With the rapid development of the cryptocurrency market, an increasing number of people are engaging in cryptocurrency investment and trading. However, due to the unique nature and high risks associated with the cryptocurrency market, regulatory authorities have been imposing stricter regulations on centralized cryptocurrency exchanges.

In this context, the new Virtual Asset Service Providers (VASP) licensing system for centralized cryptocurrency exchanges has been introduced in Hong Kong.

The Virtual VASP license refers to a new licensing regime established by the Securities and Futures Commission (SFC) of Hong Kong starting from June 1, 2023. It is designed to regulate and oversee institutions that provide virtual asset trading and related services, namely centralized cryptocurrency exchanges.

The introduction of the VASP license aims to enhance the regulation of virtual asset service providers, ensure their compliance, and protect the rights of investors.

The VASP license requires virtual asset service providers to adhere to a series of compliance requirements, including Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations, capital adequacy requirements, security measures, transparency, and reporting systems, among others.

By obtaining the VASP license, virtual asset service providers can demonstrate their compliance with regulatory requirements, enhance market confidence, attract more investors to engage in trading, and foster the development of the virtual asset market.

>>The key provisions of the VASP licensing system in Hong Kong include:

1. Appointment of two suitable Responsible Officers (RO) who are responsible for overseeing the operations of the VASP and ensuring compliance with Anti-Money Laundering (AML) and Counter-Terrorist Financing (CTF) requirements.
2. Preparation of relevant documents, including shareholder information, business plans, and company structure.
3. Completion of the WINGS application form.
4. Finalizing application details and submitting the application.
5. Leasing a specific location and carrying out necessary renovations.
6. Securities and Futures Commission (SFC) review and response to any inquiries or questions from the SFC.
7. Arranging the opening of a bank account.
8. Receipt of written notification regarding the approval of the application.
9. Engagement of subsequent compliance officers and auditors.

In the article ‘Hong Kong Web3: 1 Year, 1 License, 1 New Industry,’ we can see that the role of Responsible Officer (RO) plays a crucial role in license applications.

The RO serves as a supervisor and is responsible to the Hong Kong Securities and Futures Commission (SFC), while being paid by the licensed company. The RO needs to undergo assessment and registration by the SFC (with the validity of exam results lasting for three years) and can engage in related work for a lifetime.

The eligibility of an RO is related to individual qualifications and is independent of the licensed company they work for, allowing them to freely switch jobs between licensed companies. Under this system, if an RO violates the regulations set by the SFC, they may lose their eligibility to engage in related work for a lifetime.

Therefore, to maintain this professional qualification, an RO supervises the daily operations of licensed companies from the perspective of the SFC to ensure compliance with regulatory requirements. They are the frontline managers of licensed companies appointed by the Hong Kong SFC.

Regulatory Requirements and Compliance Measures:

1. It is recommended that trading platforms store 98% of customer virtual assets in cold wallets, with private keys and mnemonic phrases stored in Hong Kong, in order to reduce the risk of platform vulnerabilities due to hackers or attacks.
2. Platform operators are prohibited from engaging in proprietary trading, except for offline back-to-back transactions, or engaging in proprietary market-making activities.
3. Taking the FTX case as a reference, platforms are not allowed to deposit, transfer, lend, pledge, repledge, or engage in any other form of buying and selling of customer virtual assets.
4. Customer assets must be properly safeguarded through wholly-owned subsidiaries holding trust or company service provider (TCSP) licenses.
5. Platforms are required to purchase third-party insurance or set aside funds in trust, either by themselves or through affiliated companies, to provide protection for users.

The relevant laws and regulations referenced include:

1. Anti-Money Laundering and Counter-Terrorist Financing (Financial Institutions) (Amendment) Ordinance 2022.
2. Consultation Paper on Proposed Regulatory Regime for Virtual Asset Trading Platforms Operating as Licensed by the Securities and Futures Commission (VASP Consultation Paper).
3. Guidelines for Virtual Asset Trading Platform Operators (VASP Guidelines).
4. Anti-Money Laundering and Counter-Terrorist Financing Ordinance.
5. Securities and Futures Ordinance.

>>The impact on centralized cryptocurrency exchanges

How compliant exchanges will benefit when Hong Kong virtual currency exchanges obtain VASP licenses. First of all, compliance status and official recognition will enhance the legitimacy and trustworthiness of the exchanges, attracting more investors to choose the platform for trading.

As Kevin, the head of Gate.io Hong Kong Exchange, mentioned, Hong Kong has over 7.4 million local users, and obtaining a license is significant for Gate to establish a bridge for capital flow between the vast compliant capital and cryptocurrency exchanges worldwide, leveraging Hong Kong’s international financial center status.

Obtaining a license will enhance the exchange’s market reputation and industry recognition, further attracting more attention from users and institutional investors. In addition, compliant exchanges can establish partnerships with banks, payment institutions, and other financial entities, providing a broader range of trading pairs and financial instruments, expanding users’ choices.

In terms of security, compliant exchanges need to meet certain security standards and measures. Under multiple protection measures, users’ assets and data will be secured in a safer and more reliable trading environment. At the same time, regulatory compliance can reduce the risks of market manipulation, fraud, and money laundering, thereby maintaining market order and stability.

The risks and challenges of non-compliant exchanges are that exchanges operating without approval from regulatory authorities may violate local financial laws and regulations, facing the risks of fines, closure, or other legal consequences. Without regulation, users’ assets can only rely on the exchange’s own risk control system, and the lack of compliance may lead to a decrease in investors’ trust in the exchange, impacting trading volume. Under market competition pressure, it may result in user attrition.

>>The impact on the market

Market makers are a group of professionals who are most sensitive to trading activities. After interviewing several local market makers in Hong Kong, I choose to examine the impact from their perspective.

Hong Kong’s cryptocurrency market makers currently hold a cautiously positive attitude towards the new VASP licensing system, as operating in a compliant manner helps enhance trust and transparency in the entire cryptocurrency market.

Licensed exchanges adhere to stricter regulatory requirements, which can reduce trading risks and protect the interests of retail and institutional investors.

However, this is not absolute. Market makers also consider other factors when choosing exchanges, such as trading volume, transaction fees, and the technical and operational capabilities of the exchange.

Higher liquidity provides the assurance of faster and more stable trading opportunities. Transaction fees determine the associated trading costs, and a reasonable fee structure can contribute to market makers’ profit margins.

If licensed exchanges can offer competitive services in these aspects, market makers are more likely to choose to trade on those exchanges.

>>The impact on traditional finance

After cryptocurrency exchanges obtain licenses for compliant operations, their impact on traditional finance is multifaceted. Compliant cryptocurrency exchanges will introduce a large number of new financial products and services, enhancing the competitiveness of the entire financial market in Hong Kong and posing a challenge to traditional financial institutions. At the same time, this may also drive traditional financial institutions to innovate in order to meet new market demands.

The emergence of compliant cryptocurrency exchanges will change investors’ investment behavior and strategies. The high volatility of cryptocurrency investments makes them more attractive and may attract some “hot money” from the traditional financial market. This will have an impact on the flow of funds in the traditional financial market.

Furthermore, cryptocurrency exchanges typically offer more convenient services with user-friendly interfaces and can provide services around the clock. This may push traditional financial institutions to improve their services to meet customer needs and promote the integration of financial technology with traditional finance.

It is worth noting that compliant cryptocurrency exchanges may also bring new risks, such as price volatility and security issues of cryptocurrencies. This could affect the strategies and policies of financial regulatory institutions.

Overall, the compliant operation of cryptocurrency exchanges can have a profound impact not only on the traditional financial industry but also on the further integration and development of financial technology and traditional finance. The future financial market may become more diverse, open, and flexible as a result.

>>International Regulatory Comparisons and Insights

The regulatory models for Virtual Asset Service Providers (VASPs) vary significantly across different regions. The regulatory approach in each jurisdiction typically depends on its attitude towards virtual assets, legal framework, and the characteristics of its financial market.

In many regions, such as the United States, the regulation of VASPs is overseen by multiple agencies. For example, exchanges may need licenses from the Financial Crimes Enforcement Network (FinCEN) while also complying with requirements from the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). This decentralized regulatory model can provide comprehensive oversight but may increase compliance costs.

On the other hand, the European Union (EU) has adopted a more centralized regulatory model. Europe incorporates the regulation of VASPs into its Anti-Money Laundering and Countering the Financing of Terrorism (AML/CFT) regulations, which all member states are required to adhere to. The advantage of this approach is that it provides a unified regulatory framework, streamlining the compliance process.

>>The regulatory model in Hong Kong has its uniqueness.

In 2020, the Financial Services and the Treasury Bureau (FSTB) of Hong Kong proposed new regulations for the supervision of virtual asset trading, requiring all virtual asset trading platforms to obtain licenses from the Securities and Futures Commission (SFC) of Hong Kong in order to operate. Unlike many regions that only regulate services provided to retail customers, Hong Kong’s regulatory scope includes all cryptocurrency transactions, whether they are retail or institutional clients.

In addition, Hong Kong has achieved alignment between the regulation of virtual asset trading platforms and traditional financial markets. For example, the regulatory requirements of the SFC for virtual asset trading platforms are similar to those for traditional securities trading platforms. This model helps ensure the stability of the virtual asset market and provides a compliant path for the further development of virtual assets.

The regulatory model in Hong Kong has certain reference value. Firstly, it provides a comprehensive regulatory framework that covers all types of virtual asset trading. This helps prevent regulatory loopholes and mitigate potential investment risks. Secondly, by aligning the regulation of virtual asset trading platforms with that of traditional financial markets, it ensures market fairness and transparency, while also providing a compliant path for the further development of virtual assets. This offers valuable insights for other regions on how to balance innovation and regulation.

Lastly, as an international financial center and a hub for innovative technologies, Hong Kong will embrace broader development prospects after achieving compliance in virtual asset regulation. With the rapid growth of the global digital economy, virtual assets will become an integral part of financial transactions and investments.

The Hong Kong government is actively promoting the compliance of virtual assets and has established corresponding regulatory frameworks and schemes, which will undoubtedly lead the way in global financial innovation.