As Hong Kong positions itself as a leading Web3 centre for Asia, there is increasing interest among licensed intermediaries in Hong Kong to add investment products with exposure to virtual assets to their client service offering. In this article, Pádraig Walsh and Shirley Kong from our Fintech practice reviews the applicable regulatory framework set out in a Joint Circular issued by the Securities and Futures Commission (SFC) and Hong Kong Monetary Authority (HKMA) on 22 December 2023.
Scope of the Joint Circular
The Joint Circular applies to intermediaries that are licensed corporations with the SFC or registered institutions with the HKMA, and that engage in virtual asset-related services including in respect of VA-related products.
Virtual assets are interpreted according to the Anti-Money Laundering and Counter-Terrorist Financing Ordinance. This means that, subject to some limited carve-outs, the virtual asset must:
(a) be expressed as a unit of account or a store of economic value;
(b) either: (i) be used or intended to be used as a medium of exchange accepted by the public for paying for goods or services, discharging of debt or making investments (basically, a payment token); or (ii) provide rights, eligibility or access to vote on the management, administration or governance of affairs, or the terms, of any arrangements in relation to the virtual asset (basically, a governance token); and
(c) be capable of being transferred or stored electronically.
VA-related services generally include dealing and advisory services in VA-related products, tokenised securities and virtual assets, as well as VA asset management services.
VA-related products are products which:
(a) have a principal investment objective or strategy to invest in virtual assets;
(b) derive their value principally from the value and characteristics of virtual assets; or
(c) track or replicate the investment results or returns which closely match or correspond to virtual assets.
Distribution of investment products with exposure to virtual assets
VA-related products are very likely to be considered as complex products as retail investors generally may not understand the risks associated with such products. Intermediaries distributing VA-related products considered to be “complex products” (except for VA-related products considered to be complex exchange-traded derivatives and complex exchange-traded SFC-authorised non-derivative VA funds) must comply with the SFC’s requirements on the sale of complex products. This includes a suitability assessment of the VA-related product to a client that the intermediary must assess, including whether the aggregate amount to be invested by the client in VA-related products is reasonable considering the client’s financial situation (including net worth) and personal circumstances. This requirement applies irrespective of whether there has been a solicitation or recommendation by the distributor in respect of the VA-related product.
In addition to the requirements under the complex product regime, the SFC and the HKMA also require the following additional investor protection measures to be met on the distribution of VA-related products:
(a) VA-related products which are considered complex products, should only be offered to professional investors. This general rule is subject to two exceptions:
(i) The professional investors only restriction is not imposed for the distribution of VA-related derivative products that are traded on the Hong Kong Stock Exchange or other regulated exchanges specified by the SFC or exchange-traded VA derivative funds that are authorised for offering to retail investors by the SFC or by the respective regulator in a jurisdiction designated by the SFC. This is because the view of the SFC is these products are traded on an exchange where market risks are not as prevalent. The advantage is that, where there has been no solicitation or recommendation, intermediaries may execute client orders on exchange without complying with the suitability requirement or the minimum information and warning statements requirement. Nonetheless, these are still complex exchange-traded derivatives. Consequently, intermediaries must still comply with the existing requirements for derivative products and conduct a virtual asset-knowledge test. The SFC provides a non-exhaustive list of examples of complex and non-complex products published on the SFC’s website.
(ii) VA funds authorised by the SFC for public offering are not subject to the professional investors only restriction. These funds must comply with the following requirements in their distribution:
(1) SEHK listed and traded funds: If there has been no solicitation or recommendation, then intermediaries may execute client orders on exchange without complying with the suitability requirement or the minimum information and warning statements requirements. Intermediaries must still conduct a virtual asset-knowledge test; and
(2) Non-SEHK listed funds: If the fund is not listed with the SEHK, or for those listed but with the trading conducted off exchange, then intermediaries must comply with the suitability requirement and the minimum information and warning statements requirements, as well as conducting a virtual asset-knowledge test.
(b) Except for institutional professional investors and qualified corporate professional investors, intermediaries must assess whether clients have knowledge of investing in virtual assets or VA-related products before entering a VA-related products transaction, and must also ensure that clients have sufficient net worth to bear the risk and potential losses of trading VA-related products. If a client does not possess the required knowledge, the intermediary may proceed only if it has provided adequate training to the client on the nature and risks of virtual assets.
Intermediaries are expected to observe the selling restrictions in Hong Kong and other jurisdictions that apply to a particular VA-related product. These include the public offering regime that applies in Hong Kong under the Part IV of the Securities and Futures Ordinance (SFO) for investment products. The intermediary must ensure that any online distribution platform has appropriate access rights and controls to ensure compliance with selling restrictions.
Intermediaries must observe suitability obligations for VA-related products in respect of clients. This includes ensuring recommendations or solicitations are suitable, and conducting proper due diligence on the VA-related products (including their regulatory status). Intermediaries must also ensure that the client understands the nature and risks of VA-related derivative products (including the impact of leverage), and provide clients with risk disclosure statements specific to virtual asset futures contracts in complying with applicable codes for VA-related derivative products,
Intermediaries should not, as a general rule, provide any financial accommodation for investing in VA-related products to clients. If financial accommodation is given to a client, then the intermediary must assure itself the client has the financial capacity to meet the obligations arising from leveraged or margin trading in VA-related products.
Except for institutional professional investors and qualified corporate professional investors, intermediaries should provide clear and easily comprehensible information and warning statements to clients in relation to VA-related products and information on the underlying VA investments, and provide risk disclosure statements specific to virtual assets.
VA dealing services
Intermediaries may only partner with SFC-licensed VA trading platforms (SFC-licensed VATPs) for the provision of VA dealing services. This applies both by way of introducing clients to the platforms for direct trading or establishing an omnibus account with the SFC-licensed VATP.
Intermediaries must comply with all regulatory requirements imposed by the SFC and the HKMA when providing VA dealing services although the provision of VA dealing services does not amount to “dealing in securities”. This is because the conduct of the dealing services may impact the intermediary’s fitness and properness. An intermediary should only provide VA-dealing services to their Type 1 regulated activity clients.
The SFC will impose conduct requirements on intermediaries in respect of providing VA dealing services under an omnibus account arrangement. These will be imposed as licensing conditions. The key requirement is that intermediaries must comply with prescribed terms and conditions that align to the requirements imposed on dealing activities of SFC-licensed VATPs. Some key provisions under the prescribed terms and conditions are:
- All client orders should be pre-funded so that intermediaries only execute a trade for a client if there are sufficient fiat currencies or virtual assets in the client’s account to cover that trade.
- Intermediaries should not provide any financial accommodation for their clients to acquire virtual assets.
- Before providing VA dealing services to retail clients, intermediaries should:
(a) assess the client’s knowledge of virtual assets and risk tolerance level;
(b) set a limit for each retail client to ensure that the client’s exposure to virtual assets is reasonable with respect to the client’s financial situation and personal circumstances;
(c) ensure that the VA dealing activities are conducted through an omnibus account established with an SFC-licensed VATP which is not subject to the licensing condition that it can only serve professional investors; and
(d) ensure retail clients can only trade in virtual assets made available by the SFC-licensed VATP for trading by retail investors.
- Intermediaries which allow clients to deposit or withdraw virtual assets from their accounts, should only do so through segregated accounts established and maintained with their partnered SFC-licensed VATPs, or HKMA licensed banks (or their local subsidiaries) which meet the expected standards of virtual asset custody issued by the HKMA.
Intermediaries provide VA dealing services as an introducing agent must not relay any orders on behalf of their clients to SFC-licensed VATPs or hold any client assets for the introducing services. This can be imposed as a licensing or registration condition on the Type 1 intermediary.
If a client authorises an intermediary under a Type 1 dealing in securities licence to provide discretionary account management services as an ancillary service, then the intermediary should only invest less than 10% of the gross asset value of the client’s portfolio in virtual assets.
VA advisory services
Intermediaries must comply with all regulatory requirements imposed by the SFC and the HKMA when providing VA advisory services, even if the virtual assets in question are not securities. This is because the conduct of the advisory services may impact the intermediary’s fitness and properness. An intermediary may only provide VA-advisory services to their Type 1 or Type 4 regulated activity clients.
The expected conduct requirements for VA-advisory services are set out in prescribed Terms and conditions, which include suitability obligations. Intermediaries are expected to ensure that any virtual asset recommended to retail investors is of high liquidity that is an eligible large-cap virtual asset included in a minimum of two acceptable indices issued by at least two different index providers, and that the virtual asset is made available by SFC-licensed VATPs for retail trading.
VA asset management services
If a licensed asset manager provides asset management and discretionary account services which meet the de minimis threshold (i.e. a stated portfolio investment objective to invest in virtual assets or an intention to invest in 10% or more of the gross asset value of a portfolio in virtual assets), then the intermediary will be subject to additional prescribed terms and conditions for licensed corporations or registered institutions which manage portfolios that invest in virtual assets (RA9 Terms and conditions). These additional requirements may be imposed as licensing or registration conditions on the intermediary by the SFC.
VA-related activities and tokenised securities
Intermediaries providing VA-related activities (dealing, advisory and asset management) involving tokenised securities should comply with the existing requirements governing the respective activity and the expected standards of conduct and guidance on tokenised securities issued by the SFC. See our article on this link for more guidance.
Licensing conditions and additional terms
The Joint Circular sets out the key points of the regulatory framework applied by the SFC and the HKMA. However, the devil is in the detail. The Joint Circular sets out additional guidance, information and prescribed terms and conditions in the Appendix. This sets out more guidance on the knowledge assessment test, VA-product due diligence criteria, and risk disclosures. Critically, the Appendix also sets out the licensing conditions and additional terms and conditions that will be imposed on intermediaries in the categories of VA dealing, VA advisory and VA asset management. These conditions should be carefully reviewed by intermediaries who are considering to notify or apply to the SFC to engage in VA-related services.
Implementation
A three-month transition period was put in place on 20 October 2023 to provide for intermediaries who are already providing VA-related services to revise their systems to align with updated requirements. This transitional period will effectively end on 19 January 2024. Then, those intermediaries will be expected to fully comply with the Joint Circular.
Intermediaries intending to engage in VA-related services or change the scope of their current VA-related services must notify the SFC in advance. They must ensure they are able to comply with the requirements in the Joint Circular before introducing those services.
Conclusion
The Joint Circular both expands and clarifies the prior regulatory framework. The SFC and the HKMA have now set out clear guidance on the parameters that apply to retail access to VA-related services in Hong Kong. The expanded scope and additional clarity are welcome and necessary to the continuing development of Hong Kong as a Web 3 hub in Asia.
Author: Pádraig Walsh and Shirley Kong