Introduction

On 2 November 2023, Hong Kong’s Securities and Futures Commission (“SFC”) published two circulars providing guidance on trading in tokenised securities, namely first, Circular on Intermediaries Engaging in Tokenised Securities-Related Activities (the “First Circular”), and second, Circular on Tokenisation of SFC-Authorised Investment Products (the “Second Circular”) (collectively, the “Circulars”). This article examines certain expectations of SFC in relation to tokenisation and dealing in tokenised securities, and how the Circulars reflect an evolution in the SFC’s views on tokenised securities, potentially leading to a new regulatory approach.

 “Securities” are statutorily defined in the Securities and Futures Ordinance (Cap. 571) (“SFO”), which refers to traditional financial instruments such as shares, stocks, bonds or funds. To be “tokenised”, it means that the securities utilise the distributed ledger technology (“DLT”) in their security lifecycle (“Tokenised Securities”). A commonly heard illustration of DLT is blockchain technology.

What is new?

The old position

The First Circular contain a section that is tailored for clarifications regarding SFC’s Statement on Security Token Offerings dated 29 March 2019 (the “2019 Statement”) and explicitly state that the First Circular supersedes the said 2019 Statement, in which SFC took the stance that security tokens would be regarded as “complex products” and therefore attracted additional investor protection measures. SFC also limited the distribution and marketing of securities tokens to professional investors only as security tokens were a novel asset class in the 2019 Statement.  

The “new” view

The overarching principle of the SFC’s regulatory approach is “same business, same risks, same rules”. While the existing legal and regulatory requirements governing the traditional securities markets continue to apply to Tokenised Securities as they are fundamentally traditional securities with a tokenisation wrapper, namely the prospectus regime under the Companies (Winding up and Miscellaneous Provisions) Ordinance (Cap. 32) and the offers of investments regime under Part IV of the Securities and Futures Ordinance (Cap. 571), tokenisation per se does not alter the complexity of the underlying security. In other words, the complexity of a Tokenised Security shall be assessed on a case by case basis and shall be determined having regard to the factors set out in Chapter 6 of the Guidelines on Online Distribution and Advisory Platforms and paragraph 5.5 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission. Generally speaking, a complex product is an investment product whose terms, features and risks are not reasonably likely to be understood by a retail investor because of its complex structure. There is hence no need to impose a mandatory professional-investors only restriction as long as the expectations set out in the following paragraphs can be met.

SFC expectations – intermediaries

As there is an increasing number of intermediaries entering the space to explore the tokenisation of securities and the distribution of Tokenised Securities to their clients, SFC sets out its expectations towards intermediaries engaging in Tokenised Securities-related activities in the First Circular, namely:

1.       To have the necessary manpower and expertise to understand and manage the risks of Tokenised Securities-related activities;

2.       To perform due diligence on the Tokenised Securities based on all the available information to identify their key features and risks; and

3.       To provide clients with material information on the tokenisation arrangement.

It is vital to note that where intermediaries issue or are substantially involved in the issuance of the Tokenised Securities, they remain responsible for the overall operation of the tokenisation arrangement notwithstanding any outsourcing to third-party vendors and/or service providers. In short, there is no delegation of responsibility.

SFC expectations – primary dealing product providers 

While product providers shall comply with the requirements set out in the First Circular, additional requirements set out below shall also be satisfied:

1.       Product Providers should handle the management and operational soundness of the tokenisation arrangement, record keeping of ownership and the integrity of the smart contracts to SFC’s satisfaction. In addition, Product Providers should have appropriate measures in place to manage and mitigate cybersecurity and technical risks, data privacy, and maintain a comprehensive and robust business continuity plan;

2.       Product Providers should ensure that the offering documents of the Tokenised Securities set out clearly the tokenisation arrangement, the ownership representation of the tokens and the associated data, regulatory and technical risks with the tokenisation arrangement; and

3.       Product Providers should ensure that they have at least one competent staff with relevant experience and expertise to operate and/or supervise the tokenisation arrangement and to manage the new risks relating to ownership and technology appropriately.

Similarly, product providers should remain and be ultimately responsible for the management and operational soundness of the tokenisation arrangement adopted and record keeping of ownership.

Takeaways 

The Circulars reflect SFC’s efforts in actively monitoring and regulating the digital asset industry to ensure investor protection and market integrity. While concrete guidance has been provided in the Circulars, prior consultation and approval is still required for new investment products that have tokenisation features and tokenisation of existing SFC-authorised investment products. Having said that, the Circulars relate only to Tokenised Securities which are defined to include only tokenised traditional financial instruments (e.g. bonds or funds).  Other forms of tokens not involving traditional financial instruments are not included.  Investors are still advised to remain vigilant and attentive to any future guidance issued by SFC and stay informed about the evolving regulatory landscape surrounding securities and financial markets.