these categories of investors, we can draw upon current securities regulatory frameworks, including metrics for concentration, maximum risk exposure, and derivative leverage ratios, to effectively manage the risk associated with virtual asset derivatives.
2. Concurrently, it is essential to establish quantitative criteria for the types of virtual assets eligible for trading. These criteria should encompass indicators such as liquidity, trading volume, and the market share held by institutional investors. It is advisable to conduct monthly reviews of these indicators to maintain oversight of investment risks.
3. Once the Securities and Futures Commission has gathered sufficient data and developed adequate risk management expertise, it may consider gradually easing restrictions to include other investor categories. This would support the structured advancement of the virtual asset derivative market.
Through a phased approach, grounded in quantitative indicators and ongoing risk management, we aim to safeguard investor interests while fostering the sustainable growth of the virtual asset derivative market.
Question 8:
Do you have any comments on how to enhance the other requirements in the VATP Terms and Conditions when they are incorporated into the VATP Guidelines?
The document formerly known as the "Terms and Conditions for Operators of Virtual Asset Trading Platforms," is now titled the "Terms and Conditions for Virtual Asset Trading Platforms," and was established in December 2020. Our organization asserts that at that time, the Securities and Futures Commission focused solely on permitting professional investors to engage in virtual asset trading, neglecting the interests of retail investors, despite the occurrence of several adverse incidents in the past. Should future considerations allow retail investors to participate in trading, the regulatory framework will require substantial modifications. Hence, our organization strongly urges the Securities and Futures Commission to undertake a thorough and systematic review, with the aim of potentially integrating these considerations into the "Guidelines for Virtual Asset Trading Platforms."
Question 9:
Do you have any comments on the requirements for virtual asset transfers or any other requirements in Chapter 12 of the AML Guideline for LCs and SFC-licensed VASPs?
Please explain your views.
We assert that rigorous compliance with the transfer regulations established by the Financial Action Task Force (FATF), commonly referred to as the Travel Rule, is crucial. A lack of adherence to these requirements could jeopardize the virtual asset industry's ability to engage with international business partners who uphold regulatory standards.
Question 10:
Do you have any comments on the Disciplinary Fining Guidelines? Please explain your views.
We express no objections to the proposed guidelines. However, given the extensive geographical reach of the virtual asset trading market, we advise the Securities and Futures Commission to thoroughly evaluate the applicability of these measures across different countries and regions.
Should you have any questions regarding this correspondence, please do not hesitate to reach out to me at (Phone: _____ / Email: _____) or to Mr. Wong Hoi Lok Ivan, Director of the Industrial Relations Department, at (Phone: _____ / Email: _____).
Wishing you continued good health.
Sincerely,
Mofiz Chan
Chairman
Hong Kong Securities and Futures Professionals Association