Future of Web3: Triple Impact of VSAP on Exchanges, Financial Markets, and TradFi

Web3's Future: VSAP's Triple Impact on Exchanges, Financial Markets, and TradFi

>>Introduction

With the rapid development of the virtual currency market, more and more people are investing in and trading virtual currencies. However, due to the special nature and high risk of the virtual currency market, regulatory authorities are increasingly demanding stricter regulation of centralized virtual currency exchanges. In this context, the Virtual Asset Service Provider License (VASP) system for centralized virtual currency exchanges in Hong Kong has emerged.

The VASP license is a new licensing system established by the Hong Kong Securities and Futures Commission (SFC) starting from June 1, 2023, for regulating and managing institutions that provide virtual asset trading and related services, namely centralized virtual currency exchanges. The introduction of the VASP license aims to strengthen the regulation of virtual asset service providers, ensure their compliance, and protect the interests of investors.

The VASP license requires virtual asset service providers to comply with a series of compliance requirements, including KYC (Know Your Customer) and AML (Anti-Money Laundering) regulations, capital adequacy requirements, security measures, transparency, and reporting systems. By obtaining a VASP license, virtual asset service providers can demonstrate their compliance with regulatory requirements, enhance market confidence, attract more investors to trade, and promote the development of the virtual asset market.

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（Image source: Beosin Blockchain Security Audit）

>>Main provisions of the Hong Kong VASP license system

The application process includes:

1. Recruit two suitable Responsible Officers (RO) to supervise the operation of VASP and ensure compliance with AML/CTF and other regulatory requirements.

2. Prepare relevant files (shareholder information/business plan/company structure)

3. Complete the WINGS application form

4. Determine application details/submit application

5. Rent a specific venue for decoration,

6. SFC approval/respond to SFC’s relevant questions

7. Arrange to open a bank account

8. Receive written notification regarding approval matters

9. Hire subsequent compliance and audit personnel

In the article “Hong Kong Web3: 1 Year, 1 Card, 1 New Industry,” we can see that the role of RO is crucial in the licensing application. RO is a supervisor role, and the licensed company pays the salary but is responsible to the Hong Kong Securities and Futures Commission. RO needs to pass the assessment and registration of the Securities and Futures Commission (the test score is valid for three years) and can work in the relevant field for life. The RO qualification is related to personal qualifications and is independent of the licensed company. Therefore, RO can freely change jobs between licensed companies. Under this system, if the RO violates the regulations of the Securities and Futures Commission, the qualification to work in the relevant field for life may be lost. Therefore, in order to maintain this professional qualification, RO will supervise the daily operations of licensed companies from the perspective of the regulatory requirements of the Securities and Futures Commission. They are the front-line managers of licensed companies in Hong Kong Securities and Futures Commission.

Regulatory requirements and compliance measures:

• It is recommended that the trading platform use cold wallets to store 98% of customer virtual assets, and private keys and mnemonic words should be stored in Hong Kong to reduce the risk caused by hacker intrusion or attack of the platform.
• The platform operator shall not participate in self-operated transactions (except for offline back-to-back transactions) or self-operated banker activities.
• Refer to the FTX case, the platform shall not deposit, transfer, lend, pledge, re-pledge or buy and sell customer virtual assets in any other way.
• Customer assets can only be properly kept by wholly-owned subsidiaries holding trust or company service provider (TCSP) licenses.
• The platform needs to purchase third-party insurance or allocate funds as reserves in a trust manner for its or its affiliated companies to provide protection for users.

The relevant laws and regulations are as follows:

• The “Anti-Money Laundering and Counter-Terrorist Financing Ordinance 2022” (“2022 Revised Ordinance”)
• The “Consultation Paper on Proposed Regulatory Requirements for Virtual Asset Trading Platform Operators to Obtain a License from the Securities and Futures Commission” (VASP Consultation Paper)
• The “Guideline on Supervision of Virtual Asset Trading Platform Operators” (VASP Guidelines)
• The “Anti-Money Laundering Ordinance”
• The “Securities and Futures Ordinance”

>>Impact on Centralized Virtual Currency Exchanges

Compliant exchanges will benefit when Hong Kong virtual currency exchanges obtain their VASP license. First, compliance and official recognition will enhance the legality and credibility of the exchange, attracting more investors to choose to trade on the platform. As Kevin, the head of Gate Hong Kong, said, there are over 7.4 million local users in Hong Kong. Building a bridge for capital circulation between the world’s large-scale compliance capital and cryptocurrency exchanges through Hong Kong’s international financial center status is the significance of Gate’s active application for a license.

Obtaining a license will enhance the exchange’s market reputation and industry recognition, further attracting more attention from users and institutional investors. In addition, compliant exchanges can establish partnerships with banks, payment institutions, and other financial institutions to provide more trading pairs and financial tools, expanding user choice.

In terms of safety, compliant exchanges need to comply with certain security standards and measures. Under multiple protection measures, users’ asset and data security will obtain a more secure and reliable trading environment. At the same time, compliance supervision can reduce the risks of illegal activities such as market manipulation, fraud, and money laundering, and maintain market order and stability.

The risks and challenges of non-compliant exchanges. Exchanges that operate without the approval of regulatory agencies may violate local financial laws and regulations and face the risk of fines, suspensions, or other legal risks. In the absence of regulation, user assets can only rely on the exchange’s own risk control system, so the lack of compliance may lead to a decrease in investors’ trust in the exchange, affecting trading volume. It may cause the loss of users under market competition pressure.

>>Impact on the market

Market makers are the most sensitive group of professionals to trading. After interviewing several Hong Kong local market makers, I chose to look at this impact from the perspective of market makers. Hong Kong’s cryptocurrency market makers currently hold a wait-and-see but positive attitude towards the new VASP licensing system because compliant operations help to improve the trust and transparency of the entire cryptocurrency market. Exchanges holding licenses comply with stricter regulatory requirements, which is conducive to reducing trading risks and protecting the interests of retail investors and institutional investors.

However, this is not absolute. Market makers also consider other factors when choosing exchanges, such as trading volume, transaction fees, technical and operational capabilities of the exchange, etc. Higher liquidity guarantees faster and more stable trading opportunities. Transaction fees determine the associated transaction costs, and a reasonable fee structure will help market makers’ profit margins. If the 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

After obtaining a license for compliant operations, cryptocurrency exchanges have a multifaceted impact on traditional finance. Compliant cryptocurrency exchanges will introduce a large number of new financial products and services, enhance the competitiveness of the entire Hong Kong financial market, and challenge 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 is more attractive and may attract some “hot money” from traditional financial markets. This will affect the flow of funds in the traditional financial market.

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

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

Overall, compliant operations of cryptocurrency exchanges can not only have a far-reaching impact on traditional finance, but also promote further integration and development of fintech and traditional finance. The future financial market may become more diverse, open and flexible as a result.

>> Comparison and Enlightenment of International Supervision

The regulatory models of virtual asset service providers (VASPs) vary significantly in different regions. The regulatory model in each place usually depends on its attitude towards virtual assets, legal system and the characteristics of its financial market. In many regions, such as the United States, the regulation of virtual asset service providers is handled by multiple agencies. For example, an exchange may need to obtain a license from the Financial Crimes Enforcement Network (FinCEN) and also comply with the requirements of the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). This decentralized regulatory model can provide more comprehensive supervision, but may increase compliance costs.

Europe, on the other hand, has adopted a more centralized regulatory approach. Europe has incorporated the regulation of virtual asset service providers into its anti-money laundering and counter-terrorism financing (AML/CFT) regulations, which all member states must 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 own uniqueness. In 2020, the Financial Services and Treasury Bureau (FSTB) of Hong Kong proposed new rules for regulating virtual asset trading, requiring all virtual asset trading platforms to obtain a license from the Securities and Futures Commission (SFC) of Hong Kong to operate. Unlike many regions that only regulate services provided to retail customers, Hong Kong’s regulatory scope includes all cryptocurrency transactions, whether they are retail or institutional customers.

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

Hong Kong’s regulatory model has certain reference significance. First, it provides a comprehensive regulatory framework, including all types of virtual asset trading. This helps prevent regulatory loopholes and eliminates potential investment risks. Secondly, by docking the regulation of virtual asset trading platforms with the regulation of the traditional financial market, market fairness and transparency will be ensured, and a compliant path for the further development of virtual assets will also be provided. This provides valuable reference for other regions on how to balance innovation and regulation.

Finally, as an international financial center and innovation and technology hub, Hong Kong will have broader development prospects after virtual asset compliance. With the rapid development of the global digital economy, virtual assets will become an important part of financial transactions and investments. The Hong Kong government actively promotes virtual asset compliance and has established corresponding regulatory frameworks and regulatory schemes, which will surely lead the way in global financial innovation.

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