Hong Kong Crypto Law – November 2018

The regulatory position in Hong Kong regarding “virtual assets” – that is digital tokens – including cryptocurrencies (such as Bitcoin) and ICO tokens – is that these are unregulated, except to the extent they constitute securities within the definition under Hong Kong’s Securities and Futures Ordinance (SFO).

On 1 November 2018, Hong Kong’s Securities and Futures Commission (SFC) published new regulatory standards which apply to virtual asset portfolio managers and distributors of virtual asset funds that are already required to be licensed. Separately, the SFC is inviting virtual asset trading platforms and exchanges which are interested in becoming licensed to join the SFC’s Regulatory Sandbox with a view to potentially becoming licensed, if the SFC determines that they are appropriate for licensing following its assessment of their performance in the Sandbox.

The initiative is an important step forward as it demonstrates the SFC’s willingness to engage with participants in the crypto industry. There have been calls from the industry to introduce regulation in order to create legitimacy for players willing to comply with regulatory standards. The latest guidance on virtual asset portfolio managers and distributors of virtual asset funds will be particularly welcome to fund managers which manage and distribute virtual asset funds in addition to traditional securities funds as it clarifies the applicable regulatory standards. The requirements for fund distributors of third party virtual asset funds are less likely to be welcomed given the extensive due diligence they will have to perform on funds, their fund managers and counterparties. As regards the proposed licensing of trading platforms and exchanges, the proposed regulatory requirements are likely to be seen as excessively burdensome. It will be interesting to see whether exchanges’ desire for the credibility which comes with licensing will make them willing to submit to the additional regulatory burden.

Regulating around the edges

Essentially, the SFC is trying to impose regulation where it can. As it has previously spelled out [1], where a virtual asset constitutes a security (i.e. it carries rights equivalent to traditional securities such as shares, debentures or interests in a collective investment scheme) or a futures contract, it is already regulated by the SFC. Accordingly, licensing requirements apply to firms carrying on “regulated activities” in relation to such virtual assets. Licensing requirements thus apply to an exchange providing trading services for virtual assets which are securities or futures or a firm managing funds investing in them.

However, the SFC’s regulatory jurisdiction does not extend to the many virtual assets which are not securities or futures contracts – which the SFC refers to as “non-SF virtual assets”. Thus an exchange which only trades non-SF virtual assets or a firm which only manages funds investing in non-SF virtual assets is completely unregulated.

Primary market issues and offers of virtual assets (such as ICOs) which are not securities also remain unregulated.

Virtual asset exchanges

The proposals for potentially regulating virtual asset exchanges essentially involve an entirely voluntary process whereby exchanges wanting to be licensed would operate within the SFC’s Regulatory Sandbox. If the SFC decides to proceed with licensing with virtual asset exchanges, which is by no means a given, it would be a licensing condition that the exchange trades at least one virtual asset which is a security in order to bring the exchange within the SFC’s regulatory jurisdiction. Once it is, the SFC would apply its regulatory framework to all activities of the exchange irrespective of whether they involve virtual assets which are securities or not.

Virtual asset portfolio managers and virtual asset fund distributors

The SFC is imposing regulation on virtual asset portfolio managers and virtual asset fund distributors which are already required to be licensed either because:

  • they additionally manage portfolios of traditional securities or futures contracts which requires an asset management licence; or
  • they distribute funds investing solely in non-SF virtual assets. Fund distribution requires a securities dealer licence because a fund constitutes a security irrespective of whether the fund invests in virtual assets which are securities or not.

The SFC has applied additional licensing conditions to both types of firm to the extent that they manage portfolios (or portions of portfolios) that invest in virtual assets. Portfolio management includes both fund management and management of discretionary accounts (in the form of an investment mandate or a pre-defined model portfolio).

Firms distributing virtual asset funds (whether as fund managers under an asset management licence or as fund distributors under a securities dealer licence) are required to comply with:

  1. the SFC’s regulatory framework for licensed corporations including its Code of Conduct for Persons Licensed by or Registered with the SFC (Code of Conduct), including (among others) Know-your-Client (KYC) and AML and CTF obligations as well as the obligation to ensure the suitability of recommendations and solicitations to clients; and
  2. additional requirements including extensive due diligence in relation to the virtual asset funds they distribute [2], their fund managers and counterparties.

The impetus for regulation

FATF – the setter of international standards on Anti-money Laundering (AML) and Counter-terrorist financing (CTF) – revised its recommendations in October 2018 to require member countries (which include Hong Kong) to regulate “virtual asset service providers” – which include crypto exchanges [3] – for AML and CTF purposes and impose licensing or registration obligations on them so that their compliance with AML/CTF standards can be monitored. FATF is due to issue further guidance on a risk-based approach to regulating virtual asset service providers in June 2019.

As a result, a number of jurisdictions are in the process of bringing crypto exchanges within the scope of their AML/CTF and licensing regimes. In Singapore, for example, a Payment Services Bill is currently going through the legislative process and will require cryptocurrency exchanges to be licensed and subject to AML/CTF obligations.

[1] SFC. Statement on initial coin offerings. 5 September 2018.

[2] The additional requirements will not apply to funds authorised by the SFC for retail distribution.

[3] Certain types of wallet providers and providers of financial services for ICOs are also covered.