ARTICLE
8 February 2019

SFC Sets Out New Regulatory Approach For Virtual Assets

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A&O Shearman

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On 1 November, 2018, the Securities and Futures Commission of Hong Kong (SFC) issued a statement (the "Statement"), which sets out a new approach aiming to regulate virtual asset portfolio managers ...
Hong Kong Finance and Banking

On 1 November, 2018, the Securities and Futures Commission of Hong Kong (SFC) issued a statement (the "Statement"), which sets out a new approach aiming to regulate virtual asset portfolio managers and distributors of virtual asset funds and a conceptual framework for the potential regulation of virtual asset trading platforms. In an accompanying circular (the "Circular"), the SFC provided detailed guidance and reminded firms that distribute funds investing in virtual assets of the registration and regulatory requirements.

The Statement

The SFC warns investors of the significant risks of virtual assets, some of which are inherent in the nature and characteristics of virtual assets while others arise from the operations of platforms or portfolio managers. In particular, the SFC focuses the regulatory attention on the following risks: (i) valuation, volatility and liquidity; (ii) accounting and auditing; (iii) cybersecurity and safe custody of assets; (iv) market integrity; (v) risk of money laundering and terrorist financing; (vi) conflicts of interest; and (vii) fraud.

Under the existing regulatory regime, virtual assets that fall into the definition of "securities" or "futures contracts" under the Securities and Futures Ordinance and activities related to such virtual assets are subject to regulation by the SFC. Firms must also comply with certain notification requirements if they intend to provide trading and asset management services involving crypto-assets. In addition, firms engaging in the distribution of funds that invest in virtual assets, regardless of whether such assets amount to "securities" or "futures contracts," need to be licensed by or registered with the SFC. However, since some virtual assets may not constitute "securities" or "futures contract," many investors are still left unprotected if they trade in virtual assets through unregulated trading platforms or invest in virtual asset portfolios that are managed by unregulated portfolio managers.

To address such regulatory concerns, the SFC plans to bring a significant portion of virtual asset portfolio management activities into its regulatory net through the following means.

  • Scope of Supervision. The expanded scope of supervision of the SFC catches (i) persons managing funds which solely invest in virtual assets that do not constitute "securities" or "futures contracts" and distribute the same in Hong Kong; (ii) persons that are licensed or are to be licensed for Type 9 regulated activity (asset management) for managing portfolios in "securities," "futures contracts" or both; and (iii) persons distributing funds that invest (solely or partially) in virtual assets in Hong Kong.
  • Regulatory Standards. With respect to virtual asset portfolio managers under (i) and (ii) above, a set of standard terms and conditions which reflect the essence of the existing regulatory requirements under the SFC will be imposed on them as licensing conditions with certain variations to better address the risks associated with virtual assets.

    Some of the key terms and conditions are available here.

    Virtual asset fund distributors under (iii) above will be subject to further guidance on the expected standards and practices as provided in the Circular.
  • Licensing process. License applicants and licensed corporations are required to inform the SFC if they are managing or planning to manage portfolios that invest in virtual assets so that the SFC can assess their business activities and decide the next steps, including imposing the abovementioned standard terms and conditions, rejecting licensing applications and unwinding existing virtual assets portfolios.

In addition to regulating virtual asset fund managers and distributors, the SFC also sets out a conceptual framework for the potential regulation of virtual asset trading platforms. At the current stage, the SFC proposes to work with interested platform operators by placing them in a regulatory sandbox to explore whether such platforms are suitable for regulation. Factors to be considered include the adequacy and effectiveness of the proposed conceptual framework, ability to comply with the terms and conditions and investors' interests, as well as local market and international regulatory developments.

Details of the conceptual framework are available here.

The Statement is available here.

The Circular

The SFC reminds persons licensed or registered for Type 1 regulated activity (dealing in securities) or Type 9 regulated activity (asset management) that are engaged in distributing virtual asset funds under their management about the existing regulatory requirements and provides guidance on the expected standards and practices in relation to the such distribution.

Distributions of virtual asset funds, regardless of whether they are authorized by the SFC, are subject to the regulation of the SFC. However, the Circular further sets out the following additional requirements for firms which distribute non-SFC authorized funds that have a stated investment objective to invest in virtual assets or intend to invest or have invested more than 10% of their gross asset value in virtual assets directly or indirectly: (i) selling restrictions and concentration assessments; (ii) due diligence on virtual asset funds not authorised by the SFC; and (iii) information for clients.

The Circular is available 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.

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