The New Era of Virtual Money Exchanges: An Analysis of Hong Kong's VASP Licensing System

Introduction

With the booming development of the Virtual Money market, investors' interest in this field is increasing day by day. However, the special nature and high-risk characteristics of the Virtual Money market have also attracted significant attention from regulatory authorities. Against this backdrop, Hong Kong has launched a brand new centralized Virtual Money exchange license system (VASP).

The Virtual Asset Service Provider License (VASP) is a new licensing system officially implemented by the Hong Kong Securities and Futures Commission (SFC) on June 1, 2023. This system aims to regulate and supervise institutions that provide virtual asset trading and related services, namely centralized virtual money exchanges. The introduction of the VASP license aims to strengthen the regulation of virtual asset service providers, ensuring their compliance while protecting investors' rights.

The VASP license requires virtual asset service providers to comply with a series of strict regulatory requirements, including customer identification (KYC), anti-money laundering (AML) regulations, capital adequacy requirements, security measures, transparency, and reporting systems, among others. By obtaining a VASP license, virtual asset service providers can demonstrate their compliance with regulatory standards, enhance market confidence, attract more investors to participate in trading, and promote the healthy development of the virtual asset market.

Main Regulations of the Hong Kong VASP Licensing System

The application process includes:

1. Hire two qualified Responsible Officers (RO) to supervise the operation of the VASP, ensuring compliance with anti-money laundering/counter-terrorism financing and other regulatory requirements.

2. Prepare relevant documents (shareholder information, business plan, company structure).

3. Complete the WINGS application form.

4. Confirm the application details and submit the application.

5. Lease the venue and carry out specific renovations.

6. Accept the review by the Securities Regulatory Commission and respond to relevant issues.

7. Arrange to open a bank account.

8. Receive written notification of application approval.

9. Hire subsequent compliance consultants and auditors.

The Responsible Officer (RO) plays a key role in the licensing application process. The RO is a supervisory position, compensated by the licensed company, but accountable to the Hong Kong Securities and Futures Commission (SFC). The RO must pass the SFC's assessment and registration (with exam results valid for three years) and may work in this capacity for life. The qualification of the RO is related to personal credentials and is independent of the licensed company they work for, allowing the RO to switch licensed companies freely. According to regulations, if the RO violates the SFC's requirements, they may lose their eligibility to work in this capacity for life. To maintain professional qualifications, the RO supervises the daily operations of the licensed company from the SFC's perspective, ensuring compliance with regulatory requirements. They are the frontline management personnel of the SFC at the licensed company.

Regulatory Requirements and Compliance Measures:

• It is recommended that the trading platform store 98% of customer Virtual Money in cold wallets, and that private keys and mnemonic phrases should be kept in Hong Kong to reduce the risk of the platform being hacked or attacked.
• Platform operators must not engage in proprietary trading (except for offline back-to-back trading) or proprietary market-making activities.
• Referring to recent events, the platform must not deposit, transfer, lend, pledge, re-pledge, or otherwise trade customer virtual money assets.
• Customer assets can only be properly held by wholly-owned subsidiaries that hold a trust or company service provider (TCSP) license.
• The platform needs to purchase third-party insurance or allocate its or its affiliated company's funds in trust as reserves to provide protection for users.

Relevant laws and regulations include:

• "2022 Anti-Money Laundering and Counter-Terrorism Financing Regulations" ("2022 Revised Regulations")
• Consultation Paper on Proposed Regulatory Requirements for Operators of Virtual Asset Trading Platforms Licensed by the Securities and Futures Commission (VASP Consultation Paper)
• Guidelines for Operators of Virtual Asset Trading Platforms (VASP Guidelines)
• Anti-Money Laundering Regulations
• Securities and Futures Ordinance

Impact on Centralized Virtual Money Exchanges

Compliant exchanges will benefit from multiple aspects. Once a Hong Kong virtual money exchange obtains a VASP license, firstly, its compliance status and official recognition will enhance the legitimacy and trustworthiness of the exchange, attracting more investors to choose the platform for trading. Hong Kong has over 7.4 million local users, and through its status as an international financial center, it plays a significant role in bridging the flow of funds between the vast global compliant capital and cryptocurrency exchanges.

Obtaining a license will enhance the market reputation and industry recognition of the exchange, further attracting the attention of users and institutional investors. In addition, compliant exchanges can establish partnerships with banks, payment institutions, and other financial entities to provide more trading pairs and financial instruments, expanding the options available to users.

In terms of security, compliant exchanges need to meet certain security standards and measures. With multiple protective measures in place, the safety of users' assets and data will receive more reliable protection. At the same time, compliant regulation can reduce the risks of market manipulation, fraud, and money laundering, maintaining the order and stability of the market.

In contrast, exchanges operating without the approval of regulatory agencies may face the risk of violating local financial laws and regulations, including fines, suspension of operations, or other legal sanctions. User assets completely rely on the exchange's own risk control system in the absence of regulation, so a lack of compliance may lead to a decrease in investor trust in the exchange, affecting trading volume. Under market competition pressure, this may cause user attrition.

Impact on the Market

From the perspective of market makers, cryptocurrency market makers in Hong Kong currently hold a cautiously optimistic attitude towards the new VASP licensing system. Compliance in operations helps to enhance the overall trust and transparency of the cryptocurrency market. Exchanges holding licenses comply with stricter regulatory requirements, which is beneficial for reducing trading risks and protecting the interests of retail and institutional investors.

However, market makers also consider other factors when choosing an exchange, such as trading volume, trading fees, and the technical and operational capabilities of the exchange. Higher liquidity ensures faster and more stable trading opportunities. Trading fees determine the associated trading costs, and a reasonable fee structure will help the profit margin for market makers. If a licensed exchange can provide competitive services in these areas, market makers are more likely to choose to trade on these exchanges.

Impact on Traditional Finance

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

The emergence of compliant cryptocurrency exchanges will change investors' investment behaviors and strategies, and the high volatility of cryptocurrency investments will become more attractive, drawing some "hot money" from traditional financial markets. This will impact the flow of funds in traditional financial markets.

In addition, the services provided by cryptocurrency exchanges are usually more convenient, with user-friendly interfaces, and can operate around the clock. This may drive traditional financial institutions to improve their services to meet customer needs, facilitating the integration of fintech with traditional finance.

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

Overall, the compliance operation of cryptocurrency exchanges can not only have a profound impact on traditional financial industries but also promote further integration and development of financial technology and traditional finance. The future financial market may thus become more diversified, open, and flexible.

Comparison and Insights of International Regulation

The regulatory model for Virtual Asset Service Providers (VASPs) varies significantly across different regions. The regulatory approach in each location typically depends on its attitude towards virtual assets, legal framework, and the characteristics of the financial market. In many areas, such as the United States, the regulation of Virtual Asset Service Providers is overseen by multiple agencies. Exchanges may need to obtain a license from the Financial Crimes Enforcement Network (FinCEN), while also meeting the requirements of the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). This decentralized regulatory model can provide more comprehensive oversight, but may also increase compliance costs.

The European Union (EU) has adopted a more centralized regulatory model. Europe has incorporated the regulation of virtual money service providers into its anti-money laundering and counter-terrorism financing (AML/CFT) regulations, which all member states are required to comply with. The advantage of this model is that it provides a unified regulatory framework, simplifying the compliance process.

Hong Kong's regulatory model has its uniqueness. In 2020, the Hong Kong Financial Services and the Treasury Bureau (FSTB) proposed new regulatory rules for virtual asset trading, requiring all virtual asset trading platforms to obtain a license 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, regardless of whether they are retail or institutional clients.

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

Hong Kong's regulatory model has certain reference significance. First, it provides a comprehensive regulatory framework that includes all types of Virtual Money transactions. This helps prevent regulatory loopholes and eliminate potential investment risks. Secondly, by connecting the regulation of Virtual Money trading platforms with the regulation of traditional financial markets, it will ensure market fairness and transparency, while also providing a compliant path for the further development of Virtual Money. This offers valuable insights for other regions on how to balance innovation and regulation.

Finally, Hong Kong, as an international financial center and innovation technology hub, will usher in a broader development prospects after the compliance of virtual assets. With the rapid development of the global digital economy, virtual assets will become an important component of financial transactions and investment. The Hong Kong government is actively promoting the compliance of virtual assets and has established a corresponding regulatory framework and supervision plan, which will surely lead the way in global financial innovation.