Hong Kong Cryptocurrency Regulation Takes Effect on June 1: Exchanges Have Heavy Responsibility to Protect Retail Investors, Temporary Ban on Trading Stablecoins

The Hong Kong Securities and Futures Commission (SFC) released a regulatory framework for public consultation this afternoon on 5/23, which will be officially implemented on 6/1. Below is a summary of the content.

Earlier report: The Hong Kong Securities and Futures Commission (SFC) is set to announce retail investor compliance trading conditions today.

Can retail consumers use licensed exchanges?

Yes, provided they adhere to a series of appropriate investor protection measures covering establishing business relationships with customers, governance, disclosure, and token due diligence and inclusion.

Do licensed exchanges need to confirm investor knowledge?

Yes, licensed exchanges must ensure that both professional and retail investors have a full understanding of virtual assets to receive investor protection.

Should exchanges specify risk exposure limits?

No, the Securities and Futures Commission (SFC) of Hong Kong believes that setting guidelines in this area may not be appropriate. The platform operators (rather than the SFC) are best positioned to impose limits based on information obtained during the "Know Your Customer" (KYC) process.

Do exchanges have disclosure responsibilities for virtual assets?

Yes, the SFC states that although obtaining and verifying information from issuers may be challenging, licensed exchanges should act with appropriate skill, care, and diligence. They should take all reasonable steps to obtain information about each virtual asset as the basis for their token inclusion decisions.

The SFC further states: Even if a token is included by another licensed exchange, it does not exempt other exchanges from conducting due diligence.

Should exchanges verify smart contracts?

It is recommended. The SFC only expects licensed exchanges to engage independent assessment experts or rely on audits conducted by another party (such as the issuer) in reasonable circumstances to reduce investor risks.

Which cryptocurrencies can exchanges list?

Recommended guidelines include:

• Tokens tradable by retail investors should be less susceptible to market manipulation
• Tokens must belong to qualified large virtual assets, i.e., those included in at least two accepted indices by two independent index providers. Regarding recommended indices
• High market value does not equate to high liquidity; exchanges must ensure tokens have high liquidity

Can exchanges temporarily not offer stablecoin trading?

Yes, the SFC states that stablecoins unable to maintain their pegging function or return investor funds upon redemption should not be considered stable. This risk leads the relevant financial authorities to plan implementation between 2023 and 2024, and until formal regulations are in place, stablecoins should not be included for retail trading. "The regulatory arrangements for stablecoins are expected to be implemented in 2023/24. Until stablecoins are regulated in Hong Kong, we believe stablecoins should not be included for retail trading."

Can exchanges offer derivative trading?

Not yet decided. The SFC states: "We appreciate the detailed and rich feedback received on this issue. As explained in our consultation document, the SFC is aware of the importance of virtual asset derivatives to institutional investors. We will consider the substantial feedback received and conduct an independent review at the appropriate time."

What reserve insurance mechanisms should exchanges have?

The SFC believes:

• Customer virtual assets held online and through other storage methods should be fully covered by compensation arrangements of licensed virtual asset trading platforms
• Offline cold storage provides a higher level of protection. Exchanges basing 98% of customer virtual assets on offline storage, the SFC is prepared to lower the protection threshold for customer virtual assets held in offline storage to 50%, as even traditional financial institutions do not have full compensation requirements
• Virtual assets should be backed by the same reserve virtual assets to mitigate market fluctuation risks
• Insurance funds must be kept separate from the exchange and managed in trust; the virtual asset portion also needs to be segregated and managed in compliance with the Virtual Asset Trading Platform Guidelines

Prohibition of proprietary trading by exchanges

The SFC prohibits exchanges from acting as market makers for liquidity or holding positions in virtual assets themselves but allows third-party market makers to provide liquidity.

"Regarding proprietary trading, we agree that liquidity on the trading platform is crucial for customers. Therefore, the SFC allows market-making activities by third-party market makers. However, the current prohibition on proprietary trading is comprehensive and effectively prohibits licensed virtual asset trading platforms or their group companies from holding any virtual asset positions."

Is algorithmic trading allowed?

The SFC states that licensed exchanges can provide algorithmic trading systems.

Prohibition of lending and wealth management services

Common services such as income, deposits, and lending, even for licensed exchanges, are prohibited. The reason being: "The primary business of licensed virtual asset trading platforms is to act as an intermediary and provide a counterparty route for customer transactions. Any other activities may lead to potential conflicts of interest and require additional safeguards; therefore, licensed virtual asset trading platforms are currently not allowed to engage in such activities."