“The kind of environment that we developed Google in, the reason that we were able to develop a search engine, is the web was so open. Once you get too many rules, that will stifle innovation.”

- Sergey Brin

INTRODUCTION

ONC Lawyers welcomes this opportunity to provide our Response, comments and feedback on FSTB’s CP. It is our view that it is inevitable for Virtual Asset (“VA”) to become more integral in the daily lives of ordinary citizens of Hong Kong. Accordingly, the setting down of ground rules is both a long overdue and welcoming development.  In order to facilitate the readers of this Response with the understanding of the rationale behind our comments and recommendation, it is important that we provide context via our general observations of the intended act of regulating the VA ecosystem as well as the reality on the ground before going into our Response. 

General Observations

As mentioned hereinabove, it is our view that it is inevitable for VA to become an ever integral part of the lives of ordinary citizens in Hong Kong. Regulation is therefore a must both as a matter of protecting the general citizenry as well as maintaining Hong Kong as Asia’s leading first tier financial centre. 

It has also been observed that owing to Hong Kong’s special status as the leading financial centre in all of Asia, it is well known that some of the world’s longest running and largest VA Exchanges can all trace their roots from Hong Kong. 

Further, as an incubator of Asia’s innovation, it is extremely important in striking a balance between the roll out of rules as well as ensuring that the VA community will be eased into the rules, as opposed to abrupt roll out of new rules (which tends to drive out these treasured companies from Hong Kong). 

Alas, it is the view of the author of this Response that the setting down of rules is just as important as having the means to ensure that existing VA Service Providers (“VASP”) will be eased into any intended rules that will be rolled out. 

In this connection, it should also be noted that the Financial Action Task Force (“FATF”) has provided member states with three (3) options for regulating the VA space on descending severity:

1. Prohibition: which is the most severe and draconian of options – effectively extinguishing the VA market from Hong Kong;
2. Licensing: whilst more moderate than prohibition will still be significant stress on existing VASP (as they might be prevented from operating in jurisdiction in absence of license and it may take time to get their business up to standard required for granting of a license); and
3. Registration: being the most lenient of approach wherein while operators will be subject to enhanced rules and standards, will not lose their ability to operate past a certain date.

It is noted that while Dealers in Precious Metals and Stones (“DPMS”), a well-established sector within the commodities trade, is only subject to the Registration approach, the CP provides that VASP be placed under a Licensing Regime.  

It is also well noted that various public bodies of Hong Kong have historically noted that VA are akin to [virtual] commodities, it therefore leaves a question as to why different standards are now adopted, though it is understandable given the Government’s prior acquired experience with regulating VASP via their previous opt-in licensing regime.  

Going forward, it should be stressed that any sudden/radical implementation of licensing requirement without a sufficient grace period or sufficient facilitation to guide existing VASPs into being qualified for license will have significant impact on the VA ecosystem in Hong Kong.  

A two-step approach (first by registration then by licensing after specified time) may be preferred in order to ease VASPs into the new set of regulations. Change does after all takes time, and radical change will result in errors and chaos. 

Our Answers to Questions Raised in CP (VASPs) 

Q1 Do you agree that Hong Kong should continue with efforts to strengthen the AML/CTF system having regard to international standards, in keeping with our status as an international financial centre that is safe and clean for doing business? 

Answer: We agree with the CP’s position that Hong Kong should continue to strengthen her AML/CTF policies in order to maintain our status as Asia’s leading financial centre.  

That said, it should also be noted that regulations alone are only effective for behavioural modification, not making it where the industry wishes to abide by such guideline as a matter of an ideal state to strive for. Ease of transition and facilitation to assist VASP into changing/upgrading its internal practice so that they will qualify for license. 

Accordingly, the short answer is that whilst we agree, any action must also factor in proportionality wherein it must not stifle/disrupt existing VASP’s ability to continue its operation in Hong Kong. This is where our ‘two-step’ proposal comes into play.  

Q2  Do you agree that a balanced approach should be adopted for the current legislative exercise, complementing the need to have an effective system for tackling ML/TF risks in the VASP and the DPMS sectors in accordance with the FATF Standards, while minimising regulatory burden and compliance costs on the businesses? 

Answer: Again, we agree with the above statement. As repeatedly echoed throughout this Response, we must stress that it is not just “regulatory burden and compliance costs” that the Government should take into account but also whether sufficient support is provided to assist VASP to be brought up to speed/standard FATF has outlined.  

By adopting a facilitative approach (e.g. facilitating by providing concrete resources/assistance for VASP to be brought up to FATF standards), Hong Kong will also have the opportunity to absorb even greater number of VASP to be based in the city currently operating elsewhere.  

Again, we are of the view that the standards rolled out by FATF is the future, but the key question is how we can ease VASP into such standard. Limitation of burden is only one side of the coin, facilitative measures must also be addressed.  

Q3  Do you agree with the proposed scope and coverage of the regulated activity of operating a VA exchange?  

Answer: As mentioned hereinabove, whilst we believe that VA exchanges should be regulated, we believe that in order to ensure smooth transition, a registration approach should be contemplated followed by licensing regime.  

As reflected in some previous ICO cases in Hong Kong, a VA may well fall within the definition of “securities”, resulting in the intervention by the SFC. It is suggested that a clarification be made in cases where a VA also constitutes “securities” within the definition of the SFO, whether it will be exempted from the application of the SFO. Assuming that there is no such exemption, further studies may be necessary to prevent or deal with the potential conflicts between the two regulatory regimes.       

Q4  Do you agree with the proposed definition of VA? Other than closed-loop, limited purpose items, are there other digital items that should be excluded from the definition?  

Answer: We agree with the proposed definition of VA, subject to the above.  

Q5  Should peer-to-peer VA trading platforms be covered under the licensing regime? 

Answer: In our view, as emphasized above, all proposals must be proportionate and taking into account and with a view: 

1. Not to be over burdensome to existing businesses in terms of compliance costs;
2. Not to drive out existing VASP by automatically classifying them as not eligible for license (conditional license can also be considered as an interim measure).  

At this time, whilst AML/ risks needs to be addressed, the regulation (via legislation) of peer-to-peer (“P2P”) VA trading platforms should only take place should specific need deem to have arisen in the future.  

Q6  Do you agree that only locally incorporated companies may apply for a VASP licence? 

Answer: In our view, such restrictions (whilst understandable in light of the existing regime), can be loosen given the fact that off-shore companies can obtain license from the SFC.  It will of course make sense to impose certain conditions. Having said that, we reckon that it is relatively easy for any person to set up a company in Hong Kong. Requiring all the licensed persons to be a Hong Kong company may make it easier to subject them to regulation.  

Q7  Should other criteria be added to the fit-and-proper test given the nature and risks of VASP 

Answer: We are of the view that the current proposed criteria for the fit-and-proper test appears to be sufficient and in line with the proportionality principle. However, we noted that the scope of services provided by service providers are not defined. If a service provider provides custodian services in respect of the VA, there should be additional and a lot more stringent requirements on his eligibility to be such a service provider. 

Q8  Should other regulatory requirements be added to mitigate the risks of VASPs? 

Answer: The proposed regulatory requirements appears to be sufficient. However, we noted that currently some VA exchanges are involved in proprietary trading. The involvement in such activity will necessarily expose the exchange to huge financial risk due to the volatile nature of the market. It is suggested that clarification be made as to whether a VASP is allowed to engage in proprietary trading. Assuming that they will be so allowed, there should be rules or codes in place to minimize the exposure to risk and deal with the potential conflict of interest. 

Q9  Do you agree that a VASP licence should be open-ended or should it be periodically renewed? 

Answer: In order to ensure that VASPs operating in Hong Kong will be able to anticipate its continued operation (as well as to guarantee its users), we are of the view that any VASP licence to be issued (if adopted) should be open-ended.  

That said, similar regimes of interim audits, assessment, sanctions and revocation should be implemented as the situation may so warrant.  

Q10  Do you agree with the exemption arrangement and the 180-day transitional period for application of a VASP licence? 

Answer: It is only reasonable that existing licensed VASP should be exempted given the fact that such VASP has already been qualified by the SFC. 

That said, the suggestion of a 180-day transitional period is unrealistic due to far too many wild factors. 

On the contrary, a multi-step approach to ease VASP into the new regulatory regime should be considered. For example, existing VASP operators already operating within Hong Kong should be assessed whether it should qualify for a, say, conditional license where regulators will then work with such VASP to get them up to new standards and implement new internal controls as appropriate.  

Alternatively, the same transitional period for DPMS should be considered for the transitional period. The existing proposal is too draconian and may result in the exodus of existing VASP.  

Further, a time limit should also be imposed upon regulators as to how fast an application is to be processed (as at times, processing time of regulators to consider individual application is outside the control of applicants).  

Q11  Do you agree that, for investor protection purpose, persons without a VASP licence should not be allowed to actively market a VA exchange business to the public of Hong Kong? 

Answer: Yes 

Q12  Do you agree that the penalty level for carrying out unlicensed VA activities should be sufficiently high to achieve the necessary deterrent effect?  

Answer: Yes, we agree with the position proposed by the CP 

Q13  Do you agree with the proposed sanctions, including that it shall be a criminal offence for a person to make a fraudulent or reckless misrepresentation to induce someone to acquire or dispose of a VA? 

Answer: We agree that it should be a criminal offense where a person induce another to acquire or dispose VA via fraudulent or reckless misrepresentation.  

Q14  Do you agree that the Tribunal be expanded to hear appeals from licensed VASPs against future decisions of the SFC? 

Answer: In order to provide clear cut jurisdiction of matters, the power to hear appeal by the Anti-Money Laundering and Counter Terrorist Financing Review Tribunal should be limited to AML/CTF matters. It will be improper for the Anti-Money Laundering and Counter Terrorist Financing Review Tribunal to have the power to review decisions by the SFC, the proper jurisdiction of which should be the Securities and Futures Appeals Tribunal.    

Our Answers to Questions Raised in CP (DPMS) 

Q15  Do you agree generally with the proposed scope of “regulated activities” and related definitions for DPMS, which draw reference from the FATF requirement and overseas legislation? 

Answer: Whilst the scope has seemingly sufficiently covered traditional DPMS, the existing scope in our view can benefit from better definition to include businesses of a more novel nature (e.g. ‘virtual gold, etc.).  

Q16  Are there any other business activities in respect of precious metals, precious stones, precious products, and precious-asset backed instruments that should be covered under the registration regime? 

Answer: Please see our answer in Q15. We do note that under the existing regime, the scope can be dealt with by way of legislative amendment. That having been said, such avenue may unrealistically be time consuming and it may be better to empower the proper regulatory body to expand such scope by administrative means (especially in light of how technology can rapidly and radically change the DPMS ecosystem in the foreseeable future).  

Q17 Do you agree with the proposal to have a two-tier registration regime, such that registrants who do not engage in large cash transactions can be separated from those who do, with the former being subject to simple and mere registration requirements and the latter to standard AML/CTF requirements currently applicable to other DNFBPs? 

Answer: We are of the view that the two-tier registration system will not be helpful in enhancing AML/CTF work given the fact that there is no guarantee that money laundering will only occur with large transaction. On the contrary, the two-tier approach proposed will effectively render money laundering activities of a microtransaction nature automatically undetected if offenders intentionally keep transaction amounts to smaller sums. Such system will therefore be counterproductive and may in fact result in ‘designed’ money laundering schemes. 

A flexible approach as to how businesses can based on factual circumstances of each case rather than an arbitrary amount be adopted as a means of detecting ‘irregular’ activities.   

In any event, even if a two-tier approach is ultimately adopted, the threshold of HK$120,000 is far too low and will capture many commercial transaction causing undesirable complications in transaction.  

In this respect, we are of the view that such rigid/arbitrary number is not in line with the proportionality principle and therefore suggest that this section be subject to re-consideration.  

Q18  Do you agree generally with the respective requirements for Category A and Category B registrations, including that Category B registration should be renewed every three years? 

Answer: As mentioned in our answer to Q17, the current design should be reconsidered owing to obvious flaws in its approach.  

Q19  Do you agree that financial institutions which are already regulated under the AMLO should be exempted from the registration regime when carrying on a DPMS business that is ancillary to their principal business? 

Answer: Yes 

Q20  Do you agree that non-domestic dealers who visit Hong Kong only occasionally should be exempted from the registration regime, subject instead to the requirement of filing cash transaction reports with possible sanctions for failure to do so? 

Answer: Respectfully, this proposal should be re-considered due to lack of practicality. It is trite that non-domestic dealers will pose the same AML/CTF risks as local dealers, if not more. Not only is this proposal potential reverse discriminatory in nature, it will have implication on how Hong Kong will be seen overall (e.g. regulations are supposed to improve Hong Kong’s global standing, not bringing the label of hub for international money launderers). This section should therefore be reconsidered and redesigned.  

Q21  Do you agree with a 180-day transitional period and the deemed registration arrangement for incumbent dealers to facilitate their migration to the registration regime? 

Answer: Yes. We note that registration requirements are substantially different from licencing requirements and therefore is in line with proportionality principle.  

Q22  Do you think the proposed sanction is adequate in deterring the operation of a DPMS business without registration?  

Answer: No explanation has been provided as to why the sanctions for VASP is significantly different from DPMS. Sanctions and penalty requires rationale in order for proper implementation and execution by the Judicial process.  

The significant differences in proposed sanction therefore raised more questions than answers.  

Q23  Do you agree that Category B registrants should be subject to the same administrative sanctions as other DNFBPs, and not to criminal sanctions, for non-compliance with the AML/CTF requirements in the AMLO? 

Answer: Again, no rationale for the proposal is clearly made out and useful comments can only be provided upon full and proper explanation being given as to the rationale for the proposed alignment.  

Q24  Do you agree that the Tribunal be expanded to hear appeals from registrants against future decisions of the Registrar? 

Answer: We agree.  

Q25  Do you agree with the miscellaneous amendments proposed by the Government to address some technical issues identified in the Mutual Evaluation Report and other FATF contexts? 

Answer: We agree that there should be confidentiality requirements imposed in order to protect the integrity for investigation. 

That having been said, usual exemptions (e.g. for seeking legal advice, etc.) should be incorporated in order to ensure the new rules are constitutional. 

For this purpose, reference to the confidentiality clause pursuant to section 378 of the Securities and Futures Ordinance (Cap. 571) (“SFO”) should be made for the purpose of designing the proper clauses, failing which, we foresee significant defects in the laws that will be implemented.  

Concluding Remarks 

Again, we conclude by stating that we welcome regulatory improvement to both the VASP DPMS space brining up the general standards to those recommended by FATF. That having been said, in order for Hong Kong to continue its status as the premier financial centre of all of Asia, it is essential that any new rules to be passed must  

(i) be business effaceable (being in touch with the realities on the ground) and  

(ii) regulators must take a more active role in facilitating industry plays in their transition from an unregulated space to that of a regulated one.  

Regulators must also give consideration to operators already within the jurisdiction so as to not alienate them from our jurisdiction, less we wish to fall behind the rest of the globe as virtual assets continues to proliferate. It is therefore only with a facilitative approach that Hong Kong will stand out amongst other jurisdiction as being the prime destination for industry to enter into.  

Sherman Yan, Dominic Wai & Joshua Chu of

ONC Lawyers