Hong Kong Implements a Comprehensive Regime on the Regulation of Virtual Assets

Executive summary

Licensed intermediaries are permitted to provide a range of services related to virtual assets (VAs) to professional investors, subject to complying with a suite of investor safeguards. The safeguards include partnering only with SFC-licensed VA trading platforms when providing VA dealing services and conducting client knowledge assessments before distributing any VA-related products. Retail investors are excluded from the regime except in relation to the distribution of a limited category of exchange-traded VA derivative products and funds.

This bulletin focuses on the new SFC requirements.

Introduction

On 28 January 2022 Hong Kong financial regulators issued the following guidance to regulate the VA space:

1. SFC and HKMA - Joint Circular on Intermediaries’ Virtual Asset-related Activities (Joint Circular);

2. HKMA - Regulatory Approaches to Authorized Institutions’ Interface with Virtual Assets and Virtual Asset Service Providers; and

3. Insurance Authority - Regulatory Approaches of the Insurance Authority in Relation to Virtual Assets and Virtual Asset Service Providers.   

This represents a comprehensive policy update to regulating VAs and VA-related activities and builds upon the following guidance issued in recent years:

• November 2018 statement on the regulatory framework for VA portfolio managers, fund distributors and trading platform operators (see our previous briefing for more detail):

  • Licensed VA portfolio managers are to ensure only professional investors invest in their VA funds. ‘Recommendation/ solicitation’ suitability requirements and ‘complex product’ suitability requirements will likely apply other than to a category of professional investors (being institutional professional investors and qualified corporate professional investors (Exempt PIs));

  • on 4 October 2019 the SFC published the Pro Forma Terms and Conditions for VA portfolio managers (RA9 T&Cs);   

• the SFC position paper dated 6 November 2019 on the regulation of VA trading platforms. Platforms which offer trading of at least one VA that constitutes a ‘security’ may opt-in to a licensing regime. They should only offer services to professional investors and assess the client’s VA knowledge (other than Exempt PIs); and

• the Financial Services and the Treasury Bureau’s May 2021 consultation conclusions to introduce a new compulsory licensing regime for VA exchanges (largely covering exchange function crypto-assets such as Bitcoin as well as stablecoins). The regime will be housed in the anti-money laundering legislation and will require VA exchanges to offer services to professional investors only. See our previous briefing for more detail.

The November 2018 circular on distribution of VA funds has been superseded by the new guidance.

This briefing focuses on the Joint Circular issued in January 2022, which contains (among other things) the investor protection measures that intermediaries (i.e. licensed corporations and registered institutions) are expected to follow when providing VA-related services.

What VA and VA-related products are covered?

What is meant by a ‘crypto-asset’ or a ‘virtual asset’ can be confusing. The Bank for International Settlements has issued the following crypto-asset classification which was recently followed by the HKMA:

This classification of crypto-assets excludes digital representations of fiat currencies issued by central banks (commonly known as CBDCs).

The new regime relates to all crypto-assets in the above classification (albeit only peripherally to utility tokens).

Joint Circular

‘VA’ is defined broadly under the Joint Circular to catch any digital representation of value (except CBDCs) which may be in the form of digital tokens (e.g. utility tokens, stablecoins or security- or asset-backed tokens), crypto assets or other assets of the same nature, irrespective of whether they amount to ‘securities’ or ‘futures contracts’ under the Securities and Futures Ordinance. VA therefore covers a wider range of crypto assets than security tokens, and includes crypto-coins such as Bitcoin.

‘VA-related products’ refer to investment products which have a principal investment objective to invest in VAs, derive their value principally from the value and characteristics of VAs, or track / replicate the investment results or returns which closely match or correspond to VAs.

The Joint Circular’s requirements broadly can be categorised as follows:

1. Where the intermediary provides VA dealing services

An intermediary may provide VA dealing services if:

1. the intermediary is licensed for Type 1 regulated activity;

2. it partners only with SFC-licensed VA trading platforms for the dealing, either by way of introducing clients to the platforms for the client’s direct trading or the intermediary establishing an omnibus account with the platforms and trading for the clients. As at today, there is only one such platform although more are expected to be licensed;

3. the client is a professional investor. This tracks the professional investor requirement which applies to SFC-licensed VA trading platforms;

4. it complies with certain conduct requirements such as only allowing clients to withdraw or deposit fiat currencies – see paragraphs 19 to 21 of the Joint Circular; and

5. in particular, under an omnibus arrangement, the licensing conditions in Appendix 6 will apply, similar to those that apply to SFC-licensed VA trading platforms. Save for Exempt PIs, suitability requirements will apply where there is a recommendation or solicitation, and the client’s knowledge of VAs and related risks should be prior assessed and training given if there is insufficient knowledge.

Accordingly, retail investors wishing to invest in VAs cannot do so via SFC-licensed trading platforms and intermediaries.

2. Where the intermediary distributes investment products which are VA-related products 

The Joint Circular imposes various requirements on intermediaries distributing investment products which are VA-related products depending on the nature of the product. Appendix 3 to the Joint Circular contains an illustrative flow chart.

For non-derivative VA-related products, these are ‘very likely’ complex products and the following investor safeguards would apply to their distribution irrespective of any solicitation or recommendation by the intermediary:

1. only be offered to professional investors;

2. intermediaries must conduct a VA knowledge test on the client (unless it is an Exempt PI). If assessed to have insufficient knowledge, the intermediary should only proceed if it’s in the client’s best interest and provide client training; and

3. existing requirements under the complex products regime i.e. ensuring suitability, minimum information and warning statements (unless the client is an Exempt PI).

For derivative VA-related products, the starting point is that the same requirements as for non-derivative products apply. Accordingly, they can only be offered to professional investors and the full scope of complex product requirements apply as described above. In addition, the derivative product KYC requirements under paragraphs 5.1A (knowledge assessment) and 5.3 (e.g. ensure sufficient net worth) of the Code of Conduct apply, with unauthorised VA funds having additional due diligence requirements under Appendix 4 to the Joint Circular.

Less onerous investor protection measures apply to a limited suite of derivative VA-related products which are traded on a specified exchange (being one of the 64 exchanges listed in Schedule 3 to the Securities and Futures (Financial Resources) Rules) and, additionally in the case of funds, are authorised / approved in a designated jurisdiction (being one of 12 jurisdictions listed in Appendix 2 to the Joint Circular). These products are considered complex exchange-traded derivatives under the existing complex products regime. This means that for this limited category of products:

1. the VA knowledge test and the derivative product KYC requirements apply (with certain exceptions for Exempt PIs);

2. the products may be distributed to retail investors, subject to the usual selling restrictions / offer of investments to the public regime in Hong Kong or other applicable jurisdiction; and

3. where there has been no solicitation or recommendation, intermediaries do not need to comply with the suitability requirement under the complex products regime (this operates in a similar fashion to the existing paragraph 5.5(b) Code of Conduct carve-out from the complex products suitability requirement for paragraph 5.1A(a) exchange traded derivatives).

Any distribution of a fund which is a VA-related product that is not authorised for retail distribution by the SFC is subject to product due diligence to be carried out by the intermediary over the fund manager, the fund and the fund’s counterparties. The specific product due diligence requirements are contained in Appendix 4 to the Joint Circular. 

The above means that certain derivative VA-related products traded on a specified exchange may, in certain circumstances, be available to retail investors.

3. Providing VA asset management services

A Type 9-licensed intermediary can provide VA-related fund asset management services and VA-related discretionary account management services. Those providing such services which meet the de minimis threshold (10% or more of the gross asset value of a portfolio in VAs) must comply with the existing requirements (including suitability requirements) set out in the RA9 T&Cs. Type 9 intermediaries would not be subject to these requirements if operating below the threshold. The Joint Circular clarifies that where a Type 1 (dealing in securities) intermediary is authorised by its clients to provide VA dealing services on a discretionary basis as an ancillary (i.e. wholly incidental) service, that Type 1 intermediary should invest less than 10% of the gross asset value of the client’s portfolio in VAs. 

In each case, the intermediary should allow only professional investors to invest in the fund/account.

4. Providing VA advisory services

To provide VA advisory services, intermediaries must:

1. be licensed in Type 4 (advising on securities) regulated activity (or Type 1 (dealing in securities) regulated activity where presumably the advice will be wholly incidental to the dealing);

2. offer such services only to professional investors who are existing clients;

3. comply with the conduct requirements for VA advisory services set out in Appendix 6 to the Joint Circular, such as conducting a VA knowledge test (unless the client is an Exempt PI). Where – as there usually will be – a recommendation or solicitation is made to a client, suitability requirements will apply (except where made to an Exempt PI); and

4. where it is providing advisory services in VA-related products, observe the same requirements as for the distribution of VA-related products.