New regulatory approach for virtual assets

On 1 November 2018, the Securities and Futures Commission (SFC) announced a new regulatory framework for virtual assets. 

Virtual assets are digital representations of value and are commonly referred to as cryptocurrencies, crypto-assets and digital tokens. The SFC’s regulatory measures affect:

• Managers, who manage or intend to manage portfolios investing in virtual assets: please refer to the SFC’s statement on regulatory standards for licensed corporations managing virtual asset portfolios for detail;

• Distributors of funds investing in virtual assets: please refer to the SFC’s circular on distribution of virtual asset funds for detail; and

• Operators of virtual asset trading platforms: please refer to conceptual framework for the potential regulation of virtual asset trading platform operators for detail.

The SFC has expressed significant concerns about the risks associated with investing in virtual assets, particularly in relation to valuation, volatility, liquidity, accounting and audit issues, cybersecurity, safe custody, money laundering, conflicts of interest and fraud, and the general regulatory uncertainty of the market in virtual assets.

Many virtual assets potentially fall outside the scope of regulation by the SFC as they are not constituted as “securities” or “futures contracts”: managing funds investing solely in virtual assets which do not constitute “securities” or “futures contracts” does not amount to a “regulated activity” in Hong Kong; nor does providing trading services for virtual assets which are not “securities”. However, if firms are engaged in selling interests in funds which invest in virtual assets, irrespective of whether the underlying assets of those funds constitute “securities” or “futures contracts”, such firms require a licence because the interests in the funds are “securities”, and marketing such interests is a regulated activity (Type 1 – Dealing in Securities).

The SFC proposes to impose terms and conditions on licensed entities which is expected to bring a significant portion of virtual asset portfolio management and distribution activities within the scope of SFC regulation and supervision.

The SFC proposes to explore how to regulate virtual asset trading platforms by inviting virtual asset trading platform operators that have demonstrated a commitment to adhering to high standards of conduct to make use of its regulatory sandbox. This will give the SFC an opportunity to consider whether virtual asset trading platforms are, in fact, appropriate to be regulated by the SFC in light of the performance of these trading platforms in the regulatory sandbox. Factors to be considered include the adequacy and effectiveness of the SFC’s proposed conceptual framework; ability to comply with the proposed terms and conditions and standards of conduct; investors' interests; as well as local market and international regulatory developments.

The new regulatory framework will raise many issues for managers, distributors and platform operators. We have sought to address a few of these very briefly below.

Managers’ questions

1.    Do I need an SFC licence to manage virtual assets?

Yes, if the virtual assets you manage are constituted as securities or futures contracts.

Even if you only manage funds which invest solely in virtual assets which are not securities or futures, you will need a Type 1 licence to market those funds, and the management of such funds will effectively be brought under the SFC's oversight through the imposition of licensing conditions.

2.     I am already licensed with the SFC. What should I do if I want to manage virtual assets or now have virtual assets in my managed portfolios of securities/futures contracts?

You need to notify SFC.

The SFC will impose licensing conditions on licensed corporations which manage or plan to manage portfolios with (i) a stated investment objective to invest in virtual assets; or (ii) an intention to invest 10% or more of the gross asset value of the portfolio in virtual assets (Designated VAP).

3.     What licensing conditions are likely to be imposed on a Type 9 manager investing in virtual assets?

(i)  Allowing only professional investors to invest into the Designated VAP;

(ii) Disclosing to potential investors and distributors all risks associated with investing in the Designated VAP;

(iii) Making appropriate custodial arrangements for the virtual assets;

(iv) Maintaining adequate insurance to cover virtual assets;

(v) Adopting appropriate valuation principles, methodologies, model and policies for the Designated VAP;

(vi) Maintaining appropriate risk management controls;

(vii) Appointing independent auditors for the funds they manage, with suitable experience in dealing with virtual assets; and

(viii) Maintaining sufficient liquid capital (and for a Type 9 manager who holds virtual assets (albeit not securities or futures contracts), it will need to maintain a minimum liquid capital of HK$3 million or its variable required liquid capital (whichever is higher).

4.     What will happen to the Designated VAPs I am currently managing if I cannot comply with the proposed licensing conditions?

You will need to wind them down, or sell the virtual assets, within a reasonable timeframe as the SFC requires.

Distributors’ questions

5.     Do I need an SFC licence to distribute a fund investing in virtual assets?

(i) Yes, you need a Type 1 (Dealing in Securities) licence to distribute a fund, regardless of the types of assets it invests in.

6.     I am already licensed with the SFC. What should I do if I want to distribute funds investing in virtual assets?

If the stated investment objective of the fund is to invest in virtual assets, or if the fund intends to invest 10% or more of its gross asset value in virtual assets, you should notify the SFC.

7.     To whom can I sell a fund investing in virtual assets?

Only to professional investors under the Securities and Futures Ordinance. Note that distributors will need to assess the suitability of the investment for each investor they target, except for institutional professional investors.

8.     What are the additional requirements for distributors of funds investing in virtual assets?

In addition to the existing know-your-client (KYC), product due diligence and suitability requirements, you will need to observe the following requirements:

(i) KYC – Assess whether your clients have knowledge of investing in virtual assets or related products;

(ii) Product due diligence – Conduct additional due diligence on the fund (including its use of leverage, custody arrangements and risks) having regard to its exposure to virtual assets and its services providers (including fund managers, trading firms and custodians);

(iii) Information to client – Provide prominent warning statements to clients in connection with the risks, price volatility and lack of secondary markets for the fund.

Platform operators’ questions

9.     What should I do if I want to operate an online trading platform for virtual assets?

You will need to approach the SFC Fintech Contact Point and let them consider your business proposal for entering into the regulatory sandbox.

If the SFC considers you appropriate, they will impose appropriate licensing conditions for you to commence business within the confines of the regulatory sandbox. The SFC will monitor your business activities within the confines of the regulatory sandbox for a minimum period of 12 months. After the 12 months, you may apply to the SFC for removal or variation of some of the licensing conditions and exit the regulatory sandbox.

10.    What criteria will the SFC consider when putting me into its sandbox?

In the initial exploratory stage, the SFC will not grant a licence to platform operators. Instead, it will discuss its expected regulatory standards with platform operators and observe the live operations of the virtual asset trading platforms in light of these standards. It will also consider the effectiveness of the proposed regulatory requirements in addressing risks and providing adequate investor protection. If the SFC is minded to grant a licence to a qualified platform operator, the SFC will impose licensing conditions which are likely to include the core principles below:

(i) the relevant platform trading activities are undertaken by a single entity under the SFC’s jurisdiction;

(ii) the operator is able to comply with the regulatory requirements (e.g. KYC and AML/CTF requirements);

(iii) the use of the platform is confined to professional investors only;

(iv) initial coin offering (ICO) tokens may not be admitted for trading onto the platform earlier than 12 months after completion of the relevant ICO, or the ICO project has started to generate profit, whichever is earlier;

(v) the operator should only execute a trade for a client if there are sufficient fiat currencies or virtual assets in the client’s account.