Understanding Web3 in Hong Kong (Part 1): What Sets a Licensed Exchange Apart

The Balance Between Regulation and Innovation

The struggle between regulation and innovation has always been the main theme of emerging technological waves. With the new administration taking office, 2022 was undoubtedly a turning point for Hong Kong policy landscape, positioning the city to compete with Singapore, London, and New York for the status of a global digital finance hub. Notably, on 1 June 2023, the Securities and Futures Commission (SFC) has issued guideline setting out clear and precise rules for the regulation of licensed digital asset exchanges​.

OSL has launched the "Understanding Web3 in Hong Kong" series, focusing on the differences between regulated and unregulated exchanges. The series delves into the struggle between regulation and innovation, the application process and experiences of licensed platforms, and the development of regulated exchanges' specific businesses. Additionally, we will conduct in-depth research and analysis on how licensed exchanges innovate, and achieve a balance under strict regulation.

What Qualifies a Platform as a "Regulated Exchange"?

From ICOs and STOs in 2017 to digital asset trading, or from tokenised bonds, digital Hong Kong dollars, CBDCs to stablecoins, Hong Kong has gradually shaped a regulatory framework centred on licensing, further solidifying the stability of the local financial market. According to SFC, digital asset trading platforms must apply for three types of licences for compliant operations​:

• A licence for providing virtual asset services under the Anti-Money Laundering Ordinance (AMLO) (operating a virtual asset exchange).

• Type 1 (dealing in securities) and Type 7 (providing automated trading services) regulated activity licences under the Securities and Futures Ordinance (SFO).

*Source: SFC

Currently, there are only two licensed digital asset trading platforms, including OSL. There are other applicants for the VATP licence, but none of them has been formally licensed as of this writing. 

OSL’s exchange has clear advantages, including:

• High security: User assets are protected, providing safer and more reliable services than non-compliant exchanges.

• Potential extension to other digital asset innovation: For example on ETFs, SFC requires that virtual asset ETFs must use an SFC-licensed exchange as the custodian and trading platform. Licensed exchanges will then become a major force in the future virtual asset market.

The process of applying for a licence is complex and strict. It involves setting up a legal compliance team, investing in security and technology resources, implementing fund segregation and risk management mechanisms, establishing auditing and reporting systems, and conducting compliance training and education, and many more.

Application Fees and Operating Costs

The SFC's website lists licence application fees ranging from thousands of Hong Kong dollars, however, it could go up to millions of US dollars to meet compliance capital operations. 

Licensed exchanges must adhere to AML laws, such as KYC/AML/CFT policies, and review transactions to ensure investors' assets are not used illicitly. Coin listings must pass due diligence on project teams, liquidity, technical security, and regulatory status, ensuring no scam projects are featured. 

At OSL, a significant part of operating costs is dedicated to investor protection, including private key management, cold wallet maintenance, and purchasing third-party insurance for custodial assets, providing multiple layers of protection and add-on value for clients.

Accounting and Auditing

Licensed digital asset exchanges and their subsidiaries must regularly perform financial audits for the SFC. They should maintain highly liquid assets in Hong Kong, equal to at least 12 months of operating expenses. The SFC can inspect and investigate business premises as needed, and stricter regulations take precedence if discrepancies arise.

OSL Group (863.HK), the parent company of the OSL exchange, is listed on the main board of the Hong Kong Stock Exchange. In addition to meeting the SFC's requirements, OSL is audited by a Big Four accounting firm, allowing investors to understand the company's actual situation and make informed decisions.

Summary

On 1 June 2024, the transitional period for Hong Kong's VATP licensing regime ended. Hong Kong now leads globally in digital asset regulation, prompting some platforms to exit the market earlier this year. Balancing innovation and regulation is crucial. 

The future of digital asset exchanges is evolving, from STO and OTC businesses to the newly launched virtual asset ETF business. OSL, as a leading regulated and compliant platform, plays a key role. Patience is needed as industry leaders develop, with product innovation under regulatory compliance becoming increasingly significant in global competition. Though this trend is not obvious, its impact will grow over time.