>"Many people don’t realize the role Hong Kong plays in the global cryptocurrency space. Hong Kong is home to some of the largest enterprises and dominates the growing futures market. Earlier this month the Hong Kong Securities and Futures Commission (SFC) released a proposal stating that regulation was no longer optional, but mandatory. If passed into law, enterprises who continue to operate without a license could see their executives face imprisonment. The impact of eliminating unregulated platforms in Hong Kong could be far-reaching. Below we take a look at which digital asset companies are based in Hong Kong or have a major operational presence. This includes major trading venues like BitMEX and FTX which are headquartered in Hong Kong and others like Huobi, OKEx, and Bybit that have offices in the region. Most notably, Hong Kong is dominant in the crypto futures market touching 72% of ETH and 57% of BTC futures. Total ETH and BTC futures volumes are $5 billion and $18 billion a day. When BitMEX faced charges last month, data provided by Skew showed open positions in Bitcoin perpetual futures fell -22% and that of ETH dropped by -37%. Data from Glassnode also showed BitMEX deposits fell -25%. Below, we discuss what the regulation is, why it happened, what it takes to get a license, and what all the unregulated companies can do. What happened? In this year’s Hong Kong Fintech Festival, the SFC announced that, under the Anti Money Laundering (AML) Ordinance, regulation for crypto businesses was no longer optional. The SFC referred to the requirements under Financial Action Task Force (FATF) guidance. The FATF, established in the 1989 G7 summit, is an important international financial body. Countries that are “non-cooperative” – such as Bahamas, Iceland, Syria, Zimbabwe – or “blacklisted” – such as Iran and North Korea – are deemed high-risk and receive limited access to international financing. Simultaneously, the HK Financial Services and Treasury Bureau (FSTB) released a public consultation (until Jan. 31, 2021) for the regulation of virtual asset services providers. The new regulation covers digital assets exchanges, custodians, administration of digital assets, and financial service providers in the space. Subsequently, such regulations undertake the legislative process, which could take a day or three years, depending on complexity. In this case, it would most likely take six months. If passed, companies have 180 days to comply or face a HK$5,000,000 (US$645,000) fine and seven years imprisonment. This is a departure from last year’s HK Fintech Festival, where the SFC announced.pdf) it would regulate enterprises that support at least one “security”. Previously, the SFC only regulated assets under their legal definition of securities or futures. That definition excluded digital assets (including stablecoins and utility tokens) so companies could previously opt-out of regulation. That said, it wasn’t previously clear if cryptocurrency derivatives and leveraged products were under the purview of regulators, though the SFC has issued warnings%20without%20a%20licence.) to seven cryptocurrency exchanges. Why is Hong Kong issuing new regulations? In 2018, after complaints against unlicensed and fraudulent ICO issuers, the SFC wrote to seven companies, who confirmed compliance and ceased to offer tokens to local residents. In 2019, the SFC warned of unregulated venues and the risks associated with virtual asset futures contracts. Offering futures contracts without a license is in violation of the Securities and Futures Ordinance (SFO) or the Gambling Ordinance. The regulations are intended to provide investor protection in addition to curating the ecosystem to develop into a mature financial market. As one of the largest financial hubs in the world, the SFC already has its eye on institutional adoption and the future of Security Token Offerings (STOs). Unique to other jurisdictions, the SFC has injected crypto regulation into the existing financial framework. In other jurisdictions including New York, Japan, and Singapore, regulators created a separate regulation to deal with cryptocurrencies. In Hong Kong, while this means licensed entities need to be on par with traditional financial institutions, it also means that they’re ready to offer STOs. What’s it going to take to get a license? To date, there have only been two entities regulated in Hong Kong. Venture Smart Asia Limited, with blockchain arm Arrano Capital, was afforded a license to manage virtual asset funds (Type 9 Virtual Assets) while BC Technology Group (under the brand “OSL”) was the first to be regulated for the virtual asset Automated Trading Services (Type 7) and Broker-Dealer License (Type 1). Asset managers that intend to have more than 10% of gross asset value in digital assets will need to apply for a license. It took the SFC two years to award the license to Arrano Capital as not only does the team need to pass the licensing requirements for an asset manager, they also need to demonstrate that their virtual assets operations procedure is secure. Each new fund by the asset manager needs permission from regulators. Arrano Capital currently operates a passive Bitcoin fund with daily liquidity, similar to that of Greyscale, and also has the mandate to launch a hedge fund, which is expected to launch in Q1’2021. Exchanges have a different set of requirements, equally as rigorous. What does this mean for the business continuity of the large players including BitMEX and FTX, and those with Hong Kong regional offices such as Bybit, Huobi, and OKEx? People: Other than being locally incorporated with a permanent place of business in HK, applicants need to pass a rigorous fit-and-proper test. They also need to have two Responsible Officers who, together with the owners, will be held liable in case of non-compliance. More Licenses: A digital assets exchange must apply for Type 1 and Type 7 licenses. However, some requirements are difficult to fulfill. For example, requirements most unregulated participants don’t satisfy include: client segregated banking services, cybersecurity assessments, hot and cold wallet insurance, a 98% cold storage requirement, single legal entity undertakings, and market surveillance. Financial Disclosures: Financial returns reporting is also required. This is similar to that of Japan, where submitting audited financials is required for a license. In Korea, all companies with assets above KRW 12 billion (US$10 million), which includes the largest exchanges, must provide publicly-available audited financial statements. In Hong Kong, BC Group is listed on the HK Stock Exchange, and as such its financials are publicly available. Professional Investors: Enterprises must prove they conduct client suitability assessments and perform know-your-client (KYC) procedures to only onboard professional investors. This means clients would need to prove they have HK$8 million (US$1 million) in liquid assets, which includes equities and cash but excludes digital assets. As a result, this eliminates retail clients. Prevention of Conflicts of Interest: Proprietary trading activities (see box above of major companies) or market-making activities would not be permitted under the proposed new rules. What can unregulated companies do? Enforcing cross-border rules and stopping companies from marketing to residents will be tough. However, as a Special Administrative Region of China, enterprises are paying attention. It’s a possibility that the SFC might make changes after considering public feedback. But in the current form of the proposal, what are their options? Operations: They can cease operations, just as BX (Thailand’s then-largest exchange) chose to do when the Thailand SEC introduced regulations. Also, at least ten companies announced that they were ceasing business after New York State released its BitLicense. Satisfying regulatory compliance is expensive and for many, it might mean running an unprofitable operation. Alternatively, enterprises can amend their business and attempt to satisfy the new policies. They would need to cease any lending, derivatives or leverage businesses. They would also need to KYC every customer to prove they have at least US$1 million in liquid assets. Peer-to-peer platforms that do not hold custody of assets are excluded so creating a decentralized platform is also possible. However, because it’s decentralized, there should be no controlling mechanisms nor ownership by a centralized entity. If profits or governance is still dominated by a specific party, regulators will not view this favorably. Mergers & Acquisitions: Regulated companies can’t “loan out” their license to unregulated enterprises because of the “single legal entity undertakings” requirement. However, unregulated entities could consider selling to a licensed operator. Relocation: They could consider leaving Hong Kong but choices are limited. Companies need access to talented human capital, regulatory clarity, and property rights. In terms of domicile, some companies have chosen to physically operate outside their place of registry, such as Malta or Seychelles. However, with the future of regulation seeming inevitable globally, there’s no certainty that companies can continue to do this. OKEx and Huobi are not registered in China but are rumored to still face local regulations. In terms of physical location, Singapore is a close competitor to Hong Kong. However, while the Monetary Authority of Singapore (MAS) has grandfathered 107 companies under the Payments Services Act (PSA) for now, they have not published final regulations. It is possible that they adopt similar requirements to HK’s SFC. Final Thoughts Ashley Alder, Chief Executive of the SFC said: “same business, same risks, same rules”. Given the recent crackdowns in the US and China, the cryptocurrency ecosystem is facing increased regulation. While this may hurt select enterprises, history tells us that digital asset adoption has continued to thrive despite the failures of some centralized exchanges. Large exchanges that have closed, like BTCC (China) and Mt Gox (Japan), did not have a lasting impact on the ecosystem. Regulatory clarity may be positive for the ecosystem in the long term. Though Hong Kong retail investors and those who trade derivatives will soon no longer have local access, the SFC is paving the way for institutional adoption and the growth of the STO market. If HK regulators succeed in curating the digital assets space, traditional financial conglomerates can help in complementing the ecosystem and, with crypto-native enterprises, they might create one of the most dominant STO markets in the world. The future of cryptocurrencies is very bright."