by Simon Hawkins and Adrian Fong

The latest statements from the government and regulators indicate that Hong Kong is moving forward with enhancing its virtual asset regulatory and legal regime.

The Hong Kong government and the Securities and Futures Commission (SFC) announced their policy stances and further measures to support the development of virtual assets (VA) in Hong Kong at the Hong Kong Fintech Week 2022. Senior government officials and regulators expressed support for Hong Kong to continue to establish a responsible legal and regulatory framework to develop its VA industry.

The Financial Services and the Treasury Bureau (FSTB) published a policy statement recognizing that VAs were “here to stay” and would create opportunities in finance, e-commerce, Web3, and the Metaverse for Hong Kong. Consistent with the policy approach that Hong Kong’s financial services regulators previously mentioned, the government intends to adopt the “same activity, same risks, same regulation” principle to manage risks alongside innovation.

The FSTB noted the following developments showcasing Hong Kong’s readiness to calibrate its legal and regulatory regime to ensure the sustainable development of VAs:

• The forthcoming amendment to Hong Kong’s anti-money laundering laws will introduce a licensing regime for virtual asset service providers (VASPs) operating crypto exchanges in Hong Kong. The Hong Kong Legislative Council is considering the amendment bill, which is expected to come into force on March 1, 2023, with a transitional period.
• The government is open to future review of property rights for tokenized assets and the legality of smart contracts to provide a solid legal foundation for their development.
• The Hong Kong Monetary Authority’s consultation on the licensing regime for stablecoins aims to establish a risk-based regime drawing reference from relevant international standards and guidance.
• Hong Kong continues to explore pilot projects to demonstrate its willingness and commitment to financial innovation, such as by issuing non-fungible tokens, tokenizing government green bond issuances for subscription by institutional investors, and launching e-HKD, Hong Kong’s central bank digital currency.

Julia Leung, the deputy chief executive officer and executive director of intermediaries of the SFC, presented a speech titled “Embracing Innovation, Regulation and the Future of Finance.” She noted the strengthened resolve of regulators to properly regulate VA service providers in light of the recent turmoil in the markets. This resolution extends to decentralized finance (DeFi), in which regulators intend to relentlessly pursue a regulatory solution to regulating DeFi and other parts of the VA ecosystem to protect investors and market integrity.

The SFC also made additional updates on various parts of the VA legal and regulatory regime:

VA Futures ETFs

Historically, the SFC has only permitted “professional investors” (e.g., high net-worth individuals with a portfolio of at least HK$8 million (around US$1 million), corporations with portfolios of at least HK$8 million or total assets of at least HK$40 million (around US$5.16 million), or institutional investors such as licensed banks, broker-dealers, and asset managers) to invest in VA products (such as VA funds) through SFC-licensed intermediaries.

In January 2022, the SFC issued a Joint Circular with the Hong Kong Monetary Authority (Joint Circular) which relaxed this requirement slightly. It permitted intermediaries to offer trading of VA-related derivative products, such as VA-derivative exchange-traded funds (ETFs), to retail investors in Hong Kong as long as they were authorized or approved for retail investors in designated overseas jurisdictions. The SFC requires intermediaries to apply certain investor protection measures such as ensuring the customer understands the nature and risks of the product. However, the SFC did not itself authorize any VA-derivative ETFs in Hong Kong.

Now, the SFC has stated that it is prepared to accept applications for the authorization of ETFs that obtain exposure to VAs primarily through futures contracts (VA Futures ETFs) so that they can be offered to the Hong Kong retail public.

The following requirements will need to be met in order for the SFC to authorize VA Futures ETFs for public offering in Hong Kong:

• VA Futures ETFs must comply with the applicable requirements in the Overarching Principles Section (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 (SFC Handbook). These rules apply generally to funds offered to the Hong Kong public.
• The management company (or group) is required to (i) have a good track record of regulatory compliance; and (ii) demonstrate at least three years’ proven track record in managing ETFs. It should also carry out extensive investor education before launching the product.
• Only VA futures traded on conventional regulated futures exchanges are allowed. The management company must demonstrate that (i) the relevant VA futures have adequate liquidity for the operation of the VA Futures ETF, and (ii) the roll costs of the relevant VA futures contracts are manageable and how such roll costs will be managed.

Initially, this means that only Bitcoin futures and Ether futures traded on the Chicago Mercantile Exchange will be allowed, but the SFC will keep this under review.

• The management company of a VA Futures ETF is expected to adopt an active investment strategy to allow flexibility in portfolio composition (e.g., 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 the VA Futures ETF shall not exceed 100% of its total net asset value.
• 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; e.g., the potentially large roll costs of VA futures and operational risks related to VA futures (such as margin risk and risk associated with mandatory measures imposed by relevant parties).
• Distributors are expected to comply with existing obligations on the distribution of derivative and VA products as set out in the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission and the Joint Circular.

Relaxation of the Professional-Investor-Only Requirement

As noted above, the SFC requires its licensed intermediaries and VA exchanges to deal with professional investors only (except in the case of a small number of VA-related derivative products). This requirement locks out retail investors from trading spot VAs through regulated VA exchanges.

The SFC is now soft consulting the industry on whether and how the professional investor-only requirement should be relaxed. It is considering what the governance procedures and listing criteria VA exchanges should be required to implement to admit tokens for secondary market trading by retail investors.

The public consultation is expected to be released near the end of this year before the VASP licensing obligation is introduced in 2023.

Security Tokens

The SFC issued a high-level statement in 2019 setting out that security tokens should only be distributed by regulated intermediaries and offered to professional investors only.

However, the SFC recognizes that financial institutions are keen to tokenize instruments like debt securities or investment fund units.

The SFC has now stated that it believes tokenized securities (i.e., as digital representations of traditional securities on a blockchain) should be treated like existing financial instruments and therefore be subject to the same requirements as distribution of conventional securities (i.e., it should not be a “complex product” solely because it is issued or traded on a blockchain). The SFC is therefore prepared to allow retail access if proper safeguards are put in place.

In contrast, tokenized securities which are not digital representations of traditional securities on a blockchain (e.g., fractionalized asset-backed tokens or tokens representing an income stream from projects) will continue to be subject to the professional investor-only and complex product restrictions.

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.

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 further guidance on security tokens.

This article was first published as a Blog Post on Latham & Watkins Global Fintech and Digital Assets Blog. Simon Hawkins is a Partner and Adrian Fong is an Associate at Latham’s Hong Kong office.

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