Following the issuance of the circular on SFC-authorised funds with exposure to virtual assets (link) (VA Funds Circular) by the Securities and Futures Commission (SFC) in December 2023, the industry has been looking forward to seeing the first batch of exchange-traded funds (ETFs) being listed in Hong Kong which invest directly in virtual assets (VAs) tokens (such as bitcoin and ether) (Spot VA ETFs). In this article, we discuss the key issues that a fund manager should address when considering whether to set-up a Spot VA ETF in Hong Kong.
The SFC’s key concern for Spot VA ETFs focuses on the competence, availability, and readiness of the service providers to support the direct investments in VAs. Issues to consider include:
- Capability and expertise of trustee/custodian of SFC-authorised funds to discharge custodial functions in respect of VA holdings – Pursuant to the VA Funds Circular, the VA custody function of a Spot VA ETF may be delegated only to an SFC-licensed virtual asset trading platform (VATP), or an authorised financial institutions (AI) (or subsidiary of a locally incorporated AI) which meets the expected standards of VA custody issued by the Hong Kong Monetary Authority from time to time (VA Sub-Custodian).
Where the VA custody function is delegated, the top-level trustee/custodian should map out its relationship with the VA Sub-Custodian, such as the liabilities of the top-level trustee/custodian where the VA Sub-Custodian is at fault or where there is failure on the part of the SFC-authorised VATP, fee arrangement between the top-level trustee/custodian and the VA Sub-Custodian.
Managers should also conduct due diligence on the VA Sub-Custodian to ensure that security procedures are put in place for the Spot VA ETFs in relation to their VA holdings, and should monitor custodian arrangements on an ongoing basis. - Investible VA tokens – Spot VA ETFs can only invest in VA tokens that are accessible to the Hong Kong public for trading on SFC-licensed VATPs. The list of SFC-licensed VATPs is available on the SFC’s website (link). Managers should ensure that the SFC-licensed VATP(s) to be engaged is competent and ready in handling transactions of VAs on behalf of the Spot VA ETFs. Factors such as the size of market participants on the relevant SFC-licensed VATP(s), trading volume and liquidity of VAs on the relevant VATP(s) should be considered.
- Readiness of participating dealers – For Spot VA ETFs that intend to allow in-kind creation and redemption of units/shares, the managers should check with the participating dealers whether they are sufficiently experienced and are ready to perform their duties when the Spot VA ETFs are listed. For instance, the participating dealers should have sufficient operational flow and competent system design that will enable them to discharge their functions in respect of the Spot VA ETFs. They should also ensure that their SFC licence should contain applicable licensing conditions such that they comply with the “Terms and conditions for licensed corporations or registered institutions which manage portfolios that invest in virtual assets” issued by the SFC (link) in relation to their Type 1 regulated activity.
- Risks monitoring – Managers should put in appropriate measures in mitigating the key risks pertaining to investments in spot VAs, such as the potential liquidity issue arising from the developing nature of SFC-licensed VATPs; potential risk of delay in acquisition/disposal of VAs on SFC-licensed VATPs where trading volume on the VATPs is low; impact of the difference in the executable price of the spot VA on SFC-licensed VATPs and the valuation price; participating dealers’ and market makers’ ability to conduct effective arbitrage and provide liquidity. In light of the novelty of the underlying assets of the Spot VA ETFs, it is expected that specific and extensive risk disclosures are required in their offering documents.
Managers who are interested to set up Spot VA ETFs are encouraged to commence negotiation with potential service providers at an early stage to ascertain their abilities to comply with the relevant SFC requirements, and to ensure the viability of the operational model in respect of the VA holdings.
