Hong Kong regulators recently initiated criminal action against virtual asset trading platform JPEX and individuals associated with the platform. The case has become the first opportunity for local authorities to clarify how to enforce Hong Kong’s new cryptocurrency regulations, particularly regarding licensing requirements.
Virtual asset exchanges operating in Hong Kong or targeting Hong Kong investors would be well advised to monitor these developments closely.
Hong Kong introduced its new regulatory licensing regime for virtual asset trading platforms on June 1, 2023. The new regulations allow these platforms, particularly centralized platforms that use an automated trading engine to match orders from clients and provide custody services, to offer trading services to institutional and retail investors, with the following licensing requirements:
- For securities trading: must obtain a license under the Securities and Futures Ordinance (SFO) and the Anti-Money Laundering and Counter-Terrorism Financing Ordinance (AMLO) .
- For non-securities transactions: must obtain a license under AMLO.
However, Hong Kong’s Securities and Futures Commission (SFC) advises that virtual asset trading platforms – whether or not they offer securities trading – should apply for licensing under both regimes to ensure compliance with new regulations. This is particularly important given the evolving functionality of most virtual assets – where an insecure token may later evolve and thus be reclassified as a security token. Failure to obtain a permit is a criminal offense.
Licensed platforms are subject to certain regulatory requirements, such as secure custody of customer assets, internal controls, know your customer (KYC) and other customer onboarding requirements, asset admission criteria virtual trading platforms, token due diligence and disclosures, and insurance and indemnification arrangements.
The JPEX fraud case
In September 2023, the SFC accused JPEX of engaging in suspicious practices and making misleading statements about its licensing status.
According to the SFC, JPEX actively promoted its services and products to the public through social media influencers and over-the-counter cryptocurrency exchange shops (OTC shops), while operating without license for trading virtual assets. In particular, JPEX claimed to have obtained licenses from certain foreign regulators, and some influencers and OTC stores suggested that JPEX had submitted a license application to the SFC. However, these statements would be false because, according to the SFC, JPEX had not in fact obtained any licenses anywhere and had not filed any license applications with the SFC. Additionally, the SFC and Hong Kong Police received complaints from retail investors who were unable to withdraw their virtual assets from their JPEX accounts and, in some cases, had their account balances reduced.
As a result of this alleged misconduct, several OTC stores were closed; at least 36 people were arrested, including some JPEX officers and directors, JPEX employees, and social media influencers who helped JPEX promote its products; and more than 2,500 customers were affected.
According to the SFC, JPEX had been on its radar since March 2022, when the SFC began investigating the platform’s false and misleading representations and unlicensed activities. JPEX would not cooperate.
Following the JPEX incident, the SFC began publishing the names of virtual asset trading platforms with valid licenses and those that have applied for a license from the SFC.
Even with the new licensing regulations, Hong Kong regulators face difficulties asserting jurisdiction over foreign cryptocurrency exchanges. Under the current regulatory regime, all virtual asset trading platforms that “carry on business” in Hong Kong or “actively market” products or services to Hong Kong investors must be licensed under the SFO or AMLO, or both. However, even if a foreign virtual asset trading platform is subject to the jurisdiction of the SFC, it may be difficult for Hong Kong regulators to institute enforcement action against the exchange if it does not have offices, employees or assets in Hong Kong.
For example, in September 2017, ETRADE Securities (Hong Kong) Limited (ETrade HK), an electronic platform offering stock and futures trading services, was convicted for actively marketing to the Hong Kong public brokerage services provided by its foreign parent company E. *TRADE Securities LLC (ETrade US). While ETrade HK was authorized under the SFO, ETrade US was not. ETrade HK was found guilty of aiding and abetting ETrade US in violating the SFC’s licensing requirements and was fined HK$20,000 (approximately US$2,500). However, the SFC does not appear to have taken enforcement action against ETrade US.
Another challenge facing Hong Kong regulators is the regulation of decentralized finance (DeFi) activities. In 2019, when the SFC first introduced an initial regulatory framework for virtual asset trading platforms, it explicitly stated that it “not accept license applications from platforms that only provide a direct peer-to-peer marketplace for transactions from investors who generally retain control of their own assets.
However, this position has changed over time and in April 2023, the SFC noted in a public speech that, as long as the activities of a decentralized virtual asset trading platform fall within the scope of the SFO, they would be subject to the same regulatory requirements. applicable to centralized platforms according to the principle “same business, same risks, same rules”.
One of the main challenges in regulating decentralized platforms is identifying the appropriate target subject to regulation. Unlike centralized trading platforms, which act as an intermediary between buyers and sellers, where the SFC can easily identify the regulatory body that is accountable, “decentralized” protocols are structured in such a way that regulators can have difficult to identify a central intermediary. subject to regulation. Instead, users transact through the protocol themselves, with their interactions governed by smart contracts, which are self-executing pieces of code and protocols that automate transactions on a decentralized ledger. Additionally, some developers issue governance tokens to users of DeFi products, allowing ordinary token holders to vote on product changes or new features, potentially making it harder for regulators to hold anyone accountable.
Acknowledging that “some DeFi protocols may be decentralized in name only” but “in reality, a small group of developers, operators or their related parties may have de facto control,” the SFC noted that in determining the intermediary or entity responsible for any misconduct, it will “evaluate each DeFi service or activity on a case-by-case basis after understanding the internal workings and provisions of a DeFi protocol”.
Finally, since decentralized platforms generally do not provide custody or control over investors’ assets, it is difficult to impose enhanced KYC procedures on these platforms to identify suspicious transactions or wallets.
Other potential challenges
Derivatives. Trading in derivatives on virtual asset platforms is currently prohibited, although the SFC recognized the importance of digital asset derivatives for institutional investors and noted that it would review this topic “in due course”.
Stable coins. Similarly, trading in stablecoins (such as USDT) is prohibited in Hong Kong, mainly because regulators are still developing and debating a regulatory strategy. The Hong Kong Monetary Authority, which regulates stablecoins in Hong Kong, is expected to introduce a regulatory regime for stablecoins as early as 2024.
Following the JPEX fraud case, Hong Kong authorities took several regulatory actions. In early October 2023, the Hong Kong Police established a special task force to target virtual asset crimes in collaboration with the SFC. The SFC also recently released its “watch list” of “suspicious platforms”, which “came to the attention of the SFC because they are not licensed in Hong Kong and are suspected of targeting or having targeted Hong Kong investors.
Foreign virtual asset exchanges that may have touchpoints in Hong Kong, including platforms whose marketing materials are accessible to Hong Kong investors, should closely monitor these regulatory developments.
This memorandum is provided by Skadden, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice. This memorandum is considered advertising under applicable national laws.