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Hong Kong Crypto Law – November 2018

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The Licensing Conditions

1. Restriction to professional investors and disclosure requirements

Only professional investors as defined under the Hong Kong Securities and Futures Ordinance (SFO) are allowed to invest in a portfolio with:

  1. a stated investment objective of investing in virtual assets; or
  2. an intent to invest 10% or more of the portfolio’s GAV in virtual assets.

This restriction does not apply to funds authorised by the SFC for retail distribution under s.104 Hong Kong Securities and Futures Ordinance (SFO).

As discussed in relation to licensing trading platforms, portfolio managers may not wish to be restricted to dealing only with professional investors. 

Despite the restriction to professional investors, firms will be required to disclose all associated risks to potential investors and distributors appointed for the distribution of virtual asset funds.

2. Safeguarding of assets

Licensed corporations will be subject to requirements to ensure the safe custody of virtual assets, although the SFC acknowledges that virtual asset funds face “a unique challenge due to the limited availability of qualified custodian solutions”. The SFC is imposing onerous obligations on licensed corporations with regard to their selection of appropriate custodians. Their ability to comply with these requirements will depend on the willingness of custodians to disclose information on their financial resources, corporate governance and risk management etc.

  1. assess and select the most appropriate custodial arrangement (e.g. whether to hold the assets itself or with a third-party custodian or an exchange) taking into consideration the advantages and disadvantages of holding virtual assets at different host locations by way of “hot wallets”, “cold wallets” and “deep cold wallets”) with regard to (among others):
    1. the ease of accessibility to virtual assets, i.e. time required to transfer virtual assets to the trading venue; and
    2. the security of the custodial facility, i.e. whether appropriate safeguards are in place to protect against external threats such as cyberattacks; and
  2. exercise due skill, care and diligence in selecting, appointing and conducting on-going monitoring of custodians by reference to factors such as the custodian’s:
    1. experience and track record in providing custodial services for virtual assets;
    2. regulatory status, particularly whether its virtual asset custodial business is subject to regulatory oversight;
    3. corporate governance structure and the background of its senior management;
    4. financial resources and insurance cover for compensating customers for loss of customer assets; and
    5. operational capabilities and arrangements, for example, its “wallet” arrangements and cybersecurity risk management measures.

Where virtual assets are held by the licensed corporation itself, the licensed corporation is additionally required to:

  1. document the reasons for self-custody;
  2. implement appropriate measures to protect the assets;
  3. ensure the effective segregation of the virtual assets from the licensed corporation’s own assets on its insolvency;
  4. use best endeavours to acquire and maintain insurance cover over the virtual assets; and
  5. disclose the risks of self-custody to investors.

3. Portfolio valuation

The SFC recognizes that there are currently no generally accepted valuation principles for virtual assets, particularly ICO tokens. The licensing conditions will however require licensed corporations to select valuation principles, methodologies, models and policies which are reasonably appropriate in the circumstances and in the best interests of investors. These will also need to be disclosed to investors.

4. Risk management

Licensed corporations will be required to set appropriate limits for each product and market the portfolios invest in and each counterparty to which the portfolios have exposure. They should, for example, consider setting a cap on portfolios’ investment in illiquid virtual assets and newly-launched ICO Tokens. Periodic stress testing should be carried out to assess the effect of abnormal and significant changes in market conditions on portfolios.

Before transacting with virtual asset exchanges, licensed corporations will be required to assess the reliability and integrity of the virtual asset exchange taking into account matters such as the virtual asset exchange’s:

  1. experience and track record;
  2. legal or regulatory status, if any;
  3. corporate governance structure and background of its senior management;
  4. operational capabilities;
  5. mechanisms (e.g., surveillance systems) implemented to guard against fraud and manipulation with respect to products traded on the exchange;
  6. cybersecurity risk management measures; and
  7. financial resources and insurance cover.

Exposure to individual virtual asset exchanges should be limited by setting appropriate caps.

5. Auditors

The SFC notes that the accounting profession has no agreed standards and practices for how an auditor can perform assurance procedures to obtain sufficient audit evidence for the existence and ownership of virtual assets, and ascertain the reasonableness of the valuations. Despite this, the SFC will require the appointment of an independent auditor to audit the financial statements of managed funds. Despite the difficulties acknowledge by the SFC, it will require licensed corporations to consider auditors’ experience and capability in checking the existence and ownership of virtual assets, and ascertaining the reasonableness of their valuation, in their selection of an auditor.

Liquid Capital

A licensed corporation which holds non-SF virtual assets for portfolios under its management will need to maintain a required liquid capital of at least HK$3 million (or its variable required liquid capital, whichever is higher).