Hong Kong FSTB finalises principles for regulating virtual asset service providers and other AML/CFT regulatory enhancements

The Financial Services and the Treasury Bureau (FSTB) has recently published the conclusions to its consultation on proposals to enhance anti-money laundering and counter-terrorist financing (AML/CFT) regulation in Hong Kong, via amendments to the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO).

The AMLO amendments focus on three areas:

1. a new licensing regime for virtual asset service providers (VASPs) to be administered by the Securities and Futures Commission (SFC);
2. a new two-tier registration regime for dealers in precious metals and stones (DPMSs) to be administered by the Commissioner for Customs and Excise – Financial institutions that are already regulated under the AMLO and conduct regulated activities of DPMS ancillary to their principal businesses will be exempted from registration; and
3. amendments to address various technical issues identified in the Financial Action Task Force (FATF)’s mutual evaluation report on Hong Kong and in other FATF contexts.

In this bulletin, we will provide an overview of what is to be expected in relation to the proposed VASP licensing regime and the technical amendments to the AMLO (ie, 1 and 3 above), which are most relevant to financial institutions.

The FSTB will draft amendments to the AMLO based on the feedback received during the consultation and fine-tune the proposals to address stakeholders’ concerns. It is targeting to introduce the AMLO amendments into the Legislative Council in the 2021-22 legislative session. With regard to the VASP licensing regime, there will be a 180-day transitional period upon commencement of the regime to facilitate application by interested parties.

Objectives and potential impact

The proposed AMLO amendments are aimed at complying with FATF standards, specifically Recommendation 15, which was revised in February 2019 and requires jurisdictions to impose on VASPs the full range of AML/CFT obligations that are currently applicable to financial institutions and designated non-financial businesses and professions (DNFBPs).

In determining the appropriate amendments to the AMLO, the FSTB took into account the need to meet FATF standards in order to retain Hong Kong’s competitiveness as an international financial centre, but at the same time minimise additional regulatory burden and compliance costs on businesses as far as reasonably practicable.

To ensure a level playing field, reference has been made to the opt-in regime operated by the SFC for virtual asset trading platforms (see our November 2019 bulletin) in determining the parameters of the VASP regime under the AMLO.

Proposed VASP licensing regime

What is the scope of the regime and are there any exemptions?

Persons seeking to operate a virtual asset exchange in Hong Kong will be required to apply for a licence from the SFC, subject to meeting a fit-and-proper test.

Virtual asset exchanges that are already regulated as licensed corporations in the voluntary opt-in regime being supervised by the SFC under the Securities and Futures Ordinance (SFO) will be exempted from a VASP licence under the AMLO.

The FSTB will designate the business of operating a virtual asset exchange as a “regulated virtual asset activity” under the AMLO. Flexibility will be built into the licensing regime such that it may be expanded to cover forms of virtual asset activities other than operating a virtual asset exchange, when the need arises.

The licence will remain valid until the licensed VASP is revoked by the SFC, for example, due to misconduct or cessation of operation. The licensed VASP will be subject to the SFC’s ongoing supervision and (in the event of misconduct) potential disciplinary action, including suspension or revocation of the licence.

Any person who is not a licensed VASP will be prohibited from actively marketing (whether in Hong Kong or elsewhere) to the public of Hong Kong a regulated virtual asset activity or a similar activity elsewhere.

What is a virtual asset?

A virtual asset will be defined under the AMLO as a digital representation of value that:

• is expressed as a unit of account or a store of economic value;
• functions (or is intended to function) as a medium of exchange accepted by the public as payment for goods or services or for the discharge of a debt, or for investment purposes; and
• can be transferred, stored or traded electronically.

It will include virtual coins, whether stable or not and irrespective of the purported form of underlying assets.

It will however not include:

• digital representations of fiat currencies (including digital currencies issued by central banks);
• financial assets already regulated under the SFO;
• stored value facilities which are regulated under the Payment Systems and Stored Value Facilities Ordinance; and
• closed-loop, limited purpose items that are non-transferable, non-exchangeable and non-fungible in nature, such as air miles, credit card rewards, gift cards, customer loyalty programmes and gaming coins.

Flexibility will be provided in the AMLO by empowering:

• the SFC to prescribe characteristics that constitute the definition of a virtual asset, and
• the Secretary for Financial Services and the Treasury to determine, either generally or in a particular case, whether any digital representation of value is to be regarded as a virtual asset.

What is a virtual asset exchange?

A virtual asset exchange will be defined as any trading platform which is operated for the purpose of allowing an offer or invitation to be made to buy or sell any virtual asset in exchange for any money or any virtual asset, and which comes into custody, control, power or possession of, or over, any money or any virtual asset at any point in time during its course of business.

This will not include peer-to-peer trading platforms, to the extent that the actual transaction is conducted outside the platform and the platform is not involved in the underlying transaction by coming into possession of any money or any virtual asset at any point in time.

What are the eligibility requirements for a VASP licence?

In light of feedback, the FSTB will allow overseas-incorporated companies registered under the Hong Kong Companies Ordinance (and not just locally-incorporated companies with a permanent place of business in Hong Kong) to apply for a VASP licence. Natural persons or business establishments without a legal personality will not be eligible.

A VASP licence applicant must pass the fit and proper test. The SFC will take into account factors that are consistent with those applicable to financial institutions and DNFBPs under the AMLO:

• whether the person has been convicted anywhere of a money laundering or terrorist financing offence or other offence in which the person is found to have acted fraudulently, corruptly or dishonestly;
• whether the person has failed or may fail to observe the AML/CFT or other regulatory requirements applicable to licensed VASPs;
• the experience and relevant qualifications of the person; and
• whether the person is of a good standing and financial integrity.

A licence applicant will also be required to appoint at least two responsible officers to assume the general responsibility of ensuring compliance with AML/CFT requirements and other regulatory requirements.

What regulatory requirements do licensed VASPs have to comply with?

Despite feedback in over 40% of the consultation submissions that retail investors should be allowed to participate in the trading activities of a virtual asset exchange, the FSTB considers that licensed VASPs should only be permitted to offer services to professional investors (at least for the initial stage of the licensing regime) given the higher risks involved in virtual asset activities, and must impose rigorous criteria for the inclusion of virtual assets to be traded on its platform.

The FSTB has indicated that it will continue to monitor the evolving landscape and review the position in relation to retail investors as the market becomes more mature in the future.

Like the financial institutions and DNFBPs regulated under the AMLO, licensed VASPs will be required to comply with the AML/CFT requirements under Schedule 2 to the AMLO (including customer due diligence and record-keeping). They will also be required to meet various requirements relating to financial resources, knowledge and experience, soundness of the business, risk management, segregation and management of client assets, financial reporting and disclosure, prevention of market manipulative and abusive activities, and prevention of conflicts of interest.

What supervisory, investigatory and enforcement powers will the SFC have?

The SFC will be empowered under the AMLO to (among other things):

• enter business premises of licensed VASPs and their associated entities for conducting routine inspections;
• request the production of documents and other records;
• investigate non-compliance;
• impose restrictions and prohibitions on the operation of licensed VASPs and their associated entities where circumstances so warrant (such as to prohibit further transactions or restrict the disposal of property in order to prevent dissipation of client assets where licensed VASPs engage in misconduct); and
• impose administrative sanctions – including reprimands, orders for remedial actions, civil penalties (not exceeding HK$10 million or three times the amount of the profit gained or loss avoided, whichever is the greater), and suspensions or revocations of licences for non-compliance.

Appeals against specified decisions made by the SFC in implementing the licensing and supervisory regime for licensed VASPs can be made to the Anti-Money Laundering and Counter-Terrorist Financing Review Tribunal, the designated appeal body under the AMLO.

Apart from administrative sanctions mentioned above, will there be any criminal sanctions?

The following conduct will constitute a criminal offence:

• conducting a regulated virtual asset activity without a licence;
• provision of a false, deceptive or misleading statement in a material particular in connection with a licence application;
• non-compliance with the statutory AML/CFT requirements; and
• fraudulent or reckless misrepresentation for the purpose of inducing another person to acquire or dispose of a virtual asset.

Conducting a regulated virtual asset activity without a licence will attract a maximum penalty (on conviction on indictment) of a fine of HK$5 million and imprisonment for seven years and, in the case of a continuing offence, a further fine of HK$100,000 per day during which the offence continues.

The other offences will attract a maximum penalty (on conviction on indictment) of a fine of HK$1 million and imprisonment for two years.

Technical amendments to AMLO

The following amendments will be made to address various technical issues identified in the FATF’s mutual evaluation report on Hong Kong and in other FATF contexts:

• amending the definition of “politically exposed person” in accordance with FATF requirements and empowering regulatory authorities to make guidelines to allow the exemption of enhanced customer due diligence requirements in respect of former politically exposed persons on a risk-sensitive basis;
• better aligning the definition of “beneficial owner” in relation to a trust under the AMLO with that of “controlling person” under the Inland Revenue Ordinance by clarifying that, where a trust is concerned, it includes trustees, beneficiaries and class(es) of beneficiaries;
• providing for the use of digital identification systems to assist the conduct of customer due diligence where the customer is not physically present for identification and verification purposes;
• enhancing the deterrent effect for unlicensed money service operation by raising the sentencing level to a fine of HK$1 million and imprisonment for two years; and
• consolidating the different provisions under various ordinances enabling regulatory authorities to exchange supervisory information for AML/CFT purposes into a unified provision under the AMLO.