ARTICLE
8 January 2024
Mondaq Thought Leadership Award Winner

SFC Circular On Intermediaries Engaging In Tokenized Securities Activities (Part 1)

KG
K&L Gates

Contributor

At K&L Gates, we foster an inclusive and collaborative environment across our fully integrated global platform that enables us to diligently combine the knowledge and expertise of our lawyers and policy professionals to create teams that provide exceptional client solutions. With offices spanning across five continents, we represent leading global corporations in every major industry, capital markets participants, and ambitious middle-market and emerging growth companies. Our lawyers also serve public sector entities, educational institutions, philanthropic organizations, and individuals. We are leaders in legal issues related to industries critical to the economies of both the developed and developing worlds—including technology, manufacturing, financial services, health care, energy, and more.
On 2 November 2023, Hong Kong's Securities and Futures Commission (SFC) issued a circular addressing the participation of intermediaries in tokenized securities-related activities (the Circular).
Hong Kong Technology

On 2 November 2023, Hong Kong's Securities and Futures Commission (SFC) issued a circular addressing the participation of intermediaries in tokenized securities-related activities (the Circular). The move was timely, as we are seeing a growing interest among financial institutions in tokenizing traditional financial instruments in global financial markets.

The Circular supersedes the SFC's 2019 Statement on Security Token Offerings (2019 Statement) and clarifies the meaning of tokenized and digital securities.

Meaning of Tokenized Securities under the Circular

Tokenization involves recording ownership claims on assets that exist on a traditional ledger onto a programmable platform, often utilizing distributed ledger technology (DLT). The Circular indicates that the process of tokenization may offer potential benefits for financial markets, such as increased efficiency, enhanced transparency, reduced settlement time, and lower costs. In addition, tokenization may come with certain risks such as cybersecurity risks, blockchain network outages and other risks, as it is an emerging technology.

Tokenized securities are essentially traditional financial instruments, such as bonds or funds, that are "securities" (as defined in the Securities and Futures Ordinance (SFO) as recorded and represented using DLT (e.g., blockchain technology). Despite their digital representation, tokenized securities are fundamentally traditional securities with a tokenization wrapper. Therefore, existing legal and regulatory requirements governing traditional securities should equally apply to tokenized securities.

Digital securities encompass broader categories of securities that utilize DLT or similar technology in their security lifecycle. Tokenized securities should be a subset of digital securities, and digital securities may or may not be tokenized securities. Digital securities may take various forms and include novel or complex structures, existing exclusively on a DLT-based network and being independent of extrinsic rights or underlying assets.

Whether Tokenized Securities are Complex Products

In the 2019 Statement, security tokens were regarded as "complex products" for purposes of SFC regulations. In the Circular, the SFC renewed its position that there is no automatic classification of security tokens as "complex products" solely by virtue of their use of blockchain.

As tokenized securities are fundamentally traditional securities, according to the SFC, a tokenization wrapper should not alter the complexity of the underlying securities. The Circular indicates that a "see-through" approach should be adopted to assess the complexity of a tokenized security (i.e., assessing the complexity of the underlying traditional security).

Intermediaries' distributions of tokenized securities which are "complex products" shall follow requirements governing the sale of "complex products" provided under the SFO.

The SFC also clarified that digital securities that are not tokenized securities are likely to be regarded as "complex products" due to their bespoke nature, unique terms and features, and heightened legal uncertainties.

Conclusion

The SFC notably relaxed its previous requirements that tokenized securities should be "complex products" and noted that it will take a "see-through" approach to look at the underlying financial instruments to determine how to classify tokenized securities.

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.

Mondaq uses cookies on this website. By using our website you agree to our use of cookies as set out in our Privacy Policy.

Learn More