The Situation: Surging interest in digital tokens has caught the attention of regulators in Hong Kong.

The Development: Hong Kong's Securities and Futures Commission recently introduced additional regulatory measures, and seven cryptocurrency exchanges are under investigation for potential unlicensed trading in "securities."

Looking Ahead: Would-be buyers of digital tokens should review a number of considerations, some of which are enumerated here, before completing a purchase.

With the surging popularity of digital tokens, investments today are no longer limited to shares, bonds, and fixed deposits.

In its purest form, a digital "utility" token is a piece of computer code used to represent a particular asset or utility; it allows a person to access certain goods and services from its issuer in the virtual world. In some ways, it is not unlike a coupon issued by a department store in the physical world; that coupon allows a customer to obtain certain goods and services (e.g., a price discount) from that department store. However, the same technologies can be used to create digital currencies ("cryptocurrencies"), where encryption and blockchain techniques can be used to generate units of currency and verify the transfer of value between participants using the same currency, operating independently of a central bank. Bitcoin is probably the best-known example of a cryptocurrency, but it is by no means the only one.

Increasingly, both start-ups and established companies have sought to raise funds by offering digital tokens to investors. What has become clear from some of those offerings is that, even where the company offers a true "utility" token, it is possible for that token to appreciate in value afterwards. If the token is capable of being traded, and investors are able to realize value from holding the token for even a short period of time, there is a risk that under individual national regulatory regimes, the token will be considered as either a regulated investment, a security or even a cryptocurrency.

According to the website ICOdata, digital token offerings have raised more than US$ 5 billion in 2017 alone. In terms of daily trading volume, reports indicate that a number of cryptocurrency exchanges connected to Hong Kong rank in the top 20 globally.

This trend has alerted Hong Kong's financial and securities regulators.

In Hong Kong, the Securities and Futures Commission ("SFC") previously issued statements on September 5, 2017 and December 11, 2017 warning of the potential risks of investing in cryptocurrencies, and stressing that cryptocurrencies could constitute "securities" regulated under the Securities and Futures Ordinance ("SFO"). See Jones Day's September 2017 Commentary: Announcement Clarifies Regulatory Position on Initial Coin Offerings in Hong Kong.

On February 9, 2018, the SFC announced the taking of further regulatory measures. Seven cryptocurrency exchanges were put under investigation for potential unlicensed trading in "securities" under the SFO. The exchanges, which were not publicly identified, are said to have either confirmed that they did not knowingly trade in securities, or to have taken "immediate rectification measures" such as blocking access to Hong Kong residents.

Apart from cryptocurrency exchanges, the SFC is also scrutinizing the issuers of such cryptocurrencies, many of whom could fall under the SFC's jurisdiction on the basis of having offered or dealt in securities without complying with the provisions of the SFO and the Companies (Winding Up and Miscellaneous Provisions) Ordinance. There are harsh penalties for non-compliance. For instance, a person convicted of unlicensed securities dealing can be liable to a fine of up to HK$5,000,000 and to imprisonment for up to seven years.

The SFC has repeatedly warned investors of the risks of investing in ICOs and cryptocurrencies. Unlike shares (which give investors rights of a shareholder) and debentures (which give investors rights to principal and interest), tokens or coins issued for fundraising purposes may not offer any substantive rights to investors. Furthermore, cryptocurrency issuers often do not have a proven financial track record to deliver on their promises of return on investment.

Points to Consider Before Purchasing a Digital Token

  1. What is being offered – a "utility token", an investment token, or a combination of both?
  2. Does the offering comply with local laws and regulations?
  3. What is the purpose of the offering? In particular, what will the issuer use the funds for?
  4. Is the token legally traded on an exchange?
  5. Is the exchange operating in accordance with local laws?
  6. Is the trading of the token transparent?
  7. How secure is the token? Is it exposed to hacking risks?

THREE KEY TAKEAWAYS

1. Interest in digital currencies is surging, as evidenced by token offerings in 2017 raising more than US$ 5 billion.

2. There is risk that under individual national regulatory regimes, a digital token the token will be considered as either a regulated investment, a security, or even a cryptocurrency.

3. The regulation of digital tokens is increasing, and the SFC has indicated it will not tolerate violations of Hong Kong's securities laws.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.