Learn more about our comprehensive legal services.
Advising our clients on different opportunities and challenges of the industry.
News & Insights
Authored by: Isabella Wong
Digital tokens created to represent ownership in funds are no longer restricted to professional investors. On 2 November 2023, the Securities and Futures Commission (SFC) announced it will permit primary dealings of tokenised SFC-authorised investment products by retail investors: a fund must satisfy the applicable product authorisation requirements and be wrapped with a tokenisation arrangement with sufficient risk management safeguards before the fund’s units or shares can be offered as digital tokens to the public in Hong Kong. The dealing in, advising on, or management of the tokenised SFC-authorised funds (i.e. the fund tokens) as tokenised securities will need to comply with additional risk management, due diligence and disclosure requirements. For details of the SFC’s new guidance, please refer to the SFC’s circular on intermediaries engaging in tokenised securities-related activities, and SFC’s circular on tokenisation of SFC-authorised investment products.
Below is a quick guide for fund managers on how to tokenise their SFC-authorised funds for offering to Hong Kong retail investors based on the SFC’s new guidance.
1. Select the right product
In the context of SFC-authorised investment products, tokenisation refers to the creation of blockchain-based tokens that represent or aim to represent ownership in an investment product. SFC-authorised investment products (including SFC-authorised funds) are “securities” as defined under the Securities and Futures Ordinance (SFO). Tokenised SFC-authorised investment products are in substance, securities wrapped in a digital format (i.e. a “tokenisation wrapper”) and will be continuously governed by the SFC’s product authorisation requirements. As such, before a tokenised fund (i.e. a fund being recorded digitally on blockchain) can be offered directly to end investors, or distributed by intermediaries, or traded among the blockchain participants in the retail market, it must satisfy the applicable product authorisation under the SFO.
If a fund manager currently does not have a fund that has already been authorised by the SFC for retail offering in Hong Kong, it should create a new fund and seek the SFC’s authorisation for the fund. Prior consultation with the SFC will also be required if a new (tokenised) class of an existing SFC-authorised fund is issued.
2. Construct tokenisation arrangement
Tokenisation generally involves the use of distributed ledger technology (DLT) for digital record-keeping with integration of rules and logic governing the transfer process of the assets. For tokenising an SFC-authorised fund, the SFC discourages the use of public-permissionless blockchain networks which lack restrictions to access for privileges and have defining characteristics such as pseudonymity. The SFC disallows tokenised SFC-authorised products being issued in bearer form on such a network. A private-permissioned DLT network characterised by a centralised authority that controls and restricts access to pre-determined users (including the fund manager issuing the tokenised SFC-authorised fund) will be preferred as it enhances security of the tokenisation. The SFC is also open to a public-permissioned DLT network with a centralised authority that controls and restricts access through authentication but will likely request more security comforts.
To meet the SFC’s regulatory expectations, the fund manager of a tokenised SFC-authorised fund should include the following control mechanisms in the tokenisation arrangement:
Upon the SFC’s request, the fund manager will also need to:
3. Determine dealing model and engage services providers
Depending on the dealing model of a tokenised SFC-authorised fund, the fund manager will need to co-operate with different services providers such as the following:
Before engagement, the fund manager should conduct due diligence on the experience and track record of the service providers.
4. Enhance compliance infrastructure
The SFC anticipates new risks arising from tokenisation, in particular, the ownership risks of how ownership interests relating to fund tokens are transferred and recorded, and the related technology risks (e.g. forking, blockchain network outages and cybersecurity risks). The fund manager of a tokenised SFC-authorised fund will be held responsible for the overall operation of the tokenisation arrangement despite its outsourcing arrangement with third-party service providers.
The SFC therefore expects the fund manager to enhance its compliance infrastructure, which include among others:
5. Make proper disclosure in the fund’s offering documents
The SFC requires disclosures of the tokenisation arrangement, ownership representation of the fund tokens and associated risks with the tokenisation arrangement be included in the fund’s offering documents.
As an innovative technology, tokenisation has created a new distribution channel for SFC-authorised funds. Whilst tokenisation may bring new market opportunity to traditional investment products, Hong Kong is at a start-up stage for tokenised investment products and still needs more infrastructural supports to facilitate the operations (and more importantly, circulation) of the tokenised investment products. Before proceeding to a tokenisation route, fund managers should conduct a thorough cost-and-benefit analysis by taking into account various factors, for example:
Subscribe to Publications
Sign up for our regular updates covering the latest legal developments, regulations and case law.
For media enquiries please contact us at firstname.lastname@example.org.
Tel: +852 2825 9211