Introduction

On 28 January 2022, the Hong Kong Monetary Authority (“HKMA”)  published a circular which provides regulatory guidance to Authorized Institutions (“AIs”) when engaging in activities relating to virtual assets (“VAs”) and dealing with virtual asset service providers (“VASPs”) (the “Circular”).

Local and international regulatory developments

With the popularization of VAs, various international bodies have published reports and guidance in relation to risks associated with VAs and VASPs. The HKMA reminds AIs to observe relevant international guidance in their dealings of VA-related activities since approaches to regulation, supervision and enforcement of VA activities and VASPs vary across different jurisdiction. In particular, the Circular refers to the “Guidance for a Risk-Based Approach to Virtual Assets and Virtual Asset Service Providers” published by the Financial Action Task Force (“FATF”) in October 2021 (the “FATF Guidance”). While locally, the HKMA has issued a Discussion Paper on Crypto-assets and Stablecoins on 12 January 2022 to clarify its regulatory approach for crypto-assets (see our January 2022 newsletter issue “The Hong Kong Monetary Authority published the Discussion Paper on Crypto-assets and Stablecoins”).

HKMA’s regulatory approach

The HKMA adopts a risk-based approach in supervising AIs’ VA activities in line with applicable international standards and based on the principle of “same risk, same regulation”. As businesses of AIs may interface with VAs and VASPs through various means such as proprietary investment, or provision of banking and investment services to customer, this may present a range of risks to AIs. In light of the increasing investment in VAs by institutional and retail customers through overseas VA exchanges and the increasing instances of VA-related crime such as deception, investment fraud, theft of VAs, money laundering (“ML”), and terrorist financing (“TF”), the HKMA urges AIs to undertake risk assessments in order to identify and understand the associated risks before engaging in any VA activities, and to take appropriate measures to manage and mitigate the identified risks upon considering relevant applicable legal and regulatory requirements. Specifically, the Circular has provided detailed guidance  in relation to three areas:

(1)  Prudential Supervision

The HKMA has made it clear that so far as AIs have adopted adequate risk-management controls with sufficient oversight by their senior management, it does not currently intend to prohibit AIs from gaining financial exposures to VAs such as investing in VAs, lending against VAs as collateral, or allowing their customer to use credit cards or other payment services to acquire VAs. However, the HKMA expects AIs to conduct proper due diligence of the relevant VAs, including understanding:

·       the legal and financial structure;

·       the technology behind the creation of the VAs;

·       the background and risk-management arrangements of parties involved in the operation of the VA scheme; and

·       the provenance of the VAs which were acquired for investment.

Upon obtaining such information, the AIs should evaluate their exposures to different types of risks and adopt appropriate risk-mitigation measures, such as setting prudent limits on the institution’s overall exposures to VAs and applying conservative loan-to-value ratios for VAs which are used as collateral. AIs should also set aside sufficient capital having regard to prevailing capital requirements applicable to VAs if residual risks exist.

(2)  Anti-money laundering (“AML”),counter-terrorist financing (“CFT”) and financial crime risk

AIs are required to establish and implement effective AML/CFT policies upon considering relevant guidance issued by the HKMA such as the circular “Managing ML/TF risks associated with virtual assets and virtual asset service providers” issued in December 2019, and the FATF Guidance. In situations where customers engage in VA-related activities through their bank accounts, AIs should understand the nature of that VA-related transaction and file suspicious transaction reports to the Joint Financial Intelligence Unit when there are any grounds for suspicion with reference to Chapter 7 of the “Guideline on Anti-Money Laundering and Counter-Financing of Terrorism (For Authorized Institutions)” (the “AML/CFT Guideline”). If AIs have any business relationship with VASPs such as opening bank accounts, AIs should conduct ML/TF risk assessments with reference to the risk-based approach to differentiate the risks of individual VASPs and request the VASPs to confirm compliance with any applicable laws and regulations in Hong Kong or any other relevant jurisdiction. Depending on the nature of the relationship and the assessed ML/TF risks of the VASP, AIs may also need to conduct additional customer due diligence of different extent in a similar way as those for offering correspondent banking or similar services to financial institutions with reference to paragraphs 11.23 to 11.25 of Chapter 11 of the AML/CFT Guideline, such as by the following measures:

·       collecting information to understand the nature of the VASP’s business and to construct a comprehensive risk profile of the VASP;

·       checking whether the VASP is licensed or registered in Hong Kong or in other jurisdiction, and the type of regulatory framework it is subject to; and

·       assessing the AML/CFT controls of the VASP.

(3)  Investor protection

Due to the wide range of risks associated with customers investing in or holding of VAs which are not reasonably likely to be understood by retail investor, the HKMA notes that VA-related products are very likely be considered as complex products and some may even be subject to selling restrictions in Hong Kong or other jurisdictions. Therefore, the HKMA expects AIs to impose additional investor protection measures on the distribution of VA-related products and promote investor education. AIs are required to comply with the guidance issued by the HKMA and the Securities and Futures Commission (“SFC”), including the joint circular issued by the HKMA and the SFC on 28 January 2022 regarding intermediaries’ VA-related activities (see our February 2022 newsletter issue “SFC and HKMA published joint circular on intermediaries’ virtual asset-related activities”).

Conclusion

The Circular has helpfully clarified the HKMA’s regulatory approaches to AIs’ interface with VAs and VASPs and has provided guidelines for AIs to follow in different applicable circumstances. As a last note of the Circular, the HKMA welcomes AIs and other regulators to discuss with the HKMA and obtain its feedback on the adequacy of the institution’s risk-management controls prior to launching relevant products or services. As VA-related activities evolve rapidly and VAs’ market is on the rise, AIs should remain vigilant as to the latest regulatory developments in Hong Kong and globally.