Will the “Ranking List” of HK Virtual Asset Trading Platform be an effective regulation?

Can HK Virtual Asset Trading Platform's "Ranking List" effectively regulate?


FTX went bankrupt at the end of 2022 after making a series of shady operations, including misappropriating customer funds for real estate purchases and high-risk investments, Alameda’s financial fraud, and related party transactions. Prior to FTX’s bankruptcy, there was the collapse of the stablecoin LUNA six months earlier. However, the cryptocurrency industry largely remains unregulated, but after this series of explosive events, the call to bring virtual currency trading under regulatory oversight is growing, considering the high risk of money laundering, fraud, and other crimes due to the secrecy and opacity of virtual currency transactions, which again places investors, especially retail traders, in a huge investment black hole.

Status quo

As the collapse of related cryptocurrency exchanges and a series of other industry collapses have caused investors to suffer huge losses, regulators around the world are stepping in to alleviate investor anxiety.

01 United States

US regulators are gradually strengthening their regulatory oversight of virtual assets. In March of this year, the US Commodity Futures Trading Commission (CFTC) accused Binance and its CEO Changpeng Zhao of unauthorized derivatives trading solicitation of customers, allowing trading without verifying the user’s identity, and failing to implement effective measures to prevent money laundering/terrorism financing. At the same time, Coinbase received a Wells notice from the US Securities and Exchange Commission (SEC) in March of this year, and the US SEC will take enforcement action against the exchange. Last Friday, the US Republican Party introduced a bill to try to delineate the regulatory functions of the CFTC and SEC regarding virtual currencies and their derivatives.

02 Singapore

Singapore has also gradually tightened regulation, emphasizing licensed operations, but does not recommend public participation in digital payment token services. Singapore regulates virtual assets by subdividing them into securities, digital payment, and utility tokens. Its legislation on digital currency regulation covers all aspects of ICOs, taxation, anti-money laundering/counter-terrorism financing, and other comprehensive regulations.

03 Hong Kong, China

On May 23rd, the Securities and Futures Commission (SFC) of Hong Kong released a summary of regulatory guidelines for virtual asset trading platform operators that are licensed by the SFC. Considering that many cryptocurrency investors suffered huge losses due to the lack of regulation of virtual platform trading platforms last year, the SFC clarified the qualifications, financial stability, and custody of customer assets for virtual asset platforms in the “Consultation Summary”.

For example, the SFC clearly requires candidates to have adequate financial conditions or solvency (2.1), possess the skills, knowledge, and professional ethics necessary to perform their duties (2.6), have the ability to perform activities in a competent, honest, and fair manner (2.7), and pass the SFC’s reputation, character, reliability, and financial stability tests for individuals/companies (2.8) in the “Guidelines for Virtual Asset Trading Platform Operators”.

If the platform operator cannot maintain sufficient assets, pay sufficient capital, or liquid funds, for example, if its liquid funds fall below 120% of its prescribed liquid funds, or its liquid funds fall below 50% of the most recent declaration stated in the SEC’s submission of the latest period (6.9), the platform must make a effective notification to the SFC according to the guidelines.

Considering incidents such as platform hacking, theft, fraud, or platform operator or its related entities’ default, regardless of whether it is caused by its acts, errors, inaction, or serious negligence, or potential losses caused thereby, the SFC requires the platform operator to make insurance/compensation arrangements, including third-party insurance, trust funds (held in the form of current deposits or fixed deposits maturing within six months), and virtual assets, to reduce market risks caused by the volatility of virtual assets:

Establishment of HKVAC

On May 31st, Hong Kong’s virtual asset rating agency HKVAC officially announced its establishment. The platform reflects the reliability of trading platforms and promotes the transparency of the virtual asset trading market through credit ratings of virtual platform exchanges and virtual products.

According to information on the current webpage (https://www.hkvac.io/index.html), HKVAC will launch two major sections: “Virtual Asset Index” and “Virtual Asset Exchange Rating.”

This article will mainly discuss the virtual asset exchange rating.

The HKVAC rating service aims to use objective data to reflect the credit status of the trading platform, help reduce information asymmetry between market participants, promote fair competition, and increase the transparency and accountability of the virtual asset trading market. The rating scheme will include “entity rating” for credit rating of virtual asset trading platforms and “continuous monitoring” that provides triggering factors, risks, and other warnings.

In addition to the integration of objective data, the SFC’s “Consultation Summary” attached to the “Guidelines for Virtual Asset Trading Platform Operators” lists the main elements of the company’s competency, including its business, corporate governance, internal monitoring, operational review, risk management and compliance, as well as the overall competency of its senior management and other employees (3.7):

For Example 1:

(a) Business

(i) Information on its proposed scope of business

(ii) Information on its target market customers, products and services

(iii) Information on its compensation model and calculation benchmark

(iv) Explanation of its operation mode, such as the degree of system automation and outsourcing arrangement

(v) Analysis of risks related to major business areas, such as market risk, credit risk, liquidity risk and operational risk

(c) Competency of employees

(i) Have policies and procedures in place to ensure that positions are held by employees with appropriate qualifications (including but not limited to all responsible persons, licensed representatives, core functional supervisors, and other supervisory personnel)

(ii) All front-line and logistics supervisors should have at least three years of relevant experience and appropriate qualifications

(iii) Have arrangements to ensure that new employees are briefed on operational and monitoring policies and procedures

(iv) Have arrangements to ensure that all employees are issued with the latest operational and monitoring manuals, and that employees can access the manuals at any time

(v) Establish arrangements to ensure that all employees are briefed on changes in operating and monitoring policies and procedures

(vi) Have policies and procedures in place to ensure the competence of its employees (including compliance with continuing education requirements)

(d) Internal monitoring measures

(i) Establish adequate internal monitoring systems in accordance with relevant codes and guidelines issued by the SFC

(ii) Establish arrangements to ensure that audit trails are appropriately preserved

(iii) Establish written procedures for the proper documentation of all operational and monitoring procedures

(iv) Have reporting systems in place to ensure that comprehensive information can be compiled for risk management and decision-making purposes

(v) Have appropriate monitoring procedures in place to ensure the integrity of data and that data inputted into the risk management systems is consistent with relevant transactional and financial information

(vi) Appoint a person with appropriate experience and qualifications to be the information technology manager to maintain the integrity of the firm’s operating systems

(f) Risk management

(i) Formulate policies and procedures in accordance with the proposed business scope, including:

(I) Establishing appropriate risk-taking limits for each major business area

(II) Establishing the methods for establishing risk-taking limits and notifying responsible persons

(III) Methods for measuring and monitoring risks

(IV) Procedures for handling exceptions to risk limits

(ii) The firm has sufficient capital to withstand expected risks and expenditures (typical practice is to budget the quick funds surplus calculated in accordance with Part VI (Financial Soundness)

(iii) Set a time for reviewing established policies (e.g. periodically or when business and market changes occur)

(iv) Appoint a person with appropriate qualifications and authority to be an independent risk manager or risk management core function, to oversee and monitor the risks assumed by the firm and the systems established

(v) Have procedures in place to ensure that the firm regularly uses appropriate measures to conduct stress testing

HKVAC’s genius lies in turning complex considerations into specific ratings based on objective data, which can more effectively inform investors of the operating conditions and potential risks of relevant platforms. However, the accuracy and limitations of the ‘objective data’ itself – some of which is obtained from exchanges – may affect the functionality of risk ratings.

As regulatory frameworks around the world tighten, Hong Kong has successively released a “consultation summary” to open up retail investment and established HKVAC to provide credit ratings for trading platforms and currencies, which is of great significance:

1. Enhance consumer protection. Consumers can more easily understand the operation of the platform through credit ratings, and spontaneously choose more reliable platforms for trading.

2. Promote platform competition. Virtual platform trading ratings can encourage platforms to improve service quality, strengthen security measures, improve user satisfaction, and promote competition between platforms, thereby promoting the development of the industry.

3. Enhance regulatory effectiveness. Objective data will help regulatory authorities better understand the operation of the platform, timely discover and solve problems, and improve regulatory effectiveness.

However, even if the regulatory framework and compensation mechanism of the SFC will effectively protect investors, the Sa family team especially reminds investors not to ignore the non-transparency of cryptocurrency trading itself, which may cause non-compliance, money laundering, fraud and other crimes, and the high risk brought by the strong volatility of the cryptocurrency market itself.