Background

Under existing regulatory remits in Hong Kong, market for virtual assets is not subject to the oversight of the Securities and Futures Commission of Hong Kong (the “SFC”) if the virtual assets fall outside the ambit of the definition of “securities” or “futures contracts” under section 2 of the Securities and Futures Ordinance (“SFO”).

On 1 November 2018, the SFC issued the “Statement on regulatory framework for virtual assets portfolios managers, fund distributors and trading platform operators” (the “Statement”) and the accompanying “Circular to intermediaries – Distribution of virtual asset funds” (the “Circular”) in light of a growing investor’s interest in virtual assets investment and the inadequacy of the existing regime under the SFO to protect the investors from risks associated with investing in virtual assets, namely valuation, volatility and liquidity risks, accounting risk, cybersecurity risk, risk of money laundering and fraud etc.. A more robust approach in dealing with regulations on virtual assets market is set out in the Statement and the Circular in the hope of providing the investors with stronger protections from the risks associated with virtual assets investment.

The Statement delineates the regulatory standard expected of virtual asset portfolio managers and virtual assets fund distributors and outlines the conceptual framework for licensing and regulating virtual asset trading platform operators.

Regulations on virtual assets portfolio managers

The following virtual asset portfolio managers will be subject to the SFC’s supervision under the proposed framework:

• Firms managing funds which solely invest in virtual assets which do not constitute “securities” or “futures contracts” under the SFO and distribute the same in Hong Kong. These firms will require a type 1 (dealing in securities) regulated activity from the SFC and will be required to comply with rules and regulations as issued by the SFC, including the licensing conditions imposed by the SFC.
  
• Firms which are licensed or are to be licensed for Type 9 regulated activity (asset management) but who also manage portfolios which invest solely or partially in virtual assets that do not constitute “securities” or “futures contracts” under the SFO. The management over virtual assets is also subject to the SFC’s oversight through imposition of licensing conditions through certain terms and conditions (the “Terms and Conditions”), subject to the de minimis exemption, i.e. only virtual asset portfolio managers which intend to invest 10% or more of the gross asset value of the portfolios under its management in virtual assets will be subject to the SFC’s oversight.

As regards the two types of virtual asset portfolio managers above, a set of principle-based standard terms and conditions, with minor variations and elaborations depending on the specific business model of the virtual assets portfolio managers, will be imposed as licensing conditions which capture the existing requirements with adaptation to better address the risks associated with virtual assets. The virtual asset fund distributor will also be subject to further guidance on the standards specified in the Circular.

The Proposed Terms and Conditions

The proposed Terms and Conditions cover the following features:

• Types of investors. Only “professional investors” are allowed to invest in virtual assets portfolio which has a stated investment objective to invest in virtual assets or which intends to invest 10% or more of the gross asset value of the portfolio in virtual assets.
  
• Disclosure to investors. The virtual assets portfolio managers should clearly disclose all associated risks on virtual assets investment to potential investors and selected distributors.
  
• Custodial arrangement. The virtual assets portfolio managers have to exercise reasonable care in selecting, appointment and monitoring of custodians. If the virtual assets portfolio manager selects a self-custody arrangement, it has to document the reason for it and implement suitable measures to safeguard the assets. Proper records are also required to be maintained.
  
• Valuation principles. The virtual assets portfolio managers should exercise reasonable care in selecting valuation principles and methodologies appropriate in the circumstances and in the best interest of the investors.
  
• Caps on investment. The virtual assets portfolio managers should minimize risks by setting an appropriate cap on investment and conduct stress-testing regularly.
  
• Appointment of capable independent auditor. A capable independent auditor has to be appointed to audit financial statements of the funds.
  
• Liquidity. A virtual assets portfolio manager must maintain a liquid capital of not less than HK$3,000,000 (or its variable required liquid capital).

It has to be noted that these Terms and Conditions do not apply to (i) licensed corporations which only manage portfolios that invest in virtual asset fund i.e. funds of funds; or (ii) licensed corporations whose mandate is to mainly invest in securities or futures contracts but the investment in virtual assets exceeds the de minimis threshold due to increase in prices of the virtual assets held in the portfolio by them.

Separately, licence applicants and licensed corporation are also required to inform the SFC if they are presently managing or planning to manage one or more portfolios that invest in virtual assets. If it is in the opinion of the SFC that the firm appears to be capable of meeting the expected regulatory standards, SFC may further adjust the Terms and Conditions to suit their business model to ensure reasonableness and appropriateness.

Regulations on virtual asset fund distributors

Additional to the requirements as set out above, firms which distribute funds that invest solely or partially in virtual assets in Hong Kong will require a license or registration for Type 1 regulated activity (dealing in securities) and should observe the following requirements if the virtual asset investment products intend to invest or have invested more than 10% of their gross asset value directly or indirectly in virtual assets.

• Types of investors. The distribution of virtual asset investment products should only target “professional investors”. Except for 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.
  
• Concentration assessment. Intermediaries should ensure that the aggregate amount to be invested by a client in virtual asset funds which are not authorised by the SFC is reasonable considering the client’s net worth.
  
• Due diligence. Intermediaries which distribute virtual assets funds should conduct proper due diligence on virtual asset funds which are not authorised by the SFC. Due diligence should also be conducted in relation to their fund managers and the parties which provide trading and custodian services to the funds.
  
• Information for clients. Intermediaries need to provide relevant information for the clients in a clear and easily comprehensive manner so that they can make informed investment decisions. Warning statements should also be given which cover continuing evolution of virtual assets, price volatility, potential price manipulation and cybersecurity risks etc.

The intermediaries will have to implement adequate systems and controls to make sure that the above obligations are complied with. Failure of which may affect the properness and fitness of the intermediaries to remain licensed or registered with the SFC.

Conceptual regulatory framework for trading platform operators

Currently, some of the world’s largest virtual assets trading platforms have been seen operating in Hong Kong but they fall outside the regulatory remits of the SFC and other regulators. The SFC considers it necessary to regulate the existing trading platforms having regard to the serious investor protection issues and the international developments.  As such, the SFC sets out a conceptual framework of the potential regulation for virtual asset trading platforms in the Statement in the hope of exploring whether virtual asset trading platforms are suitable for regulation.

In initial exploratory stage, a virtual asset trading platform may opt-in and be placed in the SFC regulatory sandbox if it is interested in being licensed by the SFC and is willing to adhere to a high level of standards and practices. The SFC will only discuss its expected regulatory standards with platform operators and observe the live operations of them to evaluate the appropriateness of the regulations for the virtual assets trading platforms and determine whether they are suitable for regulations. If the SFC’s response is affirmative, it will consider granting licenses to qualified platform operators and may impose appropriate licensing conditions.  The next stage of the sandbox will require more frequent reporting, monitoring and reviews through close supervision by the SFC.  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 will cover five core principles, namely all virtual asset trading activities under a single legal entity, compliance with applicable requirements, services to be offered to professional investors only, limitations on trading of ICO tokens within the initial 12 months and transactions be pre-funded and without leverage.

There will also be a set of proposed terms and conditions which is expected to be complied with by a licensed platform operator covering financial soundness, insurance requirement, knowledge assessment, anti-money laundering and counter-financing of terrorism, disclosure requirements, segregation and custody of clients’ money and virtual assets ongoing reporting obligations etc.

Conclusion

The SFC did not impose a ban on virtual assets market. Instead, the Statement and the Circular can be seen as a major step to expand the SFC’s regulatory footprint on virtual assets market. Investor protection remains as the top priority for regulators and it is expected that the SFC will issue further guidance on virtual assets market.

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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.