Treasury and the Service Propose Regulations on Cloud and Digital Content Transactions

Introduction

2020 has been one unprecedented year! As the first year of the new decade comes to a close, it will seem that blockchain is poised to make a rebound with two major events taking the wider community by storm.

First, it was announced that China Construction Bank (the “CCB”) had been working with the Fusang Exchange to raise up to $3 billion through a publicly listed debt security on a blockchain. Whilst, CCB ultimately suspended the issuance of digital bond in order to address a number of issues related to the bond’s concept, this is a clear sign that traditional financial institutions are taking blockchain technology serious once more and are themselves moving from being mere blockchain sceptics to blockchain evangelicals. The second event is of course the rise in price of bitcoin once more. Towards the end of the November, Bitcoin has rebounded to historic high levels once more reaching values of US$19,129.30 to 1 BTC on 24 November 2020.

Security token

Security tokenisation has received increasing attention in recent years and regulatory authorities around the world have been responding to the rise of digital assets and the development of crypto-exchanges. Although CCB’s latest tokenisation project was suspended, it prompts one to reflect on the current position of Hong Kong in relation virtual assets and more specifically security tokens.

In the Statement on Security Token Offerings issued by the Securities and Futures Commission (the “SFC”), the SFC referred to security token as having features of traditional securities and they are digital representations of ownership of assets, like gold or real estate, or economic rights, like a share of profits or revenue, utilising blockchain technology.

Security tokens, as a kind of virtual asset, are often offered to professional investors and they are different from utility token, which is another type of token. As security tokens are a form of security, they require SFC approval. Utility tokens on the other hand provides the holders with the right to use a network to consume products or services while security token itself represents an asset. As utility tokens are, as their name suggests, utility only and not security, the issuing of utility tokens under existing Hong Kong laws will not require SFC approval.

Hong Kong’s current regulatory framework on Virtual Asset Exchanges

In November 2019, the SFC set out an “opt-in” regulatory framework for virtual asset trading platforms to clarify how virtual assets and some specific activities involving these assets would fall under the existing regulatory regime. It was later revealed this past month however that the SFC intends to bring all virtual asset exchanges under its auspices, abandoning the previous year’s “opt-in” approach. This new direction will of course require changes in the existing laws of Hong Kong (to be further discussed herein below).

Pending the passage of the new law intended by the SFC, the 2019 Regulatory Regime will continue to apply. Under the 2019 regulatory framework, a platform which offers trading of at least one security token would fall within the jurisdiction of the SFC and is required to apply for Types 1 (dealing in securities) and 7 (providing automated trading services) license.

The SFC will impose licensing conditions on the platform operators to address specific risks associated with their operations, such as requiring them to:

1. offer their services exclusively to professional investors;

2. only serve clients who have sufficient knowledge of virtual assets;

3. maintain stringent criteria for the inclusion of virtual assets on their platforms and obtain

prior written approval from the SFC for any plans of offering new service or product; and

4. engage independent professional firms acceptable to the SFC to conduct annual review of their activities and operations and submit the reports to the SFC.

Further, the platform operators are required to comply with prescribed terms and conditions, including:

1. holding all client assets in a segregated account established by the platform operators’ associated entity;

2. complying with the Know-Your-Client requirements to establish the true and full identity, financial situation, investment experience and investment objectives of each client;

3. establishing and implementing anti-money laundering and counter-financing of terrorism policies and controls to manage the risks as many virtual assets are traded anonymously; and

4. establishing and implementing polices and controls to identify, prevent and report any market manipulative or abusive trading activities.

Any breach of a licensing condition may be considered misconduct under Part IX of the Securities and Futures Ordinance (the “SFO”) and result in disciplinary action by the SFC, for example, license revocation, public reprimand, or fine. On the bright side, owing to intense SFC supervision, any licensed exchanges operating in Hong Kong will stand to have greate credibility with their clientele and associated reputation (as opposed to being an unregulated exchange).

Going forward

In November 2020, the Hong Kong Financial Services and Treasury Bureau issued a consultation paper outlining a proposed new licensing regime for virtual asset service providers which would require any Hong Kong-based virtual assets exchange to be licensed by the SFC.

It is noteworthy that the current regulatory framework in Hong Kong applies only to centralised exchanges, where the virtual asset trading platforms have control over the investors’ assets, but not to decentralised exchanges, where investors trade on a direct person-to-person basis. Although under the proposed new licensing regime, virtual assets service providers which operate virtual assets exchanges in Hong Kong or which target Hong Kong customers will be required to apply for a licence with the SFC, the regime still does not propose to include decentralised exchanges.

The consultation period will end on 31 January 2021 and the framework of the new licensing regime remains to be seen.

Conclusion

The applications of blockchain technology have been growing rapidly in various areas. In particular, the issuance of digital tokens using blockchain has been increasingly seen as an alternative to traditional debt financing. In September 2020, the SFC has agreed in principle to issue a licence to a cryptocurrency firm for its application to operate a virtual asset trading platform involving security tokens, subject to the final approval by the SFC upon fulfilling certain conditions. The license would allow it to operate a brokerage and automated trading service for digital assets. It is expected that more licenses will be granted to virtual asset trading platforms by the SFC in the foreseeable future and more comprehensive regulatory regime for virtual asset and blockchain activities can be introduced by the regulators to provide more protection and clarity to the market players.

(Excerpt) Read more Here | 2020-11-30 09:28:57
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