The New Regulatory Framework for Crypto Funds and Virtual Assets in Hong Kong
A virtual asset is a digital representation of value, which is also known as "cryptocurrency", "crypto-asset" or "digital token".
Under the existing regulatory framework in Hong Kong, markets for virtual assets are generally not subject to the government of the Securities and Futures Commission (SFC) in particular when the virtual assets involved fall outside the legal definition of "securities" or "futures contracts”.
Nonetheless, given the significant risks virtual assets may pose to investors, the SFC recently have decided to formulate new measures which aim to protect those who invest in virtual assets portfolios or funds, by way of imposing licensing conditions on intermediaries which manage or intend to manage funds investing in virtual assets irrespective of whether the virtual assets meet the definition of "securities" or "futures contracts.
Under the existing regulations, where virtual assets fall under the definition of "securities" or "futures contracts", these products and related activities may fall within the SFC's scrutiny. In particular, a Circular to intermediaries on compliance with notification requirements dated 1 June 2018 specified the notification requirement under the Securities and Futures (Licensing and Registration)(Information) Rules if intermediaries intend to provide trading and asset management services involving such virtual assets.
As such, if virtual assets do not amount to “securities” or “futures contracts”, then these do not fall within the jurisdiction of the SFC. Furthermore, managing funds solely investing in virtual assets which do not constitute “securities" or "futures contracts" does not amount to a "regulated activity" as specified under the SFO. Similarly, the operators of platforms which only provide trading services for virtual assets not falling within the definition of "securities" do not fall within the jurisdiction of the SFC.
The SFC emphasizes that the distribution of a fund which invests in virtual assets will now trigger the licensing or registration requirement for Type 1 regulated activity (dealing in securities) irrespective of whether or not the subject virtual assets fall within the scope of “securities” or a “futures contract” as defined in the SFO.
Intermediaries which fall within Type 1 regulated activity are required to ensure compliance with paragraph 5.2 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission along with the suitability obligation, when disturbing these funds.
Additional requirements are implemented when distributing virtual asset funds which are not authorized by the SFC for intermediaries that have an objective to invest in virtual assets or intend to invest or have invested more than 10% of their gross asset value in virtual assets.
(a) : Intermediaries should only target clients who are professional investors as defined under the SFO. For non- institutional professional investors, intermediaries should assess whether clients have knowledge of investing in virtual assets or related products prior to effecting the transaction on their behalf.
Therefore, all intermediaries intending to invest in virtual assets should observe essentially the same regulatory requirements even if the investment under their management invest solely or partially in virtual assets, irrespective of whether these virtual assets amount to "securities" or "futures contracts"
(b) Intermediaries distributing these funds should conduct proper due diligence on virtual asset funds which are not authorized by the SFC as well as their fund managers and the parties which provide trading and custodian services to the funds by way of such as the fund’s constitutive documents and due diligence questionnaire, in addition to making enquiries with the fund manager etc.
(c) : intermediaries should provide sufficient information in relation to the fund as well as the underlying virtual asset investments, in the following aspects:
- Continuing evolution of virtual assets and how this may be affected by global regulatory developments;
- Price volatility;
- Potential price manipulation on exchanges or trading platforms;
- Lack of secondary markets for certain virtual assets;
- Most exchanges, trading platforms and custodians of virtual assets are presently unregulated;
- Counterparty risk when effecting transactions with issuers, private buyers/sellers or through exchanges or trading platforms;
- Risk of loss of virtual assets, especially if held in “hot wallets” which means to the wallet used for holding virtual assets in an online environment which provides an interface with the internet, which is more susceptible to cyber-attacks; and
- Cybersecurity and technology-related risks.
As a result, the above measures formulated allow the SFC to regulate the virtual asset fund activities in either at the fund management level or the distribution level, or both.
Meanwhile, under this new framework, the SFC will explore whether virtual asset trading platforms are suitable for regulation in the SFC Regulatory Sandbox (Note 6). The SFC will observe the operations of interested trading platform operators and their compliance with proposed regulatory requirements (Note 7) in the Sandbox environment.
If it is decided at the end of this stage that it is appropriate to regulate platform operators, the SFC would then consider granting a licence and putting them under its close supervision. Alternatively, it may take the view that the risks involved cannot be sufficiently addressed and no licence shall be granted as protection for investors cannot be ensured. The SFC shall keep the development of activities related to virtual asset in mind and issue further guidance where it deems necessary.