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On November 1, 2018, the Securities and Futures Commission of Hong Kong (SFC) issued a statement titled "Statement on the Regulatory Framework for Virtual Asset Portfolio Managers, Fund Distributors and Platform Operators". negotiation[1] (VA Statement) and the accompanying Circular "Circular to Intermediaries – Distribution of Virtual Assets Funds"[2] (VA Distribution Circular) (collectively the VA Circulars), to announce a new regulatory approach to virtual asset activities, virtual asset portfolio managers and their distribution of virtual asset placement products in Hong Kong.
Conventional regulatory approach
Prior to the VA Circulars, the SFC regulated activities related to virtual assets only to the extent that these virtual assets (called digital representation of value, whose scope includes "cryptocurrencies", "crypto-active" or " digital tokens ") have terms: and features that meet the definitions of" securities "and / or" future contracts "within the meaning of the Securities and Futures Order (Section 571 of the Securities Act). Hong Kong) (OFS).
However, as noted by the SFC in the VA statement, investing in virtual assets carries significant risks for investors. These include, but are not limited to, operational issues related to virtual asset retention, the risk of hacking, inconsistent valuations, and the fragmented liquidity of virtual assets.
The CFS has now established a more robust approach to regulating virtual asset activities, with the goal of providing enhanced protection for investors investing in portfolios or virtual asset funds.
1. Wider Scope of Supervision of Virtual Asset Portfolio Managers
Virtual asset portfolio managers managing or distributing virtual asset portfolios will attract SFC licenses and will be subject to the obligations set out in the VA circulars, regardless of whether the virtual assets are "securities" and / or "contracts". future ". SFO.
According to the SFC, these virtual asset portfolio managers include:
- Companies that manage funds that invest only in virtual assets that do not constitute "securities" and / or "futures contracts" within the meaning of the SFO and distribute them in Hong Kong: the distribution of investment products in virtual assets by these companies will require a license for the regulated activity of type 1 (securities trading) by the SFC. As such, they are required to comply with the various rules and regulations issued by the SFC when distributing virtual asset placement products to their clients; and
- Companies licensed / licensed for a regulated activity type 9 (asset management) but also manage portfolios that invest exclusively or partially in virtual assets that do not constitute "securities" and / or "assets". future contracts "within the meaning of the SFO: subject to de minimis exemption (that is, when virtual asset portfolio managers invest less than 10% of the gross value of portfolio assets in virtual assets), virtual asset management is also subject to the supervision of the SFC via the imposition of certain general conditions[3] (VA General Conditions) as conditions of license for virtual asset portfolio managers. Companies are required to inform the SFC if they manage or plan to manage virtual asset portfolios. This notification applies even if the license applicant or licensee plans to manage less than 10% of the assets that are virtual assets. If they are, the SFC will work with the company to change the terms and conditions of VA in order to adapt to the business model of the respective company and to ensure that these conditions are reasonable and appropriate. The final terms and conditions of VA finalized will be imposed as conditions of license to this company. If a licensee does not agree to abide by the proposed terms and conditions for VA, his license application will be rejected. Similarly, if an existing licensee does not agree to abide by the terms and conditions proposed for VA, it will be required to liquidate that portfolio within a reasonable period of time.
2. What are the terms and conditions for virtual assets?
VA's general terms and conditions are based on principles and are subject to slight variation and development based on the business model of the Virtual Asset Portfolio Manager. In general terms, VA's general conditions cover the following areas:
- auditors:
- An independent auditor should be appointed to audit the virtual asset portfolios.
- Liquid capital:
- A virtual asset portfolio manager must maintain a minimum of HK $ 3 million in liquid capital (or its required variable capital, whichever is greater), regardless of whether it is or not under the condition of license. This requirement is important in that other alternative asset managers (for example, hedge fund managers and PE fund managers) hold a Type 9 license and do not hold client assets. only need 100,000 HKD in liquid funds.
3. Other requirements for the distribution of virtual assets
Virtual asset portfolio managers and distributors must meet the following additional requirements when they embark on the distribution of unauthorized virtual asset investment products (ie, say non-retail products) when such virtual asset investment products intend to invest or have invested more than 10% of their gross assets. value directly or indirectly in virtual assets:
- Targeted investors: Any distribution of investment products in virtual assets should target only "professional investors" as defined in the OFS.
- Concentration: Virtual asset portfolio managers need to ensure that the overall amount that the investor invests in virtual asset funds must match the net worth of the client.
- Due diligence: Proper due diligence of the fund manager, the fund and the counterparties of the fund should be conducted. This includes the review of the Fund's constating documents and due diligence questionnaire and the fund manager's investigations.
- Information for customers: Virtual asset portfolio managers need to present some important caveats such as the continued evolution of virtual assets, virtual asset price volatility and virtual asset loss risk, counterparty risk, cybersecurity and technology-related risks in a clear and easily understandable way for the customer. investor. In accordance with the VA Distribution Circular, failure to comply with the additional requirements may impair their ability to maintain a license with the SFC and virtual asset portfolio managers may be subject to disciplinary action by the SFC.
4. Conceptual regulatory framework for platform operators
At the same time, the SFC has put in place a conceptual framework for the potential regulation of future operators of virtual asset trading platforms. To do this, the SFC will initially undertake an exploratory exercise to determine if these platforms are likely to be regulated. If it concludes that these platforms should be regulated, they will be subject to license standards similar to those of the automated trading license holders.
In the conceptual framework, the result may be that a virtual asset trading platform operator will have to obtain a license and adhere to certain fundamental principles. This means that a licensed virtual asset trading platform operator may be brought to:
- Conduct all virtual asset trading activities within a single legal entity;
- Ensure compliance of its virtual asset trading business with applicable requirements;
- Offer its virtual asset trading business to "professional investors" as defined in the FSO only;
- Admit the issuance of virtual assets only through an initial offer of coins within the next 12 months; and
- Ensure that virtual asset trading transactions are prefinanced, leverage-free, or standardized futures on virtual assets or other derivatives.
Various licensing conditions relating to financial strength, insurance requirements, separation and custody of virtual assets may also be imposed on trading platform operators. Virtual assets, depending on their business practices.
The conceptual framework aims to provide a high level of standards and practices to authorized commercial operators, and to distinguish between authorized commercial operators and those not seeking a license.
SFC would like to work with the virtual asset trading platform operators interested in exploring the regulatory framework of the virtual asset trading platform in the SFC regulatory sandbox environment. This is expected to result in the disappearance of a number of trading venues that are currently operating in an unregulated environment.
Conclusion
VA Circulars can be seen as a major step taken by the SFC to extend its regulatory footprint to the world of virtual assets. While the innovative nature of virtual asset activities has created tremendous investment opportunities, investor protection against volatile financial practices remains the top priority for regulators to ensure the integrity of financial investments.
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