On 9 February 2018, the Securities and Futures Commission (the "SFC") issued a statement (the "Statement"), cautioning investors again of the potential risks of investing in cryptocurrencies and initial coin offerings ("ICOs") and using the services of cryptocurrency exchanges. In this regard, it warned investors of the heightened risk of extreme price volatility, hacking and fraud.
In the Statement, the SFC stated that it had received various complaints from investors, including allegations of misappropriation of assets, market manipulation and fraud. Some investors also complained that they were unable to withdraw fiat currencies or cryptocurrencies from their accounts maintained with cryptocurrency exchanges.
In response, the SFC has warned seven cryptocurrency exchanges in Hong Kong or with connections to Hong Kong that they should not trade cryptocurrencies which are "securities" under the Securities and Futures Ordinance (the "SFO") without a licence. Most of them either confirmed that they did not provide cryptocurrency trading services or took immediate rectification measures, including removing the relevant cryptocurrencies from their platforms. The SFC has also written to seven ICO issuers. Most of them confirmed their compliance with the SFC's regulatory regime or immediately ceased to offer the relevant digital coins/tokens ("digital tokens") to Hong Kong investors.
The SFC has said that they will continue to monitor ICOs and cryptocurrency exchanges, and will take enforcement action where appropriate, in particular against those who disregard the SFO and those who are repeat offenders.
However, the SFC acknowledged that its power to take enforcement action may be limited if cryptocurrency exchanges and ICO issuers have no nexus with Hong Kong or if the relevant digital tokens are not "securities" or "futures contracts" as defined under the SFO. Rightly so, jurisdiction over these products can be muddy since market participants often operate in different jurisdictions and in an online environment, which will make it harder for regulators and investors to pursue cryptocurrency exchanges or fraudsters to recover funds.
Nevertheless, the SFC urged investors to be wary of the risks of investing in cryptocurrencies and ICOs and using the services of cryptocurrency exchanges. The SFC also said that investors should invest in such products only if they have fully understood the risks involved or if they are prepared to take a significant loss.
These products may not be suitable for certain types of investors, especially those with a long-term investment horizon (e.g. saving for retirement). Investors who choose to invest in cryptocurrencies and ICOs should also maintain adequate and up-to-date security precautions on the devices and hardware that they use for accessing and dealing in such products.
Are digital tokens "securities"?
The Statement follows a statement issued by the SFC in September 2017 regarding the use of ICOs to raise funds in Hong Kong. It explained that, depending on the terms and/or features of the digital token i.e. the rights attached to the token, such as whether:
- the token has any equity features, e.g. the token gives or represents voting rights, or an ownership interest, in the issuer, or
- the token has any debt features, e.g. the token represents a debt owed by the issuer to the token holder, or
- the digital token proceeds will be managed collectively for profit, income or other return by a scheme operator,
such token may fall within the definition of "securities" under the SFO.
Where the digital tokens in an ICO are "securities", any person that:
- offers, deals in or advises on these digital tokens;
- manages a fund investing in these digital tokens; or
- operates a crytpocurrency exchange involving the trading of these digital tokens,
will be carrying out a "regulated activity" and is required to obtain the appropriate licence(s) and/or procure that the digital tokens are authorised by the SFC for public offer, unless one or more of the relevant exemptions apply. These licensing/authorisation requirements may also be triggered where the digital tokens or the cryptocurrency-related investment products constitute a "futures contract" under the SFO (please refer to our briefing on bitcoin futures in December 2017).
Although Hong Kong adopts the common law system and therefore US law has no legal effect in Hong Kong, it may still be useful and interesting to see what the views of the US regulators are on this subject and whether reference will be drawn from them by regulators and/or courts in Hong Kong in the future.
During a US Securities and Exchange Commission (the "SEC") and Commodities and Futures Trading Commission hearing on 6 February 2018, SEC Chairman Jay Clayton indicated that if an ICO functions like a security, "it is a security."
Summarising Chairman Clayton's various statements on the subject, the SEC will likely consider an offer and sale of digital tokens in an ICO to be a "security" and thus subject it to US securities law if:
- the offer and sale of the digital tokens are promoted as an opportunity for investors to profit, creating a reasonable expectation by investors of such profit;
- such profits depend on the entrepreneurial or managerial efforts of others (e.g. a promoter or other third party);
- the promoter or issuer of these offerings emphasizes or promotes the secondary market trading potential of these digital tokens i.e. token holders may resell them to others on a cryptocurrency exchange or platform at a profit; and
- the value of the digital token increases over time depending on the performance of the issuer or a blockchain project featuring such digital tokens, and such increase can be locked in by reselling the digital tokens on a secondary market i.e. it is promoted as an investment opportunity with an expectation of profit derived from the efforts of others.
Further, simply calling a digital token a "utility" token or structuring it to provide some right of use to the token holder (say, of a particular service provided by the issuer) does not prevent it from being treated as a "security". Instead, the determination is based on an assessment of the relevant facts and circumstances, including the economic realities of the transaction. For instance, the existence of a secondary market for a particular type of "utility" token would suggest that ownership of such tokens may not be based on a desire to use or redeem the token's utility or function (i.e. for personal consumption) but rather, based on a desire to profit from it as an investment (i.e. for investment purposes). Hence, it would appear that there is an expectation of profit in these circumstances (derived from the active efforts of others). The SEC would likely classify such "utility" token to be a "security".
Whilst regulators (including the SFC) continue to increase their understanding of the intricacies of cryptocurrencies (and blockchain technology), such emerging technology and products will inevitably be met with more regulatory oversight, especially in prevention or deterrence of fraud and manipulation, so as to ensure that investors are afforded with the appropriate protections. ICOs will continue to be an area of focus for the SFC.
The position may in fact be even muddier than the SFC has warned. Digital tokens issued in ICOs have features which could cause the issuer to be carrying on an unlicensed business of deposit taking, cause the cryptocurrency exchange operator (where there is secondary trading of the digital tokens and such operator receives fiat currencies for the purchase of digital tokens) to be operating an unlicensed business of remittance service or a money changing service in Hong Kong ("Money Services") or cause the investors to be carrying on an unlicensed business of money lending. The SFC may not have focused on this because it does not regulate deposit taking, for which the regulator is the Hong Kong Monetary Authority (the "HKMA"), Money Services, for which the regulator is the Customs and Excise Department (the "C&ED") or money lending, for which the regulator is the Registrar of Money Lenders.
It is interesting that the HKMA, which regulates banking, deposit taking and other activities involving money (including operating a stored value facility, a retail payment system and a clearing and settlement system), and the C&ED, which regulates money service operators such as money changers and remittance agents, have issued statements warning of the risks inherent in buying cryptocurrencies, including the risk that in their view they do not regulate issuers, traders, changers or remitters of cryptocurrencies because cryptocurrencies are not "money" or "currency".
However, none of the relevant ordinances defines "money" in a way which makes it clear that cryptocurrencies are not "money" for regulatory purposes, money has always been categorised as either "fiat" money or "commodity" money and money is really only a general name for a tradeable store of value.
Maybe the HKMA and C&ED should be regulating cryptocurrencies?
Parties who wish to offer digital tokens or operate a platform involving digital tokens/cryptocurrencies in Hong Kong should closely monitor the developments in this space or seek professional legal advice to ensure that the proposed activities are in compliance with the relevant laws and regulations in Hong Kong.
Stephenson Harwood has recently released a review of some of the announcements, guidance or comments of regulators in key jurisdictions towards cryptocurrencies and ICOs, which can be found here.
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.