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Hong Kong’s Securities and Futures Commission (SFC) has recently announced two key initiatives: 

These initiatives are part of the SFC’s “ASPIRe” roadmap to develop Hong Kong’s VA ecosystem. This article will discuss the key regulatory hurdles for licensed VATPs offering staking services and considerations for managers participating in staking for their SFC-authorised funds. 

Staking 

Staking is an arrangement of committing or locking VAs to participate in a blockchain protocol’s validation process based on a proof-of-stake consensus mechanism. This participation generates returns that are distributed to the participants. It requires an operator (commonly known as a “validator”) of one or more nodes to participate in the blockchain protocol and validate the process based on a proof-of-stake consensus mechanism. 

There are different staking models. Typically, participants need to delegate their VAs to a staking pool to earn staking rewards, and in some cases, deposit their VAs onto a platform of the staking service providers, who may in return, pay the respective staking rewards to each participant after a period of time. The SFC has viewed this staking arrangement as a collective investment scheme (CIS) which if offered to the public in Hong Kong, will require prior authorisation from the SFC (see SFC’s Statement on virtual asset arrangements claiming to offer returns to investors dated 13 December 2022). Where the staking arrangement constitutes a CIS, the operator of the staking arrangement will be dealing in securities and thus will require an SFC licence for providing the staking services as a business in Hong Kong. 

Key regulatory hurdles for licensed VATPs offering staking services 

Licensed VATPs in Hong Kong are prohibited from using their client VAs to generate returns for the clients or other parties (Restriction) under Guidelines for Virtual Asset Trading Platform Operators. To be able to offer staking services, licensed VATPs must first apply to the SFC to remove the Restriction from their licences. 

When removing the Restriction, the SFC will impose additional terms and conditions for providing staking services (Staking T&C) on the VATP licences. That means, licensed VATPs need to establish additional infrastructure to comply with the Staking T&C. The key requirements under the Staking T&C include: 

  • Service construct: Licensed VATPs can only provide staking services for their own clients. They must maintain full controls and possession of the client VAs throughout the staking process. Third-party custody is not allowed. 
  • Blockchain protocol: Licensed VATPs must designate their token admission and review committee to select and continuously review the blockchain protocols of the staking services. Their risk controls must cover the specific risks of the selected blockchain protocol. 
  • Validator operations: Licensed VATPs must thoroughly select and evaluate validators based on criteria such as hardware, software, smart contract audits, supported blockchain protocols, validator experience, and security controls, and with due diligence. They must enter into formal agreements with the validators and monitor the validators’ chain status, performance, and financial standing on an on-going basis. 
  • Client documentation and disclosures: Staking services must be provided in accordance with client standing authority or one-off written direction, with clear disclosures about the VAs, operational rules, participation requirements, returns, fees and compensation to their clients. Clients who are not institutional professional investors or qualified corporate professional investor must provide written acknowledgment of the risks. 
  • Record-keeping: Licensed VATPs must retain records relating to the provision of staking services (including details of staked client VAs, validators, and the selection of blockchain protocols) for at least seven years. It will be important to ensure smooth and timely access to the required data from the selected validators. 
  • Compliance and SFC reporting: Licensed VATPs must have appropriate policies and procedures, internal controls and risk management measures as required under the Staking T&C. They are required to notify the SFC in writing before adding new blockchain protocol for staking services to professional investors or terminate such services, as well as report any material non-compliance with the Staking T&C and provide information as requested by the SFC. 

Considerations for managers participating in staking 

Custody arrangement 

Managers can only use staking services from licensed VATPs or Hong Kong authorised institutions (i.e. banks) for their SFC-authorised funds. Whilst licensed VATPs can provide sub-custody services for SFC-authorised VA funds, managers need to carefully consider the entire staking process (including the custody arrangements and validators selected), to ensure the staking aligns with their fund’s offering documents. 

Slashing risk and compensation 

“Slashing” refers to abnormal validator behaviour that negatively impacts the staked VAs, like downtime or inactivity. Although licensed VATPs are required to have procedures to respond to slashing events, managers need to ensure their SFC-authorized funds participating in staking are properly compensated for any losses from slashing events. Disclosure on slashing risk may be needed 

Prior consultation with the SFC 

The SFC’s requirements regarding staking and VA exposure do not apply to recognized jurisdiction schemes (e.g. UCITS funds) and mutual recognition of funds arrangements. These non-Hong Kong schemes must follow the requirements of their domicile, which may have different VA-related requirements and exposure limits. 

The SFC’s VA initiatives appear to target Hong Kong domiciled funds, such as Hong Kong Open-ended Fund Companies. Managers of these funds must consult the SFC or obtain approval from the SFC before their SFC-authorised VA funds can engage in staking. 

WRITTEN BY

For further information, please contact:

Isabella Wong – Deacons,
isabellahm.wong@deacons.com

Isabella Wong – Deacons

Isabella Wong - Deacons. Isabella has extensive experience servicing financial institutions on legal and regulatory matters. As a former regulator, Isabella gained hands-on experience in dealing with SFC regulatory matters (covering licensing and compliance aspects) for asset managers, investment banks, dark/liquidity-pool operators, sponsors and brokers etc., alongside participating in policy drafting and consultation works in relation to new regulatory regimes.Isabella also worked in a global asset manager and counseled its investment management and funds distribution businesses in the APAC (ex-Japan) regions. At the beginning of her legal career, Isabella served an international law firm as a capital market lawyer.

Isabella has extensive experience servicing financial institutions on legal and regulatory matters. As a former regulator, Isabella gained hands-on experience in dealing with SFC regulatory matters (covering licensing and compliance aspects) for asset managers, investment banks, dark/liquidity-pool operators, sponsors and brokers etc., alongside participating in policy drafting and consultation works in relation to new regulatory regimes.Isabella also worked in a global asset manager and counseled its investment management and funds distribution businesses in the APAC (ex-Japan) regions. At the beginning of her legal career, Isabella served an international law firm as a capital market lawyer.

Highlights

  • Helped financial institutions from different jurisdictions structure and establish business oper-ations in Hong Kong (including conducting gap analysis, advising on set-up plan and handling li-censing and registrations etc.) and prepared their compliance infrastructure documents and services-level agreements.
  • Counseled financial institutions on implementation of regulatory changes, launch of new busi-ness initiatives and revamp of business operations.
  • Acted for various US/UK head-quartered asset management groups and PRC investment banking group in completing mergers and acquisitions involving regulated financial business in Hong Kong, including conducting regulatory due diligence, advising on legal and regulatory steps for changes of ownership and migration of business, preparing implementation docu-mentation as well as handling the relevant regulatory filings/applications.
  • Assisted clients with fintech related and tokenization projects, including but not limited to:-
    • Advising a renowned cryptocurrency exchange and custodian on a tokenization project to launch of the world’s first regulated stablecoin in Hong Kong.
    • Advising a world-class European based clearing house on Hong Kong regulatory implica-tions in connection with its plans to establish a post-trade services platform relating to over-the-counter derivative transactions.
    • Advising a major global service platform provider on regulatory issues in connection with its fintech operations and proposed offering of robo-advisory services.

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