Hong Kong SFC Unveils New Regulatory Framework for Virtual Assets

On November 1 this year, the Hong Kong Securities and Futures Commission announced new regulations governing portfolio managers and distributors of virtual asset funds.

Image placeholder By Gunnar Jaerv on 2 November 2018

"The measures announced today allow us to regulate the management or distribution of virtual asset funds in one way or another so that investors' interests would be protected either at the fund management level, at the distribution level, or both," said Ashley Alder, the SFC's CEO. "We hope to encourage the responsible use of new technologies and also provide investors with more choices and better outcomes."

In the same statement, the SFC announced a framework, initially voluntary, for the potential regulation of virtual asset trading platforms. We’ll talk more about that in another post. The SFC has set up a sandbox to trial this framework.

Why were the new rules introduced?

As things stood before, funds that fell outside the legal definition of "securities" and "futures' contracts" were not subject to SFC regulation. This meant that crypto funds managed by unregulated portfolio managers also didn’t enjoy the protection of the Securities and Futures Ordinance (SFO).

While crypto funds operated under the SFC radar, investors had little guidance on portfolio management selection either.

When the SFC decided to reach out and cover crypto funds, therefore, it did so to provide regulatory clarity to both portfolio managers and institutional investors considering entering the crypto space.

The result is wide-ranging regulatory coverage that focuses on digital assets as a new area of regulation, rather than tweaking older rules on securities to fit.

Who is subject to the new regulations?

The new regulations address three types of firms. First, those managing funds which invest solely in digital assets, but which aren’t already covered by existing securities law. These will now require a license for Type 1 regulated activity, or securities trading. In other words, firms dealing solely with digital assets will be securities traders for regulatory purposes even if the assets they trade in aren’t technically securities.

Firms that manage securities or futures contracts for clients, and are already licensed for Type 9 regulated activities (asset management), for managing securities and/or futures portfolios, will also be affected. These firms will face additional licensing requirements if 10% or more of their investment is in non-securities and futures virtual assets.

Finally, persons distributing funds that invest in virtual assets in Hong Kong, to whatever degree, will also be covered.

Changes to custody of digital assets

Until now, most crypto-funds have held their assets in their own custody. Under the new rules, this is less likely to happen, as special requirements will apply where virtual assets have to be held in self-custody and the working assumption is that a custodian will be used.

The new SFC regulations require that the most appropriate custodial arrangement should be selected, but the SFC itself acknowledges that "virtual asset funds face a unique challenge due to the limited availability of qualified custodian solutions," and that "available solutions may not be totally effective."

Typically, the best solution will likely involve the selection of a trustee like Legacy Trust Company — one qualified the Trustee Ordinance to offer custody of assets, including digital assets. This offers the optimal custodian arrangement for the majority of situations.

Regulatory standards

The regulatory standards that will be applied are laid out in an appendix to the SFC's statement, "regulatory standards for licensed corporations managing virtual asset portfolios." In summary, they will require licensees to:

  • Only permit professional investors, as defined in the Securities and Futures Ordinance, to invest in any portfolio intending to invest in virtual assets, or an intention to invest 10% or more of the GAV of the portfolio in virtual assets; there’s an exception if the fund is authorised by the SFC under section 104 of the SFO
  • Clearly disclose all associated risks to potential investors and distributors, and exercise due skill, care and diligence in their selection, appointment and ongoing monitoring of custodians
  • Exercise due care in selecting valuation principles, methodologies, models and policies, and disclose these to investors
  • Perform risk management by assessing the reliability and integrity of virtual asset exchanges, set appropriate caps to limit exposure to individual virtual asset exchanges, and set appropriate limits for each product, market and counterparty — for instance, setting a cap on investments in non-liquid virtual assets or newly-launched ICO tokens
  • Appoint an independent auditor to audit the funds
  • Where they hold virtual assets that aren’t securities or futures contracts, maintain a required liquid capital of not less than HK$3m, or its variable required liquid capital, whichever is the higher.

Conclusion

Until now, investment in digital assets has largely been unregulated, despite clear risks. As regulators worldwide move to enact frameworks to manage or mitigate that risk, Hong Kong's SFC has redefined its own role, extending its reach beyond the limitations of its previous statutory authority to regulate even those digital assets that aren’t securities and futures.

For Hong Kong’s crypto-funds, this is likely to be a mixed blessing; many in the industry will benefit from added credibility and legitimacy through more effective and transparent regulation. Some crypto-funds will baulk at the likely six-to-12 month long licensing process, and instead either withdraw from Hong Kong, or seek to move their operations under the umbrella of a licensed entity. However, many licensed entities are unwilling to engage with the digital assets market, meaning the likely effect will be a reduction in the number of crypto funds as well as a pivot to higher commitment to quality.

Disclaimer:

The article and the statements contained herein are for general, educational and reference purposes only and do not necessarily reflect those of Legacy Trust Company, its subsidiaries or its affiliates. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. This article and views herein do not constitute a financial, investment, tax, legal, accounting or other professional advice on any matter, nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Legacy Trust Company assumes no liability whatsoever for any action taken in reliance on the information contained herein, or for direct or indirect damages.

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