Embracing innovative future of finance with guardrails
The Hong Kong Fintech Week 2022 has lately been successfully concluded in November 2022. Ms Julia Leung, chief executive officer designate and executive director of the Securities and Futures Commission (“SFC”), gave a keynote speech on Day One of the Fintech Week, emphasizing the SFC’s attitude and approaches towards various virtual asset (“VA”) products and services, including VA futures exchange-traded funds (“ETFs”), security token offerings (“STOs”), and virtual asset service provider (“VASP”).
Same activity, same risks, same regulation
Though acknowledging concerns from the crypto community that regulation inhibits innovation and thus limiting Fintech development and investor choice, the SFC is also well aware of the intrinsic volatility, structural vulnerabilities and increasing interconnectedness with the traditional financial system of crypto-asset markets as noted by the Financial Stability Board (“FSB”), especially after the collapse of Luna and Terra in May 2022 and bankruptcy of Three Arrows and suspended withdrawals by crypto lending platforms. Just after this, FTX collapsed and Hong Kong also had a record high of finance scam cases with a high number of them involving crypto and crypto exchanges.
The SFC shared the same view with the FSB – instead of adopting a light touch approach in regulating crypto asset service providers limiting from an anti-money laundering perspective, “an effective regulatory framework must ensure that crypto-asset activities posing risks similar to traditional financial activities are subject to the same regulatory outcome, while taking account of the novel features of crypto-assets and harnessing their benefits” (quoted). Therefore, the SFC adopts a comprehensive approach towards the VAs based on the important principle of “same activity, same risks, same regulation”. For instance, centralised VA exchanges are regulated in ways similar to stock exchanges and broker-dealers and licensed fund managers which manage VA funds are also required to comply with detailed requirements comparable to the Fund Manager Code of Conduct.
Though putting in place a lot regulatory guardrails to ensure the innovation of VAs be well-contained in a sustainable manner, the SFC has also granted approvals to 8 virtual asset fund managers and one virtual asset exchange, with another one approved in principle, and approvals to two brokers to trade virtual assets for clients under omnibus account arrangements.
Professional investor only restriction
Under the current regulatory framework, crypto asset customers, including clients of SFC-licensed trading platforms, securities token offerings and VA funds, are restricted to “professional investor only”, as defined in section 1 of Part 1 of Schedule 1 to the Securities and Futures Ordinance (Cap 571 of laws of Hong Kong) which includes banks, insurance companies, and persons belonging to a class which is prescribed under the Securities and Futures (Professional Investor) Rules (Cap 571D of laws of Hong Kong) with over HK$8 million of assets. Such overarching restriction was imposed by the SFC at an initial stage given the novelty of the regulatory framework for VAs and the high volatility of crypto assets. However, as time passed, the global market capitalisation of crypto assets has increased exponentially and more global financial institutions and service providers such as traditional custodians entered the market, therefore, the SFC now considers it as a good opportune time to review the “professional investor only” requirement and see the possibility of expanding target customers.
The SFC has been actively looking into a regime to authorise ETFs which provide exposure to mainstream VA with appropriate investor guardrails. The SFC has made it clear that VA futures ETFs will also be subject to additional requirements related to its management company, investment strategy, disclosure and investor education. At the initial stage, it is expected to see the underlying assets to be confined to Bitcoin futures and Ethereum futures traded on the Chicago Mercantile Exchange.
The SFC has noted that as STOs have been gaining traction among traditional financial institutions, one may expect “professional investors only” restriction to be relaxed and retail access be allowed with proper safeguards in place. The SFC is of the view that tokenised securities, such as digital representations of traditional securities on a blockchain, should be treated in a similar way as existing financial instruments (i.e. traditional securities) since they share similar terms, features and risks. The mere fact that the tokenised securities are issued or traded on a blockchain itself does not transform them into “complex products’. Thereby, based on the “same activity, same risks, same regulation” principle, a tokenised plain-vanilla bond would be classified as a “non-complex product” and firms distributing it would be subject only to the existing requirements for the distribution of conventional securities. However, for token features of which are more novel and complicated, for example, fractionalised asset-backed tokens or tokens representing an income stream from projects, they may be classified as “complex product”, and hence, the licensed firms distributing would need to ensure suitability and provide minimum information and warning statements, and be subject to the overarching “professional investor only” restriction that are applicable for the selling of complex products to investors.
Additionally, the SFC expects licensed firms distributing any security tokens to perform reasonable due diligence and conduct smart contract audits before the tokens are distributed to clients.
The Anti-Money Laundering and Counter-Terrorist Financing (Amendment) Bill has been passed by the Legislative Council on 7 December 2022 (the “Amendment Ordinance”). Under the Amendment Ordinance, centralised virtual asset exchanges offering services in Hong Kong must be licensed by the SFC. The SFC is minded to consult the public on whether the “professional investor only” restriction shall be relaxed, and if so, what should be the governance procedures and listing criteria for the VASP to admit tokens for secondary market trading by retail investors.
Despite of being supportive to the underlying innovative technology and welcoming the growth of the Fintech community in Hong Kong, the SFC is also fully cognizant of the risks and potential harm that may do to the investors which are adhered to these opportunities, particularly with what happened recently like the FTX collapse that has global ramifications. One may expect to see the overarching “same activity, same risks, same regulation” to continue to be in place with other robust guardrails to ensure a sustainable development of the crypto ecosystem when Hong Kong paves its way to the future of finance.
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Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.
Published by ONC Lawyers © 2022