Introduction

The virtual assets （“VA”）landscape in Hong Kong has been ever-evolving, it has been confronted by the allegations concerning the cryptocurrency exchange JP-EX Crypto Asset Platform Pty Ltd (“JPEX”) and the Securities and Futures Commission (“SFC”) has responded swiftly with various measures as detailed in our October issue on the burst of the JPEX bubble (click here). The SFC has joined hands with another regulator, the Hong Kong Monetary Authority (“HKMA”) and published the Joint circular on intermediaries’ virtual asset-related activities on 20 October 2023 (the “2023 Joint Circular”).

Regulatory history

The 2018 position

The SFC first formulated its regulatory approach for virtual assets in 2018 via its Circular to intermediaries Distribution of virtual asset funds dated 1 November 2018, and imposed an overarching “professional investors only” restriction on the distribution of virtual asset funds (“VA funds”). “Professional investors” is statutorily defined in the Securities and Futures Ordinance, Cap 571, examples of which are recognized exchange companies, intermediaries, authorized financial institutions and insurers authorized under the Insurance Ordinance. In relation to selling restrictions, before effecting the transactions, intermediaries should assess whether clients have knowledge of investing in virtual assets or related products prior to effecting the transaction on their behalf. If not, intermediaries may only proceed to effect the transaction if, by so doing, they would be acting in the best interests of the clients. Intermediaries shall also consider whether the clients have prior investment experience in private equity or venture capital or have provided capital for a start-up business in the past two years. When distributing funds that are not authorized by the SFC, intermediaries should conduct proper due diligence on the fund as well as their fund managers and the parties which provide trading and custodian services to the funds.

The 2022 position

Since then, the virtual asset landscape has evolved rapidly and begun to expand into mainstream finance. A broader range and larger number of investment products were available which provided investors, whether retail or professional, with exposure to virtual assets. In the Joint circular on intermediaries’ virtual asset-related activities by the SFC and the HKMA dated January 2022 (the “2022 Joint Circular”), SFC-licensed and registered intermediaries were allowed to offer trading of eligible VA Futures ETFs to retail investors in Hong Kong. However, the risks associated with investing in virtual assets identified by the SFC back in 2018, such as additional counterparty risks for VA-related products due to limited regulations on service providers for VA-related products, and investor protection issues continued to apply. As these risks were not reasonably likely to be understood by a retail investor, VA-related products were very likely to be considered complex products. The SFC and the HKMA therefore considered that investor protection measures, in addition to the requirements under the complex product regime, should be imposed to cover specific risks associated with these products. Only a limited suite of VA-related derivative products are traded on regulated exchanges specified by the SFC and, in the case of exchange-traded VA derivative funds, are authorised or approved for offering to retail investors by the respective regulator in a designated jurisdiction. The majority of VA-related products were still considered complex products and should only be offered to professional investors. In relation to the provision of virtual asset dealing services, to provide adequate investor protection, the SFC and the HKMA considered it appropriate and necessary to require intermediaries to partner only with SFC-licensed VA trading platforms for the provision of VA dealing services and such services should only be provided to professional investors.

The 2023 position

The 2023 Joint Circular explicitly stated that the 2022 Joint Circular shall be superseded. The Regulators’ views on the distribution of VA-related products essentially remain the same where selling restrictions and the virtual asset knowledge test still apply. In the 2023 Joint Circular, the Regulars expressly set out key terms and conditions that intermediaries shall comply with as one licensing or registration condition (“Terms and Conditions”), which provide the expected conduct requirements for intermediaries’ provision of VA dealing services under an omnibus account arrangement. The standards set out therein align with the requirements under the SFC’s regulatory framework for VA trading platforms on the performance of the dealing function carried out by intermediaries. In particular, the Regulators highlighted that intermediaries, before providing VA dealing services to retail clients, should assess each retail client’s knowledge of virtual assets and risk tolerance level, and set a limit for each retail client to ensure that the client’s exposure to virtual assets is reasonable with reference to the client’s financial situation and personal circumstances. Intermediaries shall also ensure that the VA dealing activities are conducted through an omnibus account established and maintained with an SFC-licensed platform which is not subject to the licensing condition that it can only serve professional investors, and implement adequate controls to ensure that their retail clients can only trade in those virtual assets that are made available by the SFC-licensed platform for trading by retail investors.

With respect to provision of asset management services in respect of virtual assets, the 2023 Joint Circular focuses on the requirements imposed on the intermediaries providing services which meet the de minimis threshold, i.e. a stated investment objective of a portfolio to invest in virtual assets or an intention to invest 10% or more of the gross asset value of a portfolio in virtual assets. The said intermediaries are subject to additional requirements set out in the Proforma terms and conditions for licensed corporations or registered institutions which manage portfolios that invest in virtual assets. In relation to virtual asset advisory services, when recommending any virtual assets to retail clients, intermediaries should take all reasonable steps to ensure that the virtual asset recommended is of high liquidity and is made available by SFC-licensed platforms for trading by retail investors. In assessing the liquidity of a specific virtual asset for trading by retail investors, intermediaries should, at a minimum, ensure that the virtual asset is an eligible large-cap virtual asset, i.e. it should have been included in a minimum of two acceptable indices issued by at least two different index providers. Well known cryptocurrencies such as Bitcoin and Ethereum fall within the virtual assets requirements and are available to retail investors.

Key takeaways

In light of the rapid developments in the global VA market and against the backdrop of recent VA-related incidents and investigations relating to players in Hong Kong and elsewhere, it is essential for the Regulators to review and update their existing policies on regulating intermediaries engaging in VA-related activities. While the 2023 Joint Circular merely elaborates on existing categories, namely, the distribution of VA-related products, providing VA dealing services, providing VA asset management services, and providing VA advisory services, it is apparent that the Circular continues to set higher standards in some areas as provided by the Terms and Conditions. With this proactive approach taken by the Regulators to provide guidance on dealings in virtual asset related activities, it is anticipated that investor interests can be better safeguarded in the ever-evolving realm of virtual assets.