November 08, 2018
Blockchain & Digital Assets Alert
Blockchain & Digital Assets Alert
In an effort to bring the management and distribution of virtual asset funds into the regulatory net, the Hong Kong Securities and Futures Commission has issued a circular to intermediaries setting out a new regime for the regulation of managers and distributors of such funds. This client alert describes the new regime and the action that should be taken by managers and distributors of virtual asset funds in Hong Kong.
The Hong Kong Securities and Futures Commission (SFC) has been following the development of cryptocurrencies and other virtual assets in the marketplace. Periodically, the SFC has issued statements, notices and circulars to intermediaries cautioning about the risks associated with investment and dealings in virtual assets. Because its authority derives from the Securities and Futures Ordinance (Chapter 571 of the Laws of Hong Kong), which gives it a regulatory supervisory role over securities, such as equity and debt instruments and futures contracts, hitherto the SFC has not exercised its regulatory powers in matters relating to virtual assets except where it felt that a virtual asset marketed to the Hong Kong investment public possesses the characteristics of a security or is a collective investment scheme.
That changed on November 1, 2018, when the SFC issued a public statement and a circular to intermediaries stating a change in its approach to regulating virtual assets. The SFC stated that it would bring within its regulatory net a significant portion of virtual asset portfolio management activities, even if the underlying virtual assets are not defined as securities or futures contracts and thereby are outside the scope of the SFC’s direct authority.
The new approach will, subject to certain exemptions, impose additional obligations on both existing licensed corporations and new applicants for licensing where the funds managed or distributed by them invest in virtual assets.
The following types of firms managing funds which invest in virtual assets will be subject to SFC oversight:
In each case, SFC oversight of the management and distribution of funds which invest in virtual assets will be implemented by the imposition of licensing conditions. If the firm does not agree to comply with the conditions, then it will be required to unwind existing virtual asset portfolios or, if it is a new applicant for licensing, its licence application will be rejected. Given that oversight will apply to both managers and (if different) distributors of funds investing in virtual assets, most of such funds will become subject to regulation by the SFC.
The licensing conditions will impose a set of “terms and conditions” developed by the SFC based on the existing regulatory framework, but adapted to the risks associated with virtual assets. The terms and conditions will require applicable licensed corporations to observe the following requirements:
The SFC expects that both existing licensed corporations and applicants for licensing will inform the SFC if they are managing or intend to manage any portfolio that invests or intends to invest in virtual assets (even if the de minimis exemption applies). The SFC will then discuss with the firm whether and how the standard terms and conditions (tailored as appropriate) will apply.
The SFC is also imposing additional requirements on any intermediaries that distribute virtual asset funds, whether or not they are also managers of those funds. In addition to existing obligations regarding suitability (where applicable), intermediaries will need to observe the following requirements (among others):
The new approach targets intermediaries and does not cover virtual asset transactions directly between buyers and sellers. It also does not directly cover initial coin offerings or token generation events managed by issuers directly.
Apart from these new requirements, the SFC also announced that it will use a regulatory sandbox to explore potential regulation of virtual asset trading platforms to determine if such platforms are suitable for regulation. If so, the SFC will develop standards of conduct regulation for virtual asset trading platform operators which may be comparable to those governing licensed automated trading services operators. A trading platform can enroll in the sandbox and, if deemed appropriate by the SFC, the trading platform may eventually receive an operating licence for its platform.
The new approach by the SFC signals to the crypto industry and the investing public that it now has a workable handle on dealing with risks associated with virtual assets. Since the new approach relies on superimposing new obligations on licensed corporations, it can be seen as a flexible and speedy response to some of the challenges presented by the virtual asset industry. It remains to be seen if the extended requirements may be challenged as exceeding the authority of the SFC or if the SFC plans to bring in formal legislation to cover virtual assets in due course. In any case, the cryptocurrency and virtual asset industry is attracting the interest of institutional professional investors and small investors alike. As the industry develops virtual assets as an alternative investment class, participants should welcome a regulatory framework that will help improve the legitimacy and credibility of the industry. This may also be the first step towards the SFC allowing securities token offerings in Hong Kong.
Licensed corporations and persons intending to manage or distribute virtual asset funds will need to take the new regime into account, and should consider whether disclosures to the SFC are required concerning their existing and planned activities, whether they need to apply for licenses and how best to negotiate the new license conditions that may be imposed on them.
In addition to advising on cryptocurrency and digital asset matters, our Hong Kong office is also experienced in advising on SFC licensing matters, including Type 1 and 9 licensing and registrations.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.
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