Hong Kong: Your new crypto base?

Crypto companies and exchanges are facing unprecedented pressure from financial regulators around the world, with many digital asset businesses starting to consider moving to friendlier locations. This article is part of a series discussing the key considerations of relocating, as well as comparing the appeal of a number of alternative locations.

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Crypto exchanges – dual licensing regimes

A keystone development this year has been the rollout of the licensing regime for crypto exchanges (or virtual asset trading platforms, abbreviated as VATPs), which came into effect on 1 June this year. The VATP regime brings crypto exchanges into Hong Kong securities regulator's jurisdiction and imposes Know-Your-Client obligations designed to combat money laundering. VATPs that are looking to enter into the Hong Kong market after the effective date will have to be licensed by the Securities and Futures Commission (SFC), although existing VATPs in Hong Kong are granted a 1-year grace period until 1 June 2024 to continue operations while they apply to get licensed. The grace period only applies to existing VATPs in Hong Kong that deal only in non-security tokens; that is, cryptocurrencies whose features do not fall within the definition of 'securities' under the Securities and Futures Ordinance (Cap 571) (SFO).

Many of the licensing requirements are already familiar concepts in Hong Kong, such as the appointment and designation of key personnel (namely responsible officers, licensed representatives and managers-in-charge) and their continued fitness, properness and competence to serve in those capacities. 

The SFC has also tailored certain requirements to the characteristics of the crypto industry. For one, all investors, including retail investors, are allowed to trade on VATPs, although robust guardrails have been laid down to protect investors, including client onboarding, governance and disclosure standards. VATPs are required to be selective in admitting cryptocurrencies for trading on their platforms, and retail investors may only trade in 'large-cap' virtual assets. To mitigate risks of contagion and abuse, client assets must be held on trust through an associated entity and segregated from the VATP's assets. 98% of virtual assets belonging to clients must be held in 'cold storage', with compensation arrangements (by way of third party insurance, funds or virtual assets set aside on trust and/or bank guarantees) to cover losses of up to 50% of client assets in cold storage and 100% of those in hot or other storages. A VATP is expected as well to maintain minimum liquid capital of not less than HK$3 million or an amount calculated with reference to the platform’s assets, liabilities and transactions based on Hong Kong's Financial Resources Rules, whichever is higher. In the meantime, VATPs are not allowed to offer or allow trading in VA futures and derivatives and stablecoins.

The VATP regime summarised above is limited to trading platforms that deal with non-security tokens and is provided under Hong Kong's primary anti-money laundering legislation, the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap 615) (AMLO).  If they also deal with security tokens, they will have to apply for a license from the SFC for Type 1 (dealing in securities) and Type 7 (providing automated trading services) regulated activities under the SFO. 

The SFC encourages VATPs to apply for licenses under both the AMLO and SFO regimes, as the terms and features of a virtual asset may evolve over time. From a business development perspective, we also recommend VATPs to apply for both licenses in order to avoid being hamstrung by the distinction between security tokens and non-security tokens.  We expect that most VATPs would be interested in applying for both concurrently to ensure that their platforms will be able to cater to all genres of virtual assets without falling foul of regulations, especially given that the SFC has allowed for a streamlined, concurrent application process for both licenses and that the compliance obligations are substantively similar. 

VATP operators have welcomed the clarity and certainty offered by a tailored regulatory regime, and we have received various enquiries from market participants actively interested in obtaining a license.

Stablecoins

A big pain point in regulating crypto is the systemic role and risk of stablecoins. The Hong Kong Monetary Authority plans to introduce a licensing regime in 2023/24 to regulate entities that are involved with the governance, issuance, stabilization and storage of stablecoins in Hong Kong or which reference the value of the Hong Kong dollar, or entities that market such services to the Hong Kong public. We anticipate both investors and stablecoin service providers alike will welcome the certainty and protection afforded by clear regulations.

Other developments and remaining challenges

Hong Kong has introduced a host of other incentives this year to bolster its status as a modern financial hub. 

For one, a concessionary tax regime has been introduced for family offices, wherein Hong Kong tax will not be charged on profits from 'qualifying transactions' accruing to 'family-owned investment holding vehicles'. However, as an asset class, transactions in cryptocurrencies do not as yet fall within such 'qualifying transactions', an exclusion that mirrors that of the Hong Kong's 'unified funds exemption' regime for private funds. 

It is expected that businesses may wish to migrate to Hong Kong to take advantage of these regulatory and legislative regimes, and although Hong Kong as yet has no general company re-domiciliation regime, the government has recently proposed legislative amendments to allow foreign companies of different types and scale to migrate their respective place of incorporation to Hong Kong without affecting the continuity of their legal identity. That is, the re-domiciling company will retain its legal identity and the re-domiciliation process will not affect its property, rights, obligations, contractual and legal processes as well as tax obligations to the originating jurisdiction. A public consultation for this initiative has recently concluded and it is expected that the draft legislation will be tabled in 2023 or 2024. 

Specific considerations for forming and operating a crypto fund in Hong Kong

In the Hong Kong market, Cayman Islands and British Virgin Islands domiciled fund structures still represent the main stream of crypto funds on the market.  Emerging options are the Hong Kong domiciled structures including the limited partnership fund (LPF) and the open-end fund company (OFC), which became available since 2020 and 2018 respectively.  In terms of legal structures, LPF and OFC are very similar to their respective Cayman counterparts, namely, exempted limited partnership and segregated portfolio company. However, regulatory and tax implications would require case-by-case consideration.  

Regardless of the domicile of the fund vehicle, a fund manager operating in Hong Kong generally requires a SFC license for Type 9 (asset management) regulated activity, and is often set up as a Hong Kong private company.  Fund managers with an investment objective to invest in virtual assets or intend to invest 10% or more of the fund's gross asset value in virtual assets will be subject to an additional set of licensing conditions imposed by the SFC. In particular, they will have to comply with the detailed Know-Your-Client and anti-money laundering requirements under the AMLO and relevant SFC regulations when onboarding investors.  

The JPEX saga and the way ahead 

The level of market excitement and activities about the VATP licensing regime has been so high that the SFC issued a warning in early August 2023 against improper practices of certain unlicensed VATPs, which falsely claimed that they had submitted license applications to the SFC when in fact they had not done so.  Certain industry players also exploited the transitional arrangements by setting up new entities to provide VA services in Hong Kong and/or announced their intention to apply for licenses for these new entities, even when some of the services and products offered by the new entities may not comply with the requirements under the licensing regime. 

Barely a month later, the SFC had to flex its regulatory muscle by firstly naming and shaming JPEX, a crypto trading platform claimed to have operations in multiple jurisdictions, for the suspicious features relating to its practices and promotional activities, then issued a further statement to rebuke JPEX's claims that it had been actively liaising with the SFC on licensing matters and its failure to comply with the relevant statutory secrecy provisions by releasing confidential correspondence with the SFC.  In light of the growing number of victims of the suspected scam and public concerns relating to the JPEX saga, the SFC moved to publish and maintain lists of VATPs that have been licensed, that are closing down or have been deemed licensed, as well as a list of VATP applicants pending.  There are four such applicants as of the end of September 2023.    

Despite of a bumpy start marked by the JPEX incident, market participants remain hopeful that the virtual asset trading platforms regime will fill in an important gap in Hong Kong's virtual assets regulatory landscape and that the first batch of licenses will be granted in the second half of 2024.