On November 1, 2018, following a rising tide of speculation, the Hong Kong regulator Securities and Futures Commission (SFC) announced a series of initiatives to regulate digital assets for the first time (and, apparently, without the need for any kind of legislative approval or backing). The initiatives, discussed below, take effect immediately. For purposes of the new regime, the SFC refers to “virtual assets” broadly defined to include initial coin offerings (ICOs), digital tokens (such as digital currencies, utility tokens or security or asset-backed tokens) and any other virtual commodities, cryptoassets and other assets of essentially the same nature (together “digital assets” herein as commonly understood in the industry).
During the past 12 months, the SFC has made it clear that where digital assets fall within the definition of “securities” or “futures contracts,” they are subject to the existing regulatory regime. This precipitated a crackdown of unlicensed bitcoin exchanges and ICOs. These enforcement actions hinged on arguments that those involved were carrying on regulated activities without a license.
This has meant that nascent funds investing solely in digital asset classes that fell outside the current regime (even if they mimicked conventional asset classes) were left unregulated, exposing investors to heightened risks. To plug this perceived loophole, the SFC simultaneously released two policy papers that substantially widen the current regulatory regime to net digital assets regardless of whether they constitute regulated activities. The new regime adopts a two-pronged initiative that entrenches new regulatory standards aimed at fund managers (and their distributors alike) who market virtual assets in Hong Kong as well as platform operators.
The combined effect of the new policy, said Ashley Alder, chief executive of the SFC, is to “allow [the SFC] to regulate the management or distribution of virtual asset funds in one way or another so that investors’ interests would be protected either at the fund management level, at the distribution level, or both”.
The first initiative (as more fully described in the circular) is intended to apply only to regulated fund managers (or their distributors) who have invested (or intend to invest) more than 10 percent of a mixed portfolio in digital assets. In essence, those persons are already subject to regulatory supervision. As a result, unregulated managers of “pure” cryptofunds are out of scope for the time being (absent new legislation). Further, regulated fund managers who fall within the new framework are permitted to target only “professional investors” as defined in the Securities and Futures Ordinance. Affected managers will therefore need to
- ensure that suitable selling restrictions are prominently displayed
- take necessary steps to ensure that investors are appropriately qualified
- agree to comply with bespoke licensing conditions in relation to the management of the portfolios or portion of the portfolios that relates to digital assets and related minimum liquid capital requirements
The SFC has warned that managers who fail to comply with the proposed restrictions could be forced to unwind relevant digital asset class portfolios (while distributors face potential disciplinary action).
The second initiative (as more fully described in the statement) applies to digital asset platform operators and encourages operators to opt in to a regulatory “sandbox” environment for a minimum 12-month period before the SFC reaches a definitive view on the applicable regulatory requirements. Where the SFC is minded to impose a licensing requirement, the basic expectation is that the regulatory standards for operators of digital asset platforms/exchanges ought to be the same as (if not higher than) those applicable to licensed operators of automated trading platforms. However, rather than be pinned down by the existing traditional legal framework, which may not be sufficiently robust, the SFC hopes its sandbox initiative will enable it to do a deeper dive into the underlying technology or business model of platform operators. Importantly, the SFC has stated that admission to the sandbox should not be interpreted as any assurance that operators will qualify for regulatory approval down the track (and indeed, operators will be gagged from revealing their participation in the sandbox environment to investors). Further, the SFC has expressly reserved its position to veto digital platform operators where it remains unsatisfied that overall levels of compliance and controls in place adequately safeguard investors.
Sidley has acted on the first funds to market in Asia that invest in digital assets and has launched a startup program to help firms navigate this rapidly evolving area in the regulation of digital assets.