Hong Kong’s Securities and Futures Commission (SFC) recently announced that it will adopt new measures to protect the interests of investors in virtual asset portfolios or funds, and explore the potential regulation of virtual asset trading platforms.
In the Statement on regulatory framework for virtual asset portfolio managers, fund distributors and trading platform operators (Statement) issued by the SFC on 1 November 2018, the SFC lays down the regulatory standards for firms managing virtual asset portfolios, distributing virtual asset funds, or both; and the conceptual framework for the possible regulation of virtual asset trading platform operators. The details on the regulatory standards for licensed corporations managing virtual asset portfolios are set out in Appendix 1 to the Statement and the details on the conceptual framework for potential regulation of virtual asset trading platform operators are set out in Appendix 2 to the Statement.
At the same time, the SFC also issued the Circular to intermediaries on distribution of virtual asset funds (Circular), which sets out the expected regulatory standards and practices in the distribution of virtual asset funds by licensed or registered intermediaries.
The rapid growth in the virtual assets market has led to greater scrutiny by securities market regulators worldwide, with a particular focus on the risks associated with investing in virtual assets. Virtual assets include digital tokens (such as digital currencies, utility tokens or security or asset-backed tokens) and any other virtual commodities, crypto assets and other assets of essentially the same nature.
A fundamental issue for regulators is determining whether or not they actually have legal jurisdiction over crypto firms and activities. The primary legislation in Hong Kong that governs the securities industry is the Securities and Futures Ordinance (SFO). The scope of the firms and activities over which the SFC has legal jurisdiction is set out in the SFO. Firms which engage in the conduct of “regulated activities” are subject to the licensing or registration regime of the SFC; and the SFC has supervisory powers over intermediaries which are licensed or registered with the SFC in the conduct of “regulated activities” under the SFO. The scope of “regulated activities” is defined in the SFO, and largely depends on whether the subject matter falls within the legal definitions of “securities” or “futures products” (or for completeness, “leveraged foreign exchange trading”) under the SFO.
The SFC noted that a significant portion of virtual asset activities did not fall within the SFC’s regulatory ambit because such virtual assets fall outside the legal definitions of
securities” or “futures contracts” under the SFO. It is important to note that the Statement and the Circular do not seek to expand the statutory licensing regime or the legal definitions of “securities”, “futures contracts” or “regulated activities” under the SFO. Rather, they seek to enhance the compliance obligations vis-à-vis virtual assets within the current regulatory framework for existing and potential SFC licensed or registered intermediaries.
In summary, the following persons will be affected:
- Type 1 intermediaries which distribute virtual asset funds or Type 9 intermediaries which do so in reliance on the incidental exemption;
- Type 9 intermediaries which in addition to managing portfolios investing in “securities” and/or “futures contracts”, also manage funds or portfolios which invest in virtual assets (that may not be “securities” or “futures contracts”);
- Trading platform operators which intend to be licensed with the SFC, where at least one or more of the virtual assets to be traded on the platform are “securities”.
Firms which do not conduct any “regulated activities” under the SFO, e.g., fund managers which only manage portfolios which invest solely in virtual assets which do not amount to “securities” or “futures contracts”, will not be affected and will continue to operate outside the legal jurisdiction of the SFO.
The SFC will impose licensing conditions on the following persons which manage or plan to manage portfolios with a stated investment objective to invest in virtual assets and an intention to invest 10% or more of the gross asset value (GAV) of the portfolio in virtual assets:
- SFC Type 9 licensed corporations which, in addition to managing portfolios which solely invest in “securities”, “futures contracts” or both, manage or plan to manage:
- portfolios that invest solely in virtual assets; or
- portfolios that invest partially in “securities”, “futures contracts” or both, and partially in virtual assets; and
- SFC Type 1 licensed corporations which manage or plan to manage funds which solely invest in virtual assets that do not constitute “securities” or “futures contracts” and distribute or plan to distribute such funds in Hong Kong.
The licensing conditions are developed as a set of principles-based standard terms and conditions, which are essentially the same as the existing legal and regulatory requirements that apply to licensed intermediaries, but modified to better address the risks associated with virtual assets. The detailed terms and conditions are set out in Appendix 1 to the Statement (Regulatory standards for licensed corporations managing virtual asset portfolios). In summary, they will require licensees to:
- only allow professional investors as defined in the SFO to invest in any portfolio with a stated investment objective to invest in virtual assets or an intention to invest 10% or more of the GAV of the portfolio in virtual assets (except where the fund is authorised by the SFC under section 104 of the SFO);
- clearly disclose all associated risks to potential investors and distributors;
- exercise due skill, care and diligence in selection, appointment and ongoing monitoring of custodians;
- exercise due care in selecting valuation principles, methodologies, models and policies, and disclose the same to investors;
- perform risk management by assessing the reliability and integrity of virtual asset exchanges; setting appropriate caps to limit the exposure to individual virtual asset exchanges; and setting appropriate limits for each product, market and counterparty (e.g., setting a cap on investments in illiquid virtual assets and newly launched ICO tokens);
- appoint an independent auditor to audit the funds; and
- (for those who hold virtual assets (which are not “securities” or “futures contracts”)) maintain a required liquid capital of not less than HK$3 million, or its variable required liquid capital, whichever is higher.
The SFC has set out its expected standards and practices in relation to the distribution of virtual asset funds in the Circular. The Circular is applicable to the following persons:
- SFC Type 1 licensed or registered intermediary which distributes virtual asset funds; and
- SFC Type 9 licensed or registered intermediary which distributes virtual asset funds under its management.
In addition to the general regulatory requirements such as suitability obligations, intermediaries should observe the following additional requirements if they distribute virtual asset funds which are not authorised by the SFC and which have a stated investment objective to invest in virtual assets or intend to invest or have invested more than 10% of their GAV in virtual assets:
- only target professional investors;
- ensure clients do not have over concentrated exposure to virtual asset funds which are not authorised by the SFC, having regard to their net worth;
- conduct proper due diligence on the virtual asset fund managers such as their background, relevant experience, regulatory status, internal controls and systems, IT system and risk management procedures;
- conduct proper due diligence on the virtual asset funds such as their targeted investors, underlying investments, custody arrangements, etc.;
- conduct proper due diligence on the counterparties of the virtual asset funds such as their legal and regulatory status, experience, etc.; and
- help clients make informed investment decisions by providing clear information and prominent warning statements in relation to the fund and the underlying virtual asset investments.
Trading Platform Operators
Separately, the SFC has also prepared a conceptual framework for the potential regulation of virtual asset trading platforms to explore whether it is appropriate to grant a licence to and regulate such platforms. In the initial exploratory stage, the SFC would not grant a licence to platform operators. Instead, the SFC envisages that interested operators who meet certain threshold requirements will be placed in the SFC Regulatory Sandbox, in which the SFC will be able to closely monitor the live operations of the platforms and assess their suitability to be regulated. If the SFC considers ultimately that such platforms are appropriate to be regulated, it would then consider granting a licence, subject to various licensing conditions.
The SFC expects that interested platform operators should operate an online trading platform in Hong Kong and offer trading of at least one or more virtual assets which fall under the definition of “securities” in the SFO. This would ensure that a virtual asset platform operator will fall within the SFC’s legal jurisdiction, as the relevant regulated activities would be Types 1 and 7 regulated activities. At this stage, the SFC will focus its efforts on regulation of platforms which provide trading, clearing and settlement services for virtual assets and have control over investors’ assets.
In the event the SFC does consider it appropriate to regulate a platform under its existing powers and is minded to grant a licence, the SFC will impose licensing conditions which will include core principles and other specific terms and conditions subject to modifications and discussions between the SFC and the platform operator in the sandbox. Broadly, such core principles include requiring platform operators to carry out all virtual asset trading business activities under a single legal entity, limiting services only to professional investors, restricting trading of ICO tokens to 12 months after the ICO completion, and ensuring that transactions are pre-funded and unleveraged. The other key proposed terms and conditions would cover areas like financial soundness, insurance, investor knowledge assessment, AML, investor disclosure, virtual assets eligible for trading, trading rules, prevention of market manipulation and abuse, employee dealing and proprietary trading, client asset segregation and on-going reporting. The detailed terms and conditions proposed to be imposed on a licensed platform operator are set out in Appendix 2 to the Statement (Conceptual framework for the potential regulation of virtual asset trading platform operators).
Actions to consider
Portfolio managers should consider the following actions:
- consider whether they are currently managing or planning to manage portfolios that invest in virtual assets (regardless of whether or not virtual assets amount to “securities” or “futures contracts”) or intend to hold virtual assets (which are not “securities” or “futures contracts”) on behalf of the portfolios under their management; and if so, make the relevant notifications to the SFC;
- consider whether they manage or plan to manage portfolios with a stated investment objective to invest in virtual assets or an intention to invest 10% or more of the GAV of the portfolio in virtual assets;
- assess whether they are willing to accept and are capable of meeting the additional licensing conditions that the SFC will impose in respect of the management of virtual asset funds;
- put in place adequate systems and controls to ensure compliance with the SFC’s requirements (such as selling restrictions, safeguarding of assets, portfolio valuation, risk management and liquid capital); and
- consider contingency plans (such as unwinding plans) in the event they do not agree with the SFC proposed licensing conditions or they are not capable of meeting such conditions.
Fund distributors should consider the following actions:
- consider whether they are currently distributing or planning to distribute virtual asset funds; and if so, make the relevant notifications to the SFC where appropriate;
- consider whether they distribute or plan to distribute non-SFC authorised funds with a stated investment objective to invest in virtual assets or an intention to invest more than 10% of the GAV in virtual assets;
- assess whether they are capable of meeting the additional regulatory standards set out in the Circular; and
- put in place adequate systems and controls to ensure compliance with the SFC’s requirements (such as selling restrictions, concentration assessments and due diligence processes).
Third Party Service Providers to Porfolio Managers and Fund Distributors
For service providers providing services to virtual asset portfolio managers and distributors, they should be prepared that more in-depth due diligence will be performed on them.
Trading Platform Operators
Platform operators may now be considered for licensing under the SFC regulatory framework in accordance with the SFC sandbox requirements. They should consider whether their proposed business model:
- covers trading, clearing and/or settlement services for virtual assets;
- can be operated by a single legal entity for licensing purposes;
- includes at least one virtual asset that falls within the definition of “securities” under the SFO; and
- can put in place the appropriate controls, mechanisms and arrangements to comply with the SFC’s proposed terms and conditions.
If a platform operator is interested in being licensed by the SFC and is prepared to be licensed after its assessment, we are happy to assist with approaching the SFC fintech contact point for discussion.