In a keynote speech at the Hong Kong Fintech Week on 1 November 2018, the Securities and Futures Commission (SFC) again asserted its cautious regulatory approach by announcing that it would step up its game in protecting investors of virtual assets.
A virtual asset is a digital representation of value and include digital tokens (such as digital currencies, utility tokens or security or asset-backed tokens) and other virtual commodities, crypto assets and assets of essentially the same nature. Where the virtual assets fall outside the definitions of “securities” and “futures contracts” under the Securities and Futures Ordinance (the “Non-SF Virtual Assets”), the activities relating to them may fall outside the ambit of the regulator’s jurisdiction, leaving investors unprotected.
In view of the growing investor interest in virtual assets, the SFC has decided to escalate its regulatory effort within the existing regulatory regime. The regulatory approach, requirements and their implementation are discussed in the following Statement and Circular published by the SFC on 1 November 2018:
- The Statement on regulatory framework for virtual asset portfolio managers, fund distributors and trading platform operators (the “Statement”), which identifies the material risks associated with investing in virtual assets; delineates the regulatory standards expected of virtual asset portfolio managers and virtual asset fund distributors; and outlines a conceptual framework for licensing and regulating virtual asset trading platforms (e.g. cryptocurrency exchanges)
- The Circular to intermediaries - Distribution of virtual asset funds (the “Circular”), which stipulates additional requirements that intermediaries are required to observe when distributing virtual asset funds not authorised by the SFC.
The SFC has been educating the public on the potential risks associated with dealing in cryptocurrencies and investing in initial coin offerings (ICO). The Statement reiterates the risks that are “inherent in the nature and characteristics of the virtual assets themselves” or “stem from the operation of platforms or portfolio managers”. In particular, the SFC focuses the regulatory attention on the following aspects:
- Valuation, volatility and liquidity of virtual assets
- Accounting and auditing, including existence and ownership of virtual assets and valuation standards
- Cybersecurity and safe custody of assets, including hacking risks and lack of qualified custodian solutions
- Market integrity, unregulated markets and opaque trading rules
- Risk of money laundering and terrorist financing, heightened by conversion between fiat currencies and virtual assets
- Conflicts of interest, arising from multiple roles of operators
- Fraud and use of virtual assets to defraud investors
In addressing the regulatory concerns, the SFC will adopt a new way forward to bring a significant portion of virtual asset portfolio management activities into its regulatory net. The SFC will apply the following overarching principles and standards:
- Scope – the regulatory net catches (i) persons that manage funds which solely invest in virtual assets that do not constitute “securities” or “futures contracts” and distribute such funds in Hong Kong, (ii) persons licensed or to be licensed for Type 9 regulated activity (asset management) for managing portfolios in “securities” or “futures contracts” or both who also manage portfolios which invest solely or partially in Non-SF Virtual Assets (subject to a de minimis test), and (iii) persons that distribute funds that invest (solely or partially) in virtual assets in Hong Kong.
- Standards – as regards the virtual asset portfolio managers in (i) and (ii) above, to impose, via licensing conditions, a set of principle-based standard terms and conditions that capture the existing requirements with adaptation to better address the unique risks associated with virtual assets; and the virtual asset fund distributors in (iii) above will be subject to further guidance on the expected standards and practices specified in the Circular.
- Licensing process – licence applicants and licensed corporations are required to inform the SFC existing or planned activities involving management of portfolios that invest in virtual assets, to enable the SFC to assess and decide next steps, including imposing the standard terms and conditions, unwinding existing arrangements, and taking regulatory action.
Standard terms and conditions
The SFC will impose the terms and conditions on licensed corporations subject to a de minimis test, and catches a licensed corporation which manage or plan to manage portfolios with (i) a stated investment objective to invest in virtual assets; or (ii) an intention to invest 10 percent or more of the gross asset value (GAV) of the portfolio in virtual assets.
The terms and conditions focus on two aspects: (i) the licensed corporation’s management of portfolios that invest in virtual assets (subject to the 10 percent de minimis threshold) and (ii) the financial resources if the licensed corporation intends to hold Non-SF Virtual Assets on behalf of portfolios under its management. Principal features of the standard terms and conditions include:
- Limiting investors to professional investors and risk disclosures requirement
- Assessing and selecting most appropriate custodians and custodial arrangements, whether self-custody or use of third party custodian or exchange, whether to hold through “hot wallets”, “cold wallets” or “deep cold wallets”
- Carefully selecting valuation principles, methodologies, models and policies, and disclosure to investors
- Setting caps on investment by reference to each product, market, counterparty and virtual asset exchange as appropriate and periodic stress testing
- Appointing capable independent auditor to audit financial statements of the funds
- Maintenance of required liquid capital of at least HK$3 million (or its variable required liquid capital), if the licensed corporation holds Non-SF Virtual Assets
- Complying with future guidance provided by the SFC from time to time
The Statement expressly clarifies that the terms and conditions do not apply to: (i) licensed corporations which only manage funds of funds (i.e. portfolios that invest in virtual asset funds); or (ii) licensed corporations whose mandate is to mainly invest in securities, futures contracts (or both) but the investment in virtual assets exceeds the 10 percent de minimis threshold due to increase in prices of the virtual assets held in the portfolios managed by them (BUT the licensed corporation should take all reasonable steps to reduce the value of investment in the virtual assets in a timely manner to below the threshold, AND the licensed corporation should notify the SFC if it anticipates the situation where the value exceeds the threshold to persist to enable the SFC to impose the terms and conditions, and failure to notify the SFC may result in disciplinary action).
Conceptual regulatory framework for virtual asset trading platform operators
A virtual asset trading platform operator may opt-in and be placed in the SFC regulatory sandbox if it is interested in being licensed by the SFC and the SFC considers that it can demonstrate its commitment to adhering to the high standards imposed by the SFC. The sandbox and opt-in approach are designed to set the platform operators that are committed to adhering to the SFC’s high standards apart from those that are unwilling or unable to meet the conduct standards set by the SFC.
This exploratory stage is crucial for the SFC to understand its operation and business model in order to determine whether it is suitable for regulation. If the SFC grants a licence to a qualified platform operator, it will impose certain licensing conditions and the platform operator will proceed to the next stage of the sandbox during which the SFC will continue close supervision. The SFC may also revise or refine its regulatory and supervisory approach. After a minimum 12-month period, the platform operator may apply to the SFC to remove or vary the licensing conditions and exit the sandbox.
The licensing conditions on a platform operator will include core principles and other specific terms and conditions. There are five core principles:
- All virtual asset trading activities under a single legal entity
- Compliance with applicable requirements by entire virtual asset trading business
- Services to be offered to professional investors only
- Limitations on trading of ICO tokens within the initial 12 months
- Transactions be pre-funded, and no leverage for virtual asset-related futures contracts or other derivative products
Other specific terms and conditions address financial soundness, insurance requirements, knowledge assessment of investors, anti-money laundering and counter-financing of terrorism measures, risk disclosure and other disclosure requirements, due diligence on virtual assets to be admitted for trading, publication of trading rules, measures to prevent market manipulative and abusive activities, governance of employee dealings, proprietary trading, segregation and custody of client money and virtual assets, and ongoing reporting obligations.
The SFC sets out further guidance on the expected standards and practices of intermediaries when distributing virtual asset funds. The Circular applies to entities licensed or registered for Type 1 regulated activity (dealing in securities) and/or Type 9 regulated activity (asset management) which distribute non-SFC authorised funds which (i) have a stated investment objective to invest in virtual assets; or (ii) intend to invest or have invested more than 10 percent of the gross asset value (GAV) in virtual assets directly or indirectly (e.g. funds of funds and funds which invest in derivatives with virtual assets as underlying). The new requirements fall into three categories:
- Selling restrictions and concentration assessments
- Due diligence on virtual asset funds not authorised by the SFC, including on the operations, IT system and risk management of the fund manager; and features, operation and counterparties of the fund
- Information for client, including the provision of specific information and warning statements to clients
There has been relatively limited regulatory and enforcement interventions from the SFC, mainly involving ICOs. As the SFC steps up its regulatory effort and clarifies its regulatory policy and standards relating to virtual assets, the market players should review their existing activities and business plans and take suitable steps in light of the applicable regulatory requirements.