In light of growing investor interest in gaining exposure to crypto-related investment products, regulators are seeking to provide guidance as to the marketing and distribution of these products. On 1 November 2018, the Hong Kong Securities and Futures Commission (SFC) issued circulars setting out the regulatory standards relating to virtual asset portfolio managers and fund distributors (Regulatory Standards), as well as the conceptual framework for the potential regulation of virtual asset trading platform operators (Conceptual Framework). This article provides an overview of the new Hong Kong regulatory regime, which is an expansion of the existing regulatory regime.
Existing Regulatory Regime
The regulatory regime in Hong Kong had been relatively limited, as it was based only on a number of circulars issued by the SFC, which are described below. It was unclear whether crypto-assets should be regarded as “securities” under the Securities and Futures Ordinance1 (SFO).
In its circular on 5 September 2017, the SFC stated that the distribution of funds that invest (partly or solely) in crypto-assets (Crypto-funds), as well as the management of funds of Crypto-funds, are “regulated activities”. Accordingly, such distributors and managers must be appropriately licensed, irrespective of whether the parties involved are located in Hong Kong, so long as their activities target the Hong Kong public. Crypto-funds and funds of Crypto-funds may also be subject to registration or authorisation requirements under the local law, unless an exemption applies under the SFO or the Companies (Winding Up and Miscellaneous Provisions) Ordinance.
Further, the SFC stated in its circular issued on 11 December 2017 that where crypto-assets (or “virtual assets”) fall within the definition of “securities” or “futures contracts” as defined in the SFO, the dealing in, advising on, or managing of, these products in Hong Kong may fall within the regulatory ambit of the SFC. In particular, Bitcoin futures contracts launched by certain well-established futures and commodities exchanges regulated by the U.S. Commodity Futures Trading Commission and authorised by the SFC to provide automated trading services are explicitly considered by the SFC as “futures contracts”. Accordingly, persons intending to provide regulated activities relating to Bitcoin futures contracts must be appropriately licensed and subject to the suitability and conduct requirements relating to derivative products under the Hong Kong Code of Conduct2, as well as other regulations applicable to such regulated persons issued by the SFC (e.g., the Fund Manager Code of Conduct (FMCC)).
On 1 June 2018, the SFC reiterated that existing licensed corporations or registered institutions that decide to provide trading and asset management services relating to crypto-assets must notify the SFC of their intention to engage in such activities, and may start conducting these activities only after obtaining the relevant licensing approval from the SFC3. Engaging in such activities without a relevant licence or authorisation from the SFC may be considered the commission of a criminal offence under the SFO.
However, the SFC’s regulatory ambit was limited to “securities” and “futures contracts”. Thus, the SFC had no jurisdiction to regulate where crypto-assets did not fall within such definitions (Non-SF Cryptos).
Regulatory Standards and Conceptual Framework
Regulatory Standards Relating to Virtual Asset Portfolio Managers and Fund Distributors
To enhance investor protection in respect of Non-SF Cryptos and Crypto-funds, the SFC introduced the Regulatory Standards, under which the distributors and managers of Crypto-funds are subject to the same regulatory requirements irrespective of whether or not the crypto-assets under management constitute “securities” or “futures contracts” under the SFO. These requirements include SFO rules and regulations, the Code of Conduct, FMCC, guidelines, circulars and frequently asked questions issued by the SFC from time to time (Existing Requirements). Accordingly, after a licensed corporation or a licence applicant (Firm) obtains licence approval for their business activities relating to Crypto-funds, the Existing Requirements will be imposed in the form of a set of principles-based licensing terms and conditions developed by the SFC (Standard T&Cs).
Scope of Application
The Standard T&Cs are negotiable to adapt to the business model of the Firm to ensure that those proposed by the SFC are reasonable and appropriate. After the SFC is satisfied that a Firm appears to be capable of meeting the expected regulatory standards, Standard T&Cs will be provided. Once the Firm and the SFC have negotiated and finalised the Standard T&Cs, the SFC will impose such Standard T&Cs on the Firm by way of a licensing condition.
Standard T&Cs will not be imposed on: (1) Firms with business activities involving funds that invest 10% or less of their respective gross asset values in crypto-assets (De Minimis Threshold) and do not have a stated investment objective to invest in crypto-assets; or (2) funds of Crypto-funds. In the event that the De Minimis Threshold is exceeded as a result of an increase in prices of the crypto-assets in a portfolio, there will not be a breach of the Standard T&Cs, provided that all reasonable steps are taken to reduce the exposure in a timely manner below the De Minimis Threshold and the situation does not persist.
Brief Summary of the Standard T&Cs
The Standard T&Cs require a licensed corporation to:
- Comply with all of the Existing Requirements, as well as future guidance that may be provided by the SFC from time to time;
- Offer the Crypto-funds under its management only to “professional investors” as defined under the SFO;
- Select and adopt the most appropriate custodial arrangement (i.e., self-custody, appointment of a third-party custodian and/or depositing with an exchange), taking into accounting the advantages and disadvantages of different host locations with respect to “hot wallets”, “cold wallets” and “deep cold wallets”, as well as the accessibility of the crypto-assets under the arrangement and the security of the custodial facility;
- Exercise due skill, care and diligence in the selection, appointment and ongoing monitoring of an eligible custodian in respect of its Crypto-funds;
- Where self-custody is adopted, ensure that: the reasons for adopting self-custody are properly documented; appropriate safeguards are implemented; records are properly maintained; the licensed corporation’s own assets can be effectively segregated from crypto-assets in the event of insolvency of the licensed corporation; adequate insurance is maintained to cover over the crypto-assets; and proper disclosure is made to investors regarding the risks associated with such arrangements;
- Exercise due care in selecting valuation principles, methodologies, models and policies, which are reasonably appropriate in the circumstances and in the best interests of the Crypto-fund investors, and make proper disclosures to such investors;
- Set appropriate limits in respect of each product, market, counterparty and each crypto-asset exchange for each Crypto-fund it manages;
- Conduct periodic stress testing to determine the effect of abnormal and significant changes in market conditions on the Crypto-funds it manages;
- Implement additional procedures to assess the reliability and integrity of crypto-asset exchanges before entering into transactions with them, taking into account certain factors (including, among others, the exchange’s cybersecurity risk management measures, financial resources and insurance coverage);
- Select and appoint an independent auditor to perform audits of its Crypto-funds’ financial statements, which should take into account (among other things) the auditor’s experience and capability to check the existence and ownership, and ascertain the reasonableness of the valuation, of the relevant crypto-assets; and
- Maintain a required liquid capital of not less than the greater of: (i) HK$3 million or equivalent; or (ii) its variable required liquid capital (i.e., 5% of its adjusted liabilities as calculated in accordance with the Securities and Futures (Financial Resources) Rules).
Compliance with the Standard T&Cs
If a new licence applicant does not agree to comply with the Standard T&Cs, its licensing application will be rejected. Similarly, if an existing licensed corporation does not agree to comply with the Standard T&Cs, it may not manage any new or existing Crypto-funds unless an exemption applies. In the case where a licensed corporation has invested in Crypto-funds for its clients without agreeing to the Standard T&Cs, the licensed corporation must unwind the positions within a reasonable time, taking due account of the interests of the funds’ investors.
Where a Firm has agreed to comply with the Standard T&Cs imposed by way of licensing conditions, a subsequent failure to comply will be regarded as misconduct under the SFO, and will reflect adversely on the Firm’s fitness and properness, which may lead to disciplinary action by the SFC.
Conceptual Framework for Potential Regulation of Virtual Asset Trading Platform Operators
In contrast to the Regulatory Standards, the Conceptual Framework (which at this stage only pertains to potential regulation) would adopt an opt-in approach. If a crypto-asset trading platform operator (Platform Operator) commits to adhere to the conduct standards set by the SFC (thus setting itself apart from those that are unwilling or unable to meet such conduct standards), the Platform Operator could be placed in the SFC “Regulatory Sandbox” in order to determine whether it would be an appropriate entity to regulate. Once the SFC concludes that it may grant a licence to the Platform Operator, the SFC would impose certain licensing conditions that, other than complying with the Existing Requirements, might include the core principles (Core Principles) and other terms and conditions (Example T&Cs) set out in the Conceptual Framework, which are briefly summarized below.
The Core Principles that may be applicable to a proposed qualified Platform Operator are:
- All trading and business activities relating to crypto-assets (including Non-SF Cryptos), on and off platform, and any wholly incidental activities conducted by the Platform Operator’s group of companies, but excluding the distribution or management of Crypto-funds covered by the Regulatory Standards above, (collectively, Relevant Activities) should be carried under a single legal entity licensed by the SFC.
- The Platform Operator should not conduct the Relevant Activities in relation to crypto-assets that are futures contracts or other derivatives.
- The Platform Operator should comply with all applicable regulatory requirements in respect of the Relevant Activities.
- The Platform Operator should provide its services only to “professional investors”.
- The Platform Operator should not admit to trading on its platform a crypto-asset issued in an initial coin offering (ICO) until the earlier of 12 months after the completion of the ICO or when the ICO has started to generate a profit.
- The Platform Operator should only execute a trade for a client if there are sufficient fiat currencies or crypto-assets in the client’s account to cover that trade. No financial accommodation should be provided to clients.
The Example T&Cs that may be imposed on a proposed qualified Platform Operator cover the following areas:
- Financial Soundness. The Platform Operator should maintain financial resources commensurate with the role and functions it performs and the level of risk it undertakes. The SFC could require the Platform Operator to maintain a reserve equivalent to 12 months of operating expenses as a financial buffer. The actual amount required would be decided by the SFC on a case-by-case basis.
- Insurance Requirement. The Platform Operator should maintain an insurance policy providing full coverage for crypto-assets held by it in hot storage and a substantial insurance coverage (e.g., 95%) for those held in cold storage.
- Client Knowledge Assessment. Other than for “institutional professional investors” (as defined under the SFO), the Platform Operator should assess the client’s knowledge of crypto-assets before providing any service. Where the client does not possess sufficient knowledge, the Platform Operator should only provide any service if that would be in the best interests of the client.
- Anti-Money Laundering and Counter-Terrorist Financing (AML/CFT). The Platform Operator should ensure that its AML/CFT systems can adequately manage the risks relating to the Relevant Activities, which should cover (among others): conduct of the Relevant Activities in respect of a client through a designated bank account opened in the name of the client with an authorised institution; enhanced customer due diligence and ongoing monitoring of transactions; periodic review of the AML/CFT systems, taking into account applicable laws and regulations; and selection and monitoring of any third-party service providers.
- Disclosure Requirements. The Platform Operator should fully disclose, and ensure that investors understand, the nature and risks of: trading crypto-assets (including Non-SF Cryptos); and engaging the Platform Operator's services with respect to the Relevant Activities. Compositions and descriptions of all relevant fees also should be disclosed.
- Product Due Diligence. The Platform Operator should conduct all reasonable due diligence on the crypto-products available on its platform, and establish and disclose the criteria for admitting a crypto-asset (including a Non-SF Crypto) to its platform.
- Soft Dollars. A committee should be established to make decisions regarding the admission of crypto-products. Where payments are received for admission, the Platform Operator should adopt a fee structure that avoids any potential, perceived or actual conflicts of interest.
- Trading Rules. The Platform Operator should prepare and publish on its website comprehensive trading rules governing its platform operations.
- Other Policies and Procedures. The Platform Operator should establish and implement written policies and procedures covering (among other matters): market manipulative or abusive activities; employee dealings; and proprietary trading.
- Holding of Clients’ Money and Crypto-Assets. The Platform Operator should comply with the Securities and Futures (Client Money) Rules, which (among other matters): require the establishment and maintenance in Hong Kong of one or more segregated accounts for client money in a designated trust account or client account. Separate segregated accounts should be established for the purpose of holding Crypto-Assets on behalf of clients. A substantial amount (e.g., 98%) of the Crypto-Assets should be stored under cold storage.
- Ongoing Reporting Obligations. The Platform Operator should provide the SFC with certain information as specified by the SFC on a regular basis.
The Regulatory Standards have aligned the requirements relating to Non-SF Cryptos with those relating to “securities” and “futures contracts” as defined under the SFO. Under this approach, the SFC will no longer need to classify each specific crypto-asset as a “security” or “futures contract”, given the practical difficulties in making such classification. The Regulatory Standards essentially close the regulatory loophole for escaping licensing requirements in respect of distributing or managing Non-SF Cryptos and Crypto-funds.
The opt-in approach under the Conceptual Framework demonstrates that the SFC is actively trying to learn about the operations of Platform Operators, and seeking to regulate Platform Operators despite its limited regulatory ambit in this respect. Although the Conceptual Framework is already comprehensive and the proposed requirements are wide-ranging, it is expected that this will be updated and/or upgraded to mandatory requirements in the future.
However, there are ambiguities that are not addressed in these circulars, including:
- Audit. It is unclear who should be considered as an auditor with the relevant experience and capability to conduct an audit on crypto-assets. Currently, there is no single uniform auditing standard relating to the audit and valuation of crypto-assets, and thus it is difficult to assess who may have such experience or capability. Nonetheless, this may require a global consensus before it can be resolved locally by the SFC.
- Tax. It is unclear how crypto-assets (especially Non-SF Cryptos) will be treated for tax purposes. Globally, there are only a few regulators that have issued guidance on the taxation of crypto-related assets (e.g., the Tax and Duty Manual on taxation of cryptocurrency transactions published by the Irish Tax and Customs). Although it is expected that certain legislation or guidance may be issued in the future to align the tax treatment of transactions relating to crypto-assets with transactions similar in nature and characteristics, a lengthy dialogue between the regulators globally is expected to reach a general consensus on tax treatment and to cover the automatic exchange of information relating to crypto-asset accounts.