On 1 November 2018, the Securities and Futures Commission of Hong Kong (SFC) issued a statement, "Statement on regulatory framework for virtual assets portfolios managers, fund distributors and trading platform operators" (VA Statement) and an accompanying circular "Circular to intermediaries - Distribution of virtual asset funds" (VA Distribution Circular) (collectively, the VA Circulars), to announce a new regulatory approach on virtual assets activities, virtual assets portfolio managers and their distribution of virtual assets investment products in Hong Kong.
Conventional Regulatory Approach
Prior to the VA Circulars, the SFC regulated virtual assets activities only to the extent that such virtual assets (referred to as a digital representation of value, whose scope includes "cryptocurrencies", "crypto-assets" or "digital tokens") have terms and features falling under the definitions of "securities" and/or "future contracts" under the Securities and Futures Ordinance (Chapter 571 of the laws of Hong Kong) (SFO).
However, as the SFC notes in the VA Statement, investment in virtual assets involves significant risks to investors. These include, amongst others, operational issues on custody of virtual assets, hacking risk, inconsistent valuation and fragmented liquidity of virtual assets.
The SFC has now set out a more robust approach on regulating virtual assets activities, with the aim of offering stronger protection for investors who invest in virtual assets portfolios or funds.
1. Broader Scope of Supervision on Virtual Assets Portfolio Managers
Virtual assets portfolio managers who manage or distribute virtual assets portfolios will attract SFC licensing requirements and be subject to requirements as set out in the VA Circulars, irrespective of whether the virtual assets will amount to "securities" and/or "future contracts" under the SFO.
According to the SFC, such virtual assets portfolio managers include:
- Firms managing funds which solely invest in virtual assets that do not constitute "securities" and/or "future contracts" under the SFO and distribute the same in Hong Kong: the distribution activities of virtual assets investment products by such firms will require a licence for type 1 (dealing in securities) regulated activity from the SFC. As such, they are required to comply with various rules and regulations as issued by the SFC, when they distribute virtual asset investment products to their clients; and
- Firms which are licensed/to be licensed for type 9 (asset management) regulated activity license but who also manage portfolios which invest solely or partially in virtual assets that do not constitute "securities" and/or "future contracts" under the SFO: subject to the de minimis exemption (i.e. where the virtual assets portfolio managers invest less than 10% of the gross asset value of the portfolios in virtual assets), the management over virtual assets is also be subject to supervision by the SFC through the imposition of certain terms and conditions (VA Terms and Conditions) as licensing conditions to the virtual assets portfolio managers. Firms are required to inform the SFC whether they are presently managing or planning to manage virtual assets portfolios. This notification applies even if the licence applicant or licensee plans to manage less than 10% of assets being virtual assets. If they are, the SFC will work with the firm to modify the VA Terms and Conditions in order to accommodate the business model of the respective firm and to ensure that such terms and conditions are reasonable and appropriate. The finalized VA Terms and Conditions will be imposed as licensing conditions to that firm. If a licence applicant does not agree to comply with the proposed VA Terms and Conditions, its licensing application will be rejected. Similarly, if an existing licensed corporation does not agree to comply with the proposed VA Terms and Conditions, it will be required to unwind that portfolio within a reasonable period of time.
2. What are the Virtual Assets Terms and Conditions?
The VA Terms and Conditions are by and large principles-based and are subject to minor variations and elaborations depending on the specific business model of the virtual assets portfolio manager. Broadly speaking, the VA Terms and Conditions cover the following areas:
- Type of investors and disclosure to investors:
- Only "professional investors" as defined under the SFO are allowed to invest in a virtual assets portfolio which (i) has a stated investment objective to invest in virtual assets; or (ii) intends to invest 10% or more of the gross asset value of the portfolio in virtual assets. We note that this is same condition that most alternative managers have on their licence, especially given such products are not aimed at the retail market.
- Virtual assets portfolio managers should clearly disclose all associated risks on virtual assets investment to potential investors and selected distributors of virtual assets portfolios. This is consistent with the approach of the proposed new fund manager code of conduct, which requires managers to disclose various risks and other issues to investors in offshore funds managed by an SFC licensed manager.
- Safeguarding of assets:
- Virtual assets portfolio managers should exercise due skill, care and diligence in the selection, appointment and ongoing monitoring of custodians.
- Virtual assets portfolio managers should select the most appropriate custodial arrangement for safekeeping the virtual assets, either self-custody or custodial arrangement with third-party custodians/exchanges.
- Where the virtual assets portfolio manager selects self custody arrangements, it should document the reasons for self-custody, implement appropriate measures to safeguard these assets and maintain proper records and arrangement to ensure that these virtual assets will be effectively segregated from the portfolio manager's own assets. It should also maintain adequate insurance cover over these virtual assets and make proper disclosure to investors of the risks associated with such arrangements.
- Factors such as accessibility to the virtual assets and the security of custodial facility should be taken into account when selecting the host location in holding the virtual assets. The above requirements relating to custody will represent a significant challenge given the current lack of an all-encompassing custody solution in the virtual assets area.
- Portfolio valuation:
- Virtual assets portfolio managers should exercise due care in selecting valuation principles, methodologies, models and policies which are (i) reasonably appropriate to the circumstances and (ii) in the best interests of the investors.
The above requirements also remains a challenge in terms of arriving at an objective method of valuing this asset new asset class.
- Risk management:
- An appropriate limit/cap should be imposed on how much of the portfolio will be invested in virtual assets.
- Periodic stress testing should be conducted to determine the effect of abnormal and significant changes in market conditions on the portfolios.
- Additional procedures should be implemented to minimise any risks associated with hacking of virtual assets.
- An independent auditor should be appointed to perform audit of virtual asset portfolios.
- Liquid Capital:
- A virtual assets portfolio manager must maintain a liquid capital of not less than HK$3 million (or its variable required liquid capital, whichever is higher), irrespective of whether it is under the licensing condition that it holds client assets or not. This requirement is material, in that other alternative asset managers (for example, hedge fund managers and PE fund managers) that hold a type 9 licence and who do not hold client assets have a liquid funds requirement of just HK$100,000.
3. Further Requirements on Distribution of Virtual Assets
Virtual assets portfolio managers and distributors should observe the following additional requirements when they engage in the distribution of unauthorised virtual asset investment products (i.e. non retail products) where such virtual asset investment products intend to invest or have invested more than 10% of their gross asset value directly or indirectly in virtual assets:
- Target Investors: Any distribution of virtual asset investment products should only target "professional investors" as defined under the SFO.
- Concentration: Virtual assets portfolio managers should ensure that the aggregate amount to be invested by the investor in virtual assets funds should be reasonable to the client's net worth.
- Due diligence: Proper due diligence on the fund manager, the fund and the counterparties of the fund should be conducted. This includes examining the constitutive documents and due diligence questionnaire of the fund and making enquiries with the fund manager.
- Information for clients: Virtual assets portfolio managers should present certain prominent warning statements such as continuing evolution of virtual assets, price volatility of virtual assets and risk of loss of virtual assets, counterparty risk, cybersecurity and technology related risks, in a clear and easily comprehensive manner to the investor. Pursuant to the VA Distribution Circular, a failure to comply with the additional requirements may affect their fitness and properness to remain licensed with the SFC and the virtual assets portfolio managers may face disciplinary actions from the SFC.
4. Conceptual Regulatory Framework for Platform Operators
At the same time, the SFC has introduced a conceptual framework for potential regulation of virtual asset trading platform operators in the future. This will involve the SFC initially undertaking an exploratory exercise with a view to reaching a conclusion about whether these platforms are suitable for regulation. If it concludes that these platforms should be regulated then they will become subject to similar licensing standards as licensees of automated trading services.
Under the conceptual framework, outcome may be that a virtual asset trading platform operator will need to obtain a licence, and abide by certain core principles. This means a licensed virtual asset trading platform operator may need to:
- Conduct all virtual asset trading activities under a single legal entity;
- Ensure compliance its virtual asset trading business with applicable requirements;
- Offer its virtual asset trading activities to "professional investors" as defined under the SFO only;
- Admit issuance of virtual assets only by way of initial coin offering within the initial 12 months; and
- Ensure the virtual asset trading transactions to be pre-funded, free of leverage or virtual asset-related futures contracts or other derivative products.
Various licensing conditions on financial soundness, insurance requirements, segregation and custody of virtual assets may also be imposed to virtual asset trading platform operators, depending on their business practices.
The conceptual framework is aimed to provide high level of standards and practices for licensed trading operators to follow, and to distinguish licensed trading operators from those which do not seek a license.
The SFC is eager to work with interested virtual assets trading platform operators to explore the regulatory framework of virtual assets trading platform in SFC regulatory sandbox environment. It is expected that this will result in a shake out of a number of trading platforms who currently operate in an unregulated environment.
The VA Circulars can be seen as a major step taken by the SFC to expand its regulatory footprint on the world of virtual assets. Although the innovative nature of virtual asset activities have created tremendous investment opportunities, investor protection from volatile financial practices remains as the top priority for regulators in order to ensure the integrity of financial investments.