Hong Kong: A new regulatory approach for cryptocurrencies
Since the creation of bitcoin in 2008, there has been a surge of interest in cryptocurrencies and other digital tokens. This has opened up a new promising market for investors and businesses; however, shocking volatility in market prices and a litany of major cybersecurity incidents on cryptocurrency exchanges have aroused concern from regulators across the world. Hong Kong's Securities and Futures Commission ('the SFC') is one of many regulatory authorities now looking to regulate digital assets. In this article, Ben Yates and Rico Chan of Jingtian & Gongcheng discuss the SFC's approach to regulation and what it may mean for the future of the sector.
The problem of authority
A key challenge for the SFC is that where cryptocurrencies and other digital tokens cannot be classified as 'securities' or 'futures contracts' under the Securities and Futures Ordinance ('the Ordinance'), the SFC does not, on the face of it, have the authority to regulate such products or their related activities. Other regulators around the world are facing similar difficulties.
Despite this obstacle, the SFC has recently made several moves towards regulating activities surrounding digital tokens, issuing a series of policy statements and circulars relating to digital tokens and related investment products. In these documents, the SFC has revealed an intention to interpret and apply existing laws broadly in an effort to bring virtual asset portfolios managers, fund distributors, digital token exchanges, along with those involved in offering 'security tokens' within the ambit of its authority.
Virtual asset portfolio managers and fund distributors
The management of funds solely investing in virtual assets which do not constitute 'securities' or 'futures contracts' does not amount to a 'regulated activity' under the the Ordinance. However, the SFC has found a way to regulate these fund managers. In a policy statement1 and circular2, both published on 1 November 2018, the SFC indicated that where virtual asset fund managers distribute the funds in Hong Kong, they will typically require a 'type 1' licence or registration (i.e. dealing in securities) on the basis that:
- such funds constitute 'collective investment schemes' even if the underlying assets do not constitute securities or futures contracts; and
- the act of distribution of interests in a collective investment scheme in Hong Kong falls within the SFC's purview.
The policy statement goes on to provide that new licensing conditions will be imposed on these fund managers (in addition to other requirements applicable to them as fund distributors, see below).
As for firms already licensed for 'type 9' regulated activity (i.e. asset management) for the management of portfolios of securities, futures contracts, or both, if they also manage portfolios which invest solely or partially in virtual assets that do not constitute securities or futures contracts (subject to a 10% gross asset value de minimis threshold, discussed below) such management will also be subject to SFC oversight through the imposition of licensing conditions. In other words, since such firms are already licensed and regulated, the SFC can go further and apply new licensing requirements addressing their management of virtual asset portfolios.
The new standard licensing conditions3 applicable in the above cases and adapted from those already applicable to fund managers carrying out regulated activities are as follows:
- Selling restrictions: only professional investors as defined under the Ordinance may invest in these portfolios, and all associated risks should be clearly disclosed to potential investors and distributors.
- Custody: the portfolio managers should assess and select the most appropriate custodial arrangement, e.g. self-custody, engaging a third-party custodian, or an exchange. They should consider the pros and cons of holding cryptocurrencies at different host locations by way of 'hot wallets,' 'cold wallets' and 'deep cold wallets' with reference to the accessibility of the assets and the security of the custodial facility.
- Valuation: the portfolio managers should carefully select valuation principles, methodologies, models, and policies which are in the best interests of the investors and should be properly disclosed to investors.
- Risk management: the portfolio managers should set appropriate limits on investments in relation to each product and market in which the portfolios invest, and carry out periodic stress testing on these portfolios. They should also implement procedures to assess the reliability and integrity of cryptocurrency exchanges before dealing with them by considering, for example, the legal and regulatory status of the exchanges and the cybersecurity risk management measures adopted by them.
- Audit: an independent auditor should be appointed to audit the financial statements of the funds.
- Capital requirement: if virtual assets which do not constitute securities or futures contracts are held in the portfolios under their management, a required liquid capital of not less than HK $3 million (approx. €342,000) should be maintained.
The above conditions do not apply to portfolio managers who:
- mainly invest in securities and/or futures contracts; but
- intend to invest less than 10% of the gross asset value of the portfolio in virtual assets.
As mentioned above, distributors of virtual asset funds will normally require a type 1 licence or registration (i.e. dealing in securities). Accordingly, as confirmed in the SFC circular, they will need to comply with the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission4 ('the Code of Conduct.') This applies to those distributing virtual asset funds in Hong Kong, whether or not those funds have been authorised by the SFC.
Where virtual asset funds have not been authorised by the SFC, more stringent requirements are imposed on fund distributors (subject to a 10% gross asset value de minimis threshold). For example, their products may only target professional investors as defined under the Ordinance. Licensed fund distributors should conduct a concentration assessment for their clients to ensure that the investment amount is reasonable in taking into account their net worth. Proper due diligence should be conducted on the funds, their fund managers, and the parties providing trading and custodial services to the funds. Further, prominent warnings covering, among other things, price volatility, potential price manipulation and cybersecurity risks, should be given.
In summary, the SFC has brought both the management and the distribution of virtual asset funds largely within its remit, even where the underlying assets are not securities or futures contracts, using two methods:
- applying existing rules applicable to collective investment schemes to virtual asset funds; and
- piggy-backing on existing licensing requirements for any securities management activities carried out by the same firm.
At this stage, the SFC has only set out a conceptual framework5 for potential regulation of virtual asset trading platforms, commonly known as cryptocurrency exchanges. Under this framework, the SFC adopts an 'opt-in' approach whereby cryptocurrency exchanges which voluntarily commit to adhering to the standards proposed by the SFC will be placed in a 'sandbox.' To qualify, the applicant should operate an online trading platform in Hong Kong and offer trading in at least one virtual asset which falls under the definition of a security on its platform (otherwise, the platform will not fall within the SFC's jurisdiction).
The intention behind this policy is for the SFC to explore whether it is appropriate to regulate any of these platforms. If the SFC concludes that it is, it intends to grant licences to qualifying exchanges.
The licensed exchanges will then be subject to restrictions based on certain principles. One of the principles is that all trading activities on and off the platform must be carried out under a single legal entity licensed by the SFC. Further, similar to those restrictions imposed on licensed virtual asset portfolio managers and fund distributors, licensed exchanges will only be able to provide their services to professional investors as defined under the Ordinance. In addition, initial coin offering ('ICO') tokens may only be listed on the platform one year after the completion of the ICO, or when the ICO project begins to make a profit (whichever is earlier). Trading activities are also restricted, for example, a transaction can only be carried out for clients who have sufficient 'fiat' currency or cryptocurrency deposits in their accounts on the platform, and no trading of virtual assets classified as futures contracts or other derivatives is allowed.
In accordance with these principles, the SFC may impose certain financial and insurance requirements on platform operators as conditions for the grant of a licence. For example, depending on the circumstances, licensed exchanges may be required to maintain a reserve equivalent to 12 months of operating expenses, and to take out an insurance policy for risks associated with the custody of cryptocurrencies. They should also conduct a knowledge assessment of their clients before providing services, and disclose to their clients the nature of the investments, along with risks associated with trading cryptocurrencies and using their services. They should publish the trading rules on their websites, and adopt appropriate measures to prevent market manipulation and money laundering. In addition, they will be obliged to submit certain information to the SFC on an ongoing basis, such as any changes in the scope of their services and the details of any new virtual assets to be traded on the exchange.
The SFC describes its proposed framework as merely 'exploratory,' and it is far from clear whether it will lead to a successful licensing regime. Unsurprisingly, given the significant compliance costs and stringent restrictions on the provision of services (in particular, the prohibition on the provision of services to the members of public other than professional investors, and the limitation on trading activities), it seems that the sandbox regime is unappealing to the majority of cryptocurrency exchange operators. Exchanges operating in Hong Kong, at the time of publication, bear little resemblance to the licensed exchanges described in the framework, and so far there are few indications of any race to become the first licensed exchange.
Security token offerings
As concerns have grown over the risks and regulatory uncertainties surrounding ICOs, the concept of a safe, clearly regulated security token offering ('STO') has emerged. Under an STO, the offerings are structured in a way that the digital tokens being offered will be securities under the relevant regulations. On 28 March 2019, the SFC published a policy statement6 setting out regulatory requirements with which the intermediaries marketing and distributing security tokens should comply.
The policy statement confirms that those marketing and distributing security tokens must be licensed or registered for type 1 regulated activity (i.e. dealing in securities) under the the Ordinance, failing which, disciplinary action and criminal prosecution may ensue. In addition to the Code of Conduct, those intermediaries also need to satisfy requirements similar to those applicable to virtual asset fund managers and distributors, including that:
- security tokens should only be offered to professional investors;
- proper due diligence should be conducted against the security tokens to be offered. This should include the background and financial soundness of the management, development team and issuer, and the rights attached to the assets backing the tokens; and
- the intermediaries should ensure that the information provided for clients is accurate, presented in a clear and easily comprehensible manner, and includes prominent warning statements.
While tokenisation of a wide range of assets is being energetically explored in many business sectors, the appetite for tokenised securities among professional investors is, at present, uncertain. Given the significant compliance burden, STOs are a very different proposition from those ICOs which purport not to be securities offerings, for which the major attraction is the ability to rapidly and cheaply obtain funding for early-stage projects.
Digital tokens can take many forms and fulfil a variety of functions, many of which defy classification within existing legal and regulatory frameworks. The SFC's new regulatory approach is inevitably constrained by these existing frameworks and by the limited ambit of its authority. The SFC's recent efforts to control activities relating to the trade and management of such tokens may succeed in limiting the risks facing the investing public; however, the long-term view for the SFC and other regulators remains unclear. Direct regulation of non-security tokens is not possible under the Ordinance or any other existing Hong Kong legislation, and even if legislative changes are made, there remain practical difficulties of enforcing restrictions and prohibitions across borders.
There is also a more fundamental problem facing regulators, which is disintermediation. One of the goals behind the creation of cryptocurrencies, such as Bitcoin, was to remove intermediaries from the picture. The 2008 Bitcoin white paper, entitled 'Bitcoin: A Peer-to-Peer Electronic Cash System,' described the technology as a system which 'would allow payments to be sent directly from one party to another without going through a financial institution.' Despite this stated goal, during the past decade, demand has led to the creation of numerous intermediaries in the virtual currency sector including, most notably, cryptocurrency exchanges. Unsurprisingly, regulators have focused their attention on those intermediaries, however, as regulations tighten, blockchain technology (underpinned by a largely free and open internet) continues to develop, inching closer to the goal of disintermediation. For example, decentralised cryptocurrency exchanges, which allow users to trade peer-to-peer without relying on a third-party service to manage the exchange or hold customers' funds, are rapidly growing in popularity, posing a particular challenge for regulators such as the SFC.
In the short term, regulatory efforts are likely to continue in the same way, seeking to apply existing legislation to new kinds of digital assets by whatever means available. In the medium term, Hong Kong may go a step further and introduce new regulations tailored for digital asset classes, as is occurring in some forward-looking jurisdictions. In the long run, however, it is unclear how successful regulation will be in controlling activities surrounding the trade in digital tokens, when the underlying framework of the internet permits the largely free flow of information (including blockchain-based digital tokens) across borders and peer-to-peer.
The information contained in this article is provided as general information only. It is not a complete statement of the law or intended to be relied upon or to be a substitute for legal advice in relation to any particular circumstances.
2. Available at: www.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=18EC77
4. Available at: www.sfc.hk/web/EN/assets/components/codes/files-current/web/codes/code-of-conduct-for-persons-licensed-by-or-registered-with-the-securities-and-futures-commission/code-of-conduct-for-persons-licensed-by-or-registered-with-the-securities-and-futures-commission.pdf