A summary of the new SFC regulatory framework for virtual assets

Executive summary

Here are the five points you need to know about the changes announced on 01 November 2018 by the Securities and Futures Commission (SFC) to the regulatory framework for virtual assets:

1. The SFC will supervise and regulate firms that distribute in Hong Kong funds that solely invest in virtual assets that are not securities or futures (non-SF virtual assets). Those not presently licensed, will need to apply for a Type 1 regulated activity (dealing in securities) licence.
2. The SFC will also supervise and regulate firms that are already licensed or to be licensed for managing a portfolio of securities or futures in Hong Kong, to the extent that those funds also manage portfolios which invest in non-SF virtual assets. A de minimis exception will apply.
3. All portfolio managers under the supervision of the SFC must meet the same regulatory requirements, even if some portfolios under their management only invest in non-SF virtual assets. Regulation will primarily be achieved through imposing licensing conditions based on Terms and Conditions related to virtual asset portfolios published by the SFC.
4. The SFC has given specific guidance in a circular to set out the requirements for distribution of virtual asset funds. This is supplementary to existing requirements.
5. The SFC will adopt an opt-in approach to regulation of virtual asset trading platforms. The SFC will invite applications to participate in an SFC regulatory sandbox. This will initially be on an unlicensed basis, but under the observation of the SFC. A staged process will follow that may ultimately lead to the grant of a licence to qualified virtual asset trading platform operators.

The details

Risks

The primary basis for increased supervision and regulation of virtual asset funds is the need for investor protection in light of the risks involved in virtual assets. The SFC has identified these key risks with investing in virtual assets:

• Virtual assets are not backed by physical assets. Prices of virtual assets are driven solely by supply and demand, and do not have inherent value. Prices are volatile.
• There are no agreed accounting and auditing standards and practices for virtual assets.
• There are significant cybersecurity risks, without an institutional standard custodian solution for virtual assets. Online wallets used to store cryptocurrency tokens are prone to hacking and theft.
• The trading environment for virtual assets is in its infancy, and the virtual assets market is vulnerable to manipulation and abusive activities.
• Trading of virtual assets can be done on an anonymous basis. Investors are at risk of investing in money laundering schemes or terrorist financing without their knowledge.
• Operators of virtual asset trading platforms could perform trades for both clients and principals without having to disclose this conflict.
• Virtual asset products may be placed on the market without adequate due diligence review or proper standards of disclosure and representation to investors.

Existing regime

Some virtual assets may fall outside the definition of “securities” or “futures contracts” under the Securities and Futures Ordinance (SFO). Similarly, fund managers solely investing in non-SF virtual assets, and operators of platforms that provide trading services for non-SF virtual assets, do not carry on regulated activities under the SFO and until now were considered as beyond the jurisdiction of the SFC.  The current SFC action is based on its perception that these gaps in the regulatory framework in Hong Kong resulted in inadequate protection of virtual asset investors.

New protective measures

The new measures are principally targeted at three categories of service providers, namely, virtual asset portfolio managers, virtual asset fund distributors and trading platform operators.

Virtual asset portfolio managers:

According to the SFC, the requirements in this section are applicable to the following two types of firms:

(a) firms managing funds which solely invest in non-SF virtual assets and distribute those funds in Hong Kong, and

(b) firms which are licensed or are to be licensed for managing portfolios in “securities”, “futures contracts” or both, but also manage portfolios which invest solely or partially in non-SF virtual assets. A de minimis exception will apply to the extent that non-SF virtual assets are less than 10% of the gross asset value (GAV) of the managed portfolios.

These two types of firms are typically licensed for Type 1 regulated activity (dealing in securities) and Type 9 regulated activity (asset management) respectively.

The SFC now requires that virtual asset portfolio managers should observe essentially the same regulatory requirements for regulated activities even if the portfolios or portions of portfolios under their management invest solely or partially in virtual assets. This is the expected standard even for non-SF virtual asset portfolios.

Licensing conditions for virtual asset fund managers

The SFC has provided a set of standard terms and conditions which sets out the expected standards for fund managers managing portfolios including virtual assets. These terms and conditions will form the basis of licensing conditions on the virtual asset portfolio managers.  These terms and conditions include:

• Type of investors: Only “professional investors” under the SFO should be allowed to invest in the portfolios with (i) a stated investment objective to invest in virtual assets; or (ii) an intention to invest 10% or more of the GAV of the portfolio in virtual assets;
• Safeguard of assets: The most appropriate custodial arrangement should be chosen for the virtual assets. If third-party custodians are to be appointed, then the portfolio manager must exercise due skill, care and diligence in the selection, appointment and ongoing monitoring of those custodians;
• Portfolio valuation: The portfolio manager must exercise due care in selecting valuation principles, methodologies, models and policies for the in virtual assets which are reasonably appropriate in light of the circumstances and in the best interests of the investors;
• Risk management: The portfolio manager must set appropriated limits in respect of (i) product and market the portfolios invest in; (ii) the counterparty to which the portfolios have exposure; and (iii) exposure to individual virtual asset exchanges. Additional procedures should be implemented to assess the reliability and integrity of virtual asset exchanges;
• Auditors: Independent auditors should be appointed to perform audit of the funds; and
• Liquid capital: The portfolio managers should comply with the existing Securities and Futures (Financial Resources) Rules) in relation to virtual assets based on the fact that whether they are holding client assets. The minimum liquid capital requirement threshold will be HK$3 million, or its variable required capital, whichever is higher. This will apply even if the virtual assets are non-SF virtual assets.

The SFC has reiterated that licensed corporations and licence applicants must notify the SFC if they are presently managing or planning to manage one or more portfolios that invest in virtual assets. If the SFC is of the opinion that a portfolio manager is capable of meeting the expected regulatory standards, it will use the terms and conditions as a basis for agreeing and imposing licensing conditions on the portfolio manager. If a currently licensed corporation refuses to comply with the terms and conditions, it will be required to unwind the portfolio involving virtual assets within a reasonable period of time. If a licence applicant refuses to comply with the terms and conditions, its application will be rejected.

Virtual asset fund distributors

SFC requires all firms distributing funds that invest (solely or partially) in virtual assets in Hong Kong to be licensed or registered for Type 1 regulated activity (dealing in securities), even if the funds only invest in non-SF virtual assets.

If the relevant fund distributor is distributing virtual assets funds that are not authorised by the SFC and with (i) a stated investment objective to invest in virtual assets; or (ii) an intention to invest 10% or more of the GAV of the portfolio in virtual assets, it will be subject to the following additional requirements:

• The fund distributor should only target clients who are professional investors, and should ensure that the aggregate amount to be invested by a client in unauthorised virtual asset funds is reasonable, considering the client’s net worth;
• The fund distributor should conduct proper due diligence on the virtual asset funds, their fund managers and relevant parties providing trading and custodian services. This will include scrutinising the fund’s constitutive documents and undertaking a due diligence process; and
• The fund distributor should provide relevant information in relation to the fund as well as the underlying virtual assets to its client. That information should include prominent warning statements and risk disclosures. The purpose is to facilitate investors to make informed decisions.

Trading platform operators

The SFC believes it is possible that the inherent characteristics of platform operators may mean that trading platform operators for virtual assets cannot meet the standards of regulation expected by the SFC. The SFC proposes to firstly set out a conceptual framework for the potential regulation of the trading platform operators. The SFC will invite interested trading platform operators to participate in a regulatory sandbox (“Sandbox”), and will use the information and analysis gathered from the Sandbox in collaboration with trading platform operators to assess whether it is appropriate for the SFC to regulate trading platform operators.

Initially, the SFC will grant no licence to trading platform operators participating in the Sandbox. The SFC will observe the live operations of trading platform operators in the Sandbox, discuss with the trading platform operators, and consider the effectiveness of the proposed regulatory framework in addressing the risks of virtual asset trading and providing investor protections.

If the SFC decides to proceed to the next stage, then it will select qualified trading platform operators, grant them a licence, and impose appropriate licensing conditions. The SFC would insist on more frequent and close supervision. Then, after a minimum 12-month period, a qualified platform operator may apply to the SFC for the removal or variation of some licensing conditions and leave the Sandbox.

Our thoughts

The sensible players in the crypto space in Hong Kong have sought and asked for regulation from the very early days. Now, the SFC has stepped up to the plate, and on the basis of investor protection, set out how it will regulate. We think this is a very positive, important and welcome statement from the SFC. Regulation is a necessary and vital stepping stone to maturity in this industry. Now, we know the shape of things to come and it is expected that more will follow.

Russell Bennett / Padraig Walsh / Peter Tang

The above is not intended to be relied on as legal advice and specific legal advice should be sought at all times in relation to the above.

For more information on SFO-regulated activities and licence requirements, please contact:

Russell Bennett
Partner | Email

Padraig Walsh
Partner | Email

Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.

For more information on ICOs and regulatory requirements, see our article Initial Coin Offerings Hit Regulatory Walls.