Hong Kong’s Fintech Week 2022 began with a crypto-infused bang with keynote speeches from the Government and financial regulators embracing the financial innovation made possible by virtual assets (VAs). Recognising that VAs are here to stay, Hong Kong has proposed to recalibrate the existing legal and regulatory regimes, with a focus on enabling greater access by retail investors to VA-related products and services while mitigating attendant risk. We also anticipate developments in the near future around the property rights of tokenised assets and stablecoins.
A lot of the detail can be found in the policy statement issued by the Financial Services and the Treasury Bureau yesterday, as well as the keynote speech by Julia Leung of the Securities and Futures Commission (SFC). Hong Kong will continue to adopt the “same activity, same risks, same regulation” principle, and will put in place the necessary guardrails to ensure the continued innovation of VAs in a sustainable manner.
Five key takeaways from Day One of Fintech Week
The following are five key takeaways from Day One of Fintech Week that will be of relevance to a range of market participants, including banks, broker-dealers, fund managers, VA exchanges and investors:
- The SFC has issued a circular setting out guidance on the authorisation requirements for VA futures exchange-traded funds (VA Futures ETFs);
- The SFC is prepared to move away from its current approach of classifying all tokenised securities as “complex products”, and will issue further guidance on security token offerings (STOs), including a proposed modified security token regime;
- The SFC will consult on the more detailed requirements for the new virtual asset service provider (VASP) regime, including whether the professional investor (PI)-only requirement should be relaxed. This follows the introduction of the new licensing regime for VASPs via legislative amendments which are currently being considered by the Legislative Council (LegCo) (see our June 2022 briefing and our June 2021 briefing);
- The Hong Kong Monetary Authority (HKMA) will publish its consultation outcome following its discussion paper on crypto-assets and stablecoins (see our January 2022 briefing); and
- The Government and regulators are engaging in a number of pilot projects in relation to VAs, including (i) issuance of non-fungible tokens (NFTs) for Hong Kong Fintech Week; (ii) Green bond tokenisation; and (iii) e-HKD. The HKMA has also announced a number of new initiatives to spur fintech development in Hong Kong.
Guardrails for retail access to VA products
Historically, the SFC has generally adopted a PI-only requirement for crypto asset customers. These include clients of SFC-licensed trading platforms, STOs and VA funds. However, as the crypto ecosystem has grown exponentially and somewhat matured since the SFC first introduced its regulatory framework for VAs in 2018, the SFC has announced that now is the opportune time to review the PI-only requirement.
Guidance on VA Futures ETFs
When the SFC announced its regulatory approach for VAs in November 2018, it noted the significant risks associated with investing in VAs. As such, the SFC announced that only PIs should be allowed to invest in VA funds that are offered in Hong Kong. However, the VA landscape has evolved rapidly and a broad range of investment products providing exposure to VAs are now available to both retail and professional investors in other jurisdictions and have become increasingly popular.
The increased demand for VA products led to the SFC and the HKMA issuing a joint circular on intermediaries’ virtual asset-related activities (with appendices) (Joint Circular) in January 2022. This clarified that SFC-licensed and registered intermediaries could offer to retail investors in Hong Kong trading of a limited suite of VA-related derivative products and exchange-traded VA derivative funds that are traded on regulated exchanges specified by the SFC and, in the case of exchange-traded VA derivative funds, authorised or approved for offering to retail investors by the respective regulator in a designated jurisdiction (see our March 2022 briefing).
The SFC issued a circular (VA Futures ETFs Circular) yesterday which sets out the SFC’s requirements for authorising VA Futures ETFs for public offering in Hong Kong. In particular, VA Futures ETFs seeking SFC authorisation for public offering in Hong Kong should meet the following requirements:
Firstly – the applicable requirements in the Overarching Principles Section and the Code on Unit Trusts and Mutual Funds (UT Code) in the SFC Handbook for Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted Structured Investment Products; and
Secondly – the additional requirements set out in the VA Futures ETFs Circular:
- Management companies – They are required to (i) have a good track record of regulatory compliance; and (ii) demonstrate at least 3 years’ proven track record in managing ETFs. The relevant experience in managing the same or similar types of products from the group of companies to which the management company belongs will be taken into account;
- Eligible futures – Only VA futures traded on conventional regulated futures exchanges are allowed, subject to the management company demonstrating that (i) the relevant VA futures have adequate liquidity for the operation of the VA Futures ETFs; and (ii) the roll costs of the relevant VA futures contracts are manageable and how such roll costs will be managed. Initially, only Bitcoin futures and Ether futures traded on Chicago Mercantile Exchange are allowed. The SFC will keep this in view and consider expanding the scope of eligible VA futures markets as appropriate;
- Investment strategy – An active investment strategy should be adopted to allow flexibility in portfolio composition (eg, diversification of futures positions with multiple expiry dates), rolling strategy and handling of any market disruption events. The net derivative exposure (as defined under the UT Code) of a VA Futures ETF shall not exceed 100% of the ETF’s total net asset value;
- Disclosure – The product key facts statement of a VA Futures ETF shall contain upfront disclosure of the investment objective and key risks associated with investment in VA futures such as (i) potentially large roll costs of VA futures; and (ii) operational risks related to VA futures (such as margin risk and risk associated with mandatory measures imposed by relevant parties);
- Distribution – As VA Futures ETFs are derivative products and VA-related products, intermediaries are subject to the applicable requirements under the Code of Conduct for Persons Licensed by or Registered with the SFC (Code of Conduct) and related guidelines, including the Joint Circular when they provide services to clients with respect to VA Futures ETFs. For the avoidance of doubt, intermediaries should comply with the existing conduct requirements for derivative products (paragraphs 5.1A and 5.3 of the Code of Conduct) and must also comply with the VA-knowledge test requirement;
- Investor education – Management companies of VA Futures ETFs are expected to carry out extensive investor education before launching the VA Futures ETFs in Hong Kong.
The SFC may consider introducing additional requirements or conditions as deemed necessary or appropriate.
The authorisation regime is in line with the global trend of VA ETFs being made available to investors in other jurisdictions, including Australia, Brazil, Canada, Germany, Jersey, Liechtenstein, Singapore, Sweden, Switzerland and the United States. Crucially, the SFC is of the view that investment products that invest directly in spot VAs may continue to present investor protection issues, and therefore these are not currently permitted in Hong Kong. The SFC will keep in view and closely monitor the development of the VA market and its regulatory landscape regarding the appropriateness of authorisation of ETFs that invest directly in spot VAs.
Guidance on STOs
In March 2019, the SFC issued a statement on security token offerings, which stated that tokenised securities would be regarded as “complex products” and therefore additional investor protection measures also apply to intermediaries. The statement also confirmed that security tokens should only be offered to PIs.
The SFC has now changed its stance, taking the preliminary view that tokenised securities, as digital representations of traditional securities on a blockchain, should be treated in a similar way as existing financial instruments. In substance, they have similar terms, features and risks as traditional securities, so it does not seem appropriate to classify them as “complex products” merely because they are issued or traded on a blockchain.
- Adopting this approach, a tokenised plain-vanilla bond would be classified as a “non-complex product”, and therefore the firms distributing it would be subject only to the existing requirements for the distribution of conventional securities, consistent with the SFC’s “same business, same risk, same rules” approach.
- Tokens with novel and complicated features may however still be classified as “complex products”. For example, fractionalised asset-backed tokens or tokens representing an income stream from projects will, depending on their terms and features, be classified as a “complex product” and the licensed firms distributing them would need to ensure suitability and provide minimum information and warning statements. The overarching “PI-only” restriction would also apply.
- As an additional measure for all security tokens, the SFC expects licensed firms to perform reasonable due diligence and conduct smart contract audits before the tokens are distributed to clients. Consequently, the SFC will also revisit the requirements for listing security tokens on licensed VA exchanges and see if any modifications should be made. The SFC will publish a circular to set out the modified security token regime in detail when ready.
Consultation for new VASP regime
The LegCo brief which set out an overview of the new VASP licensing regime mentioned that to further promote investor protection, the regime will at the initial stage stipulate that VASP licensees can only provide services to PIs and this restriction may be imposed by the SFC as a licence condition. However, this PI-restriction does not currently form part of the draft legislation, ie, the Anti-Money Laundering and Counter-terrorist Financing (Amendment) Bill 2022 (AMLO Amendment Bill).
The AMLO Amendment Bill is being studied by the Bills Committee and the SFC observed that a lot of feedback was received from LegCo members and the public on the PI-only restriction, noting that this requirement is not “hardwired” into the Bill.
In light of the feedback received, upon the LegCo’s passage of the AMLO Amendment Bill, the SFC will conduct a public consultation on the more detailed requirements for the new VASP regime. They will also consult on whether the PI-only restriction should be relaxed and, if so, what the governance procedures and listing criteria for the VASP to admit tokens for secondary market trading by retail investors should be. The SFC’s Fintech unit is now intensively soft consulting the industry and stakeholders of this and other issues, before finalising the proposals for public consultation.
Property rights of tokenised assets
The Government recognises that VAs have unique characteristics from traditional assets, and their features may not fit squarely into the current private property law categories or definitions in Hong Kong.
To facilitate adoption and enhance investor protection, the Government is open to future review on property rights for tokenised assets and the legality of smart contracts, so as to provide a solid legal foundation for their development.
Regulatory approach towards payment-related stablecoins
In its policy statement, the Government acknowledged that, with the lessons learned from the crypto winter, there is international consensus to put in place appropriate regulations on aspects such as governance, stabilisation and redemption mechanisms of stablecoins.
Earlier this year, the HKMA issued a discussion paper on crypto-assets and stablecoins to seek feedback on putting in place a risk-based regime for regulating activities relating to payment-related stablecoins. The consultation outcome and next steps will be announced in due course.
Other developments
Finally, the Hong Kong government and regulators are exploring various initiatives and engaging in pilot projects to test the technological benefits brought by VAs and their further applications in the financial market. The following are some examples:
- NFT issuance for Hong Kong Fintech Week: The NFT serves as proof of attendance for the attendees of the event. The Government sees the NFT issuance as a proof-of-concept project to engage the fintech and Web3 community to demonstrate its commitment to innovation;
- Green bond tokenisation: Following the successful completion of Project Genesis by the HKMA and the Bank for International Settlements Innovation Hub to concept-test the use of distributed ledger technology (DLT) for streamlining green bond retail issuance, the HKMA is working on a pilot project to tokenise Government green bond issuance for subscription by institutional investors. The objective is to test the use of DLT throughout the bond lifecycle (covering issuance, settlement, asset servicing, secondary trading and redemption) to serve as a guide for similar future issuances by market participants. Further details will be announced separately;
- e-HKD: After publishing papers in October 2021 and April 2022 to invite feedback on the technical aspects and policy and design issues for the potential issuance of Hong Kong’s retail central bank digital currency (ie, the e-HKD), the HKMA released a position paper in September 2022 to set out its policy stance and next steps in relation to the e-HKD. Next steps include laying the technology and legal foundations for the implementation of the e-HKD and taking deep dives into use cases as well as application, implementation and design issues;
- Mule account network analytics: The HKMA will apply an anti-money laundering suptech tool, using granular data from multiple banks for the first time, to test how network analysis on mule accounts can assist in understanding how and where risks move across the banking sector, in order to prevent bank accounts from being abused for fraud and protect customers from financial crime losses;
- Other initiatives include the recent launch of the Commercial Data Interchange, which has enabled consent-based data sharing to facilitate loan approvals during its pilot (with a proof-of-concept underway to study the feasibility of using digital corporate identity to support the consent process), and the completion of two pilot trials under the Greater Bay Area Fintech Pilot Trial Facility (involving cross-boundary account top-up and cross-border e-appointment for account opening).
For further information, please contact:
Hannah Cassidy, Herbert Smith Freehills
