At the start of the new year, the U.S. asset management industry welcomed the highly anticipated approval of the listing and trading of spot bitcoin exchange-traded funds (ETF) from the U.S. Securities and Exchange Commission.
Although the Securities and Futures Commission of Hong Kong (SFC) has yet to authorise investment funds that invest directly in virtual assets[1] (VA), the SFC has always recognised the rapidly evolving VA landscape and the increasing popularity and demand for investment products providing exposure to VA, including VA-related ETF. As early as October 2022, the SFC started accepting applications for ETFs that obtain exposure to VA primarily through futures contracts. As a major boost to Hong Kong’s fast-growing VA ecosystem, the SFC issued a new Circular on SFC-authorised funds with exposure to virtual assets on 22 December 2023 (Circular) (which supersedes the October 2022 version) to pave way for the authorisation of investment funds with exposure of more than 10% of their net asset value to VA, enabling retail access to funds with exposure to VA.
The Circular sets out the requirements for authorisation of funds, other than recognised jurisdiction schemes (including UCITS funds) and funds authorised under mutual recognition of funds arrangements (MRF), that may have an exposure of more than 10% of their net asset value in VA by:
(i) investing directly in the same spot VA tokens accessible to the Hong Kong public for trading on SFC-licensed virtual assets trading platforms (VATP) (i.e. direct exposure); and/or
(ii) acquiring indirect investment exposure to such VA (i.e. indirect exposure), for example, through futures traded on conventional regulated futures exchanges and other exchange-traded products (collectively, “SFC-authorised VA Funds”).
UCITS and MRF managers will need to consult the SFC separately before offering such schemes to the retail public in Hong Kong.
The SFC’s requirements under the Circular are summarised below.
What are the additional requirements on management companies?
The management company of an SFC-authorised VA Fund will need to:
(i) have a good track record of regulatory compliance;
(ii) have at least one competent staff member with relevant experience in the management of VA or related products. If the key personnel of the management company do not meet this requirement, a separate individual will need to be identified; and
(iii) be subject to the terms and conditions for licensed corporations or registered institutions which manage portfolios that invests in virtual assets imposed by the SFC’s licensing department.
What are the custodial requirements for SFC-authorised VA Funds?
The trustee/custodian of an SFC-authorised VA Fund should only delegate its VA custody function to (i) an SFC-licensed VATP, or (ii) an authorised institution which meets the expected standards of VA custody issued by the Hong Kong Monetary Authority (HKMA) from time to time (VA Sub-Custodian).
In addition, the trustee/custodian and VA Sub-Custodian must (i) hold client assets on a segregated basis (ii) store most of the VA holdings in a cold wallet (the amount and duration of VA holdings stored in the hot wallet should be minimised as much as possible, save for meeting the needs of subscriptions and redemptions) and (iii) ensure the seeds and private keys are securely stored in Hong Kong, tightly restricted to authorised personnel, sufficiently resistant to speculation and properly backed up to mitigate any single point of failure.
What are the eligible underlying VAs?
Currently, eligible underlying VAs are those VA tokens that are accessible to the retail public of Hong Kong for trading on SFC-licensed VATPs.
Are there any additional requirements on the investment strategy of an SFC-authorised VA Fund?
An SFC-authorised VA Fund may make direct and/or indirect investments in eligible VA tokens.
In addition, investments in eligible VA tokens will need to be made in accordance with the following:
(i) there should be no leveraged exposure to VA at the fund level.
(ii) if the SFC-authorised VA Fund intends to use VA futures, it should only invest in VA futures that are traded on conventional regulated futures exchanges. The management company will also need to demonstrate that the relevant VA futures have adequate liquidity and the roll costs of the relevant VA futures are manageable.
(iii) if the SFC-authorised VA Fund primarily adopts a futures-based investment strategy, an active investment strategy is expected to be adopted.
(iv) if indirect exposure to eligible VA is gained through other exchange-traded products, applicable provisions under the Code on Unit Trusts and Mutual Funds (UT Code) will need to be complied with.
Where can SFC-authorised VA Funds transact and acquire spot VA?
Transactions and acquisition of spot VA should be done through SFC-licensed VATPs, or authorised institutions (or subsidiary of a locally incorporated authorised institution) in compliance with the HKMA requirements.
Can SFC-authorised spot VA ETFs accept in kind subscriptions and redemptions?
Yes, subject to the requirements in the Circular, SFC-authorised spot VA ETFs may accept in-kind and/or in-cash subscriptions and redemptions.
How should spot VAs be valued?
When valuing spot VAs, management companies should adopt an indexing approach based on VA trade volume across major VA trading platforms.
What are the other points to note?
The management company of an SFC-authorised VA Fund should ensure that all necessary service providers are competent, available and ready to support the SFC-authorised VA Fund.
As with all SFC-authorised funds, the management company should also ensure that the offering documents of SFC-authorised VA Funds disclose the investment limits and key risks relating to the fund’s VA exposure.
Given the novelty of VAs and VA-related products, management companies should carry out investor education before launching any SFC-authorised VA Fund to ensure that investors understand the features and risks relating to such fund.
Last but not least, it is important to note that the requirements set out under the Circular are additional to the applicable requirements under the Overarching Principles Section of the SFC Handbook for Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted Structured Investment Products, the UT Code and the relevant requirements in the joint circular on intermediaries’ virtual asset-related activities.
What are the next steps for management companies wishing to offer SFC-authorised VA Funds?
As a first step, the management companies should identify at least one competent staff member with relevant experience in the managing VA or related products.
It will also be important to discuss with relevant service providers, in particular the trustee/custodian and potential VA Sub-Custodian, to put in place the relevant delegation arrangements meeting the SFC’s requirements. Internal systems and controls will also need to be enhanced, as necessary, to support the management and ongoing operation and monitoring of an SFC-authorised VA Fund.
Prior consultation and prior approval of the SFC will be required before launching an SFC-authorised VA Fund or before enabling an existing SFC-authorised fund to gain an exposure of more 10% of its net asset value in VA (whether directly or indirectly).
Although not specifically mentioned in the Circular, management companies of funds wishing to invest less than 10% of their net asset value in VA are also expected to consult the SFC prior to doing so. The SFC requirements for such funds are not detailed in the Circular, however, the SFC may impose certain requirements on a case-by-case basis.
With the issuance of the Circular, will we see the first SFC-authorised fund investing in spot VA in the next 12 months?
1 “Virtual asset” refers to any “virtual asset” as defined in section 53ZRA of the Anti-Money Laundering and Counter-Terrorist Financing Ordinance.
