It was reported by the Financial Stability Board that crypto-assets, such as bitcoin and ether, reached an estimated total market capitalisation of US$830 billion on 8 January 2018. With the rapid growth of virtual assets around the world, there are also growing concerns about the risks associated with virtual assets. It becomes of paramount importance for regulators to look into the issues and consider how the trading of virtual assets should be, or can be, regulated.
On 2 November 2018, the Securities and Futures Commission (the “SFC”) published a statement on “regulatory framework for virtual asset portfolio managers, fund distributors and trading platform operators” (the “Statement”), which seeks to clarify how the SFC looks at certain aspects of virtual assets trading.
Given that the SFC cannot require, or grant, licences where the Securities and Futures Ordinance (the “SFO”) does not require them, it cannot regulate the management, distribution or trading of virtual assets, except to the extent that the regulatory regime can be stretched to cover such activities. The Statement cleverly stretches the regime to not only boost investor protection but also create a regulatory framework designed to encourage reputable providers of virtual asset products and services to operate in Hong Kong.
So, what are the key messages from the Statement? They are as follows:
Regulatory standards for virtual asset portfolio managers and fund distributors
Portfolios comprising solely virtual assets which are not “securities” or “futures contracts” (“non-SF virtual assets”)
- Given that type 9 (asset management) regulated activity refers only to the management of REITs or portfolios of securities or futures contracts, it is neither possible nor necessary for someone who manages only a portfolio of non-SF virtual assets to obtain a type 9 licence.
- However, a fund vehicle which invests solely in non-SF virtual assets (a “Non-SFVA Fund”) is itself a collective investment scheme, and hence interests in such a fund will fall within the definition of “securities” under the SFO. As a result, anyone who markets or distributes a Non-SFVA Fund is required to obtain a type 1 (dealing in securities) licence.
- The SFC will impose specific licensing conditions on such type 1 licensees with respect to the distribution and management of a Non-SFVA Fund, despite the fact that management of such a fund is technically outside the SFO’s regime.
Portfolios comprising solely or partially non-SF virtual assets
- Subject to the next bullet point, if an asset manager needs and has a type 9 licence because it is managing a portfolio of securities, futures contracts or both, but it also manages another portfolio that solely or partially comprises non-SF virtual assets, the SFC will impose licensing conditions on that manager with respect to its management of that portfolio (or that part of the portfolio which invests in non-SF virtual assets), despite the fact that management of such other portfolio (or part of the portfolio) is technically outside the SFO’s regime.
- Specific licensing conditions will only be imposed on a type 9 manager which manages a portfolio with (i) a stated objective to invest in virtual assets or (ii) an intention to invest 10% or more of the gross asset value of the portfolio in virtual assets.
- Furthermore, if a firm manages a fund of funds, regardless of whether each underlying fund invests solely or partially in non-SF virtual assets, the firm is required to obtain a type 9 licence. That makes sense, because a fund of funds is a fund that itself invests in other funds, which are themselves securities. However, if the firm only manages a fund that invests in virtual asset funds, the SFC will not impose any additional licensing condition on such manager.
What are the specific licensing conditions?
In broad terms, the SFC’s specific licensing conditions will impose requirements on a licensee regarding the type of investors (i.e. professional investors only), disclosures to be made, safeguarding of assets, portfolio valuation, risk management, auditors and liquid capital requirements. The SFC will decide, on a case-by-case basis, as to what conditions should be imposed on a particular licensee.
Conceptual framework for the potential regulation of virtual asset trading platform operators
- As a starting point, under the SFO, the SFC can only grant licences to someone who carries on a business in a “regulated activity” (as defined in the SFO). Therefore, only platform operators which offer trading of at least one or more virtual assets which fall within the definition of “securities” (“S-VA Platform Operators”) on their platforms fall within the SFC’s jurisdiction. S-VA Platform Operators in Hong Kong are required to obtain type 1 (dealing in securities) and type 7 (providing automated trading services) licences.
- The SFC will first focus on S-VA Platform Operators which provide trading, clearing and settlement services for virtual assets and have control over investors’ assets. It is prepared to place such operators in the SFC Regulatory Sandbox (the “Sandbox”) such that they can operate the platform in a confined regulatory environment and the SFC can also assess the appropriateness for such operators to be licensed in the long run.
- Licensing conditions will be imposed on such S-VA Platform Operators. Essentially, all virtual asset trading activities should be conducted by a single legal entity in a corporate group structure and with professional investors only. Despite the fact that activities relating to non-SF virtual assets may not be captured by the SFO, when considering the overall fitness and properness of an S-VA Platform Operator, the SFC will take into account the fact that the operator conducts such activities. There will also be restrictions on the trading of new ICO tokens and the provision of financial accommodation by the operators.
Unresolved issues
- The Statement indicates the SFC’s willingness to work with market participants to provide a clearer framework for virtual assets, but there remains the difficulty in determining whether certain virtual assets fall within the definition of “securities” and hence whether the dealing or management in or of them is caught by the SFO. When we look at the situation in the UK, in its report in October 2018, the Cryptoassets Taskforce recognises that security tokens fall within the current regulatory perimeter in the UK, but “the novel nature of some cryptoassets and the presence of new market participants may mean the regulatory perimeter is not being correctly understood. In addition, the complexity and opacity of many cryptoassets means it is difficult to determine whether they qualify as security tokens”.
- To provide further clarity on the way regulation applies to security tokens, the Financial Conduct Authority in the UK (the “FCA”) will consult on perimeter guidance by the end of 2018. The guidance will then set out the FCA’s interpretation of the current regulatory perimeter. It will be interesting to see what comes out of the FCA’s guidance and how it may be relevant to us in Hong Kong.
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