Hong Kong and Crypto currencies
Hong Kong and Cryptocurrencies
Are cryptocurrencies securities?
The key issue under Hong Kong law is whether any particular cryptocurrency is a security for the purposes of Hong Kong’s regulatory framework.
On 5 September 2017, Hong Kong’s Securities and Futures Commission (the SFC) issued a statement on ICOs (the SFC Statement) which provides that while digital tokens offered in typical ICOs are usually characterised as a “virtual commodity”, depending on the facts and circumstances of an ICO, digital tokens that are offered or sold may be “securities” as defined in the Securities and Futures Ordinance (Cap. 571) (the SFO), and subject to the securities laws of Hong Kong.
The SFC Statement outlines three scenarios in which digital coins might constitute “securities”, namely where the coins could be regarded as shares, debentures or interests in a collective investment scheme (CIS).
According to the SFC Statement, digital tokens or coins offered in an ICO may be regarded as “shares” where they represent equity or ownership interests in a corporation, for example where coin holders are given shareholders’ rights, such as the right to receive dividends and the right to participate in the distribution of the corporation’s surplus assets upon winding up.
Where digital coins are used to create or acknowledge a debt or liability owed by the coin issuer, the SFC may regard them as “debentures”, for example where an issuer may repay coin holders the principal of their investment on a fixed date or upon redemption, with interest paid to holders.
(c) Interests in a CIS
The SFC Statement provides that if token proceeds are managed collectively by the ICO scheme operator to invest in projects with the aim of enabling coin holders to participate in a share of the returns provided by the projects, the digital coins may be regarded as interests in a CIS.
The SFC’s guidance indicates that the essential features of a CIS are:
- it must involve an arrangement in respect of property (property is broadly defined);
- participants do not have day-to-day control over the management of the property (even if they have the right to be consulted or to give directions about the management of the property);
- the property is managed as a whole by or on behalf of the person operating the arrangements, and/or the participants’ contributions and the profits or income are pooled; and
- the purpose or effect (or pretended purpose or effect) of the arrangement is to provide participants with profits, income or other returns from the acquisition or management of the property.
The definitions of securities and collective investment schemes are however broad and potentially include tokens outside the categories highlighted above. There have been no court decisions on the meaning of “collective investment scheme” in Hong Kong and whether or not any particular ICO falls within the definition will depend on the facts and circumstances of the ICO and ultimately, the courts’ interpretation of the statutory definition.
However, the SFC has stopped one ICO, that of Black Cell Technology Limited (Black Cell), from being publicly offered in Hong Kong. According to the SFC’s press release of 19 March 2018 , the SFC considered that the Black Cell ICO may constitute a CIS since funds raised in the ICO were to be used to fund the development of a mobile application and holders of the tokens would be eligible to redeem equity shares of Black Cell. Black Cell had promoted the ICO to sell digital tokens to investors through its website which was accessible by the Hong Kong public. The SFC had concerns that Black Cell had engaged in potential unauthorised promotional activities and unlicensed regulated activities. Following the SFC’s regulatory action, Black Cell agreed to unwind ICO transactions for Hong Kong investors by returning the relevant tokens to them and undertook not to devise, set up or market any scheme that constitutes a CIS unless in compliance with the relevant requirements under the SFO. Although the SFC has not made public its detailed reasoning in this case, it indicates that the SFC appears to view an ICO which will fund the development of a project as satisfying the first three elements of the CIS definition set out above. In this case, the element of return to token holders was clear – the right to redeem shares in the company, which is unusual. Care should be taken to ensure that ICOs are not represented to provide any form of profit or return to holders and that marketing does not encourage speculation.
In Hong Kong, as in the US and other jurisdictions, ICOs have typically being structured so that the digital coins will represent a right of access to the technology whose development the ICO proceeds will fund. The intention behind this is to characterise the tokens or coins as pre-payment vouchers rather than as securities. White papers thus typically present the digital coins as providing purchasers with the right to use the technology and they sometimes additionally act as the means of payment for use of the services offered by the technology. These are sometimes referred to as “utility tokens”.
On 9 February, 2018, the SFC published a statement warning investors of the potential risks of investing in ICOs and dealing with cryptocurrency exchanges . The statement also confirmed that the SFC wrote to seven ICO issuers, most of whom confirmed SFO compliance or ceased offering tokens in Hong Kong. The statement describes ICOs as “essentially crowdfunding by blockchain start-ups” and notes that ICO issuers are typically “assisted by market professionals such as lawyers, accountants and consultants” to structure the ICO as an offering of “utility tokens to fall outside the purview of the SFO and to circumvent the scrutiny of the SFC”. The statement thus appears to acknowledge that digital tokens which are “utility tokens” are not “securities” under the SFO.
There is however no legal definition of “utility token”. An old-fashioned example would be fairground tokens used to purchase rides. The difficulty with ICO tokens is that it is uncertain whether to be a utility token, tokens must have an actual use on issue (i.e. at the ICO stage) and whether that must be the sole use. ICO Guidelines  published by the Swiss Financial Market Supervisory Authority provide that utility tokens will be treated as securities only if their sole purpose is to confer digital access rights to an application or service and if the utility token can actually be used in this way at the point of issue. If a utility token additionally or only has an investment purpose at the point of issue, it will be treated as a security.
There are also difficult questions as to what would be regarded as a “return” to the token holders. Would, for example, a potential profit on a future sale of tokens be considered to constitute a return? Token issuers must take particular care to ensure that ICOs are not marketed so as to encourage speculation.
(d) Structured Products and Regulated Investment Agreements
Although not specifically mentioned in the SFC’s Statement, in certain circumstances, digital coins issued in an ICO might constitute structured products or regulated investment agreements, both of which are “securities” for the purposes of the SFO.
A structured product is broadly defined  and includes:
- Any product where all or part of the return or amount due (or both) or the settlement method is determined by reference to any one or more of:
- changes in the price, value or level (or within a range) of securities, commodities, indices, property, interest rates, currency exchange rates or futures contracts, or any combination or basket of any of these;
- the occurrence or non-occurrence of any specified event(s) other than an event relating only to the issuer and/or the guarantor of the product; or
- A regulated investment agreement which is an agreement, the purpose or effect (or pretended purpose or effect) of which is to provide to any party to the agreement a profit, income or other return calculated by reference to changes in the value of any property (e.g. equity linked deposits) (but does not include a collective investment scheme).
This classification is therefore likely to apply where the return on a coin is linked to changes in the price or value of any property, which would include the price of cryptocurrencies such as Bitcoin etc. or of any securities index etc.
(e) Bitcoin futures
Bitcoin futures were launched in the US on two major exchanges, the Cboe and CME, in December 2017. The SFC issued a circular  stating that Bitcoin futures contracts constitute futures contracts for the purposes of the SFO notwithstanding that Bitcoin itself is not regulated.
Accordingly, parties carrying on a business of dealing in Bitcoin futures, which include those who relay or route Bitcoin futures orders, are required to be licensed to deal in futures contracts (Type 2 Regulated Activity), in the absence of an applicable exemption. Licensed intermediaries should not directly route Bitcoin futures orders to an exchange which is not authorised by the SFC under Part III SFO . The SFC has also reminded intermediaries of the need to strictly observe the suitability requirement under paragraph 5.2 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the Code of Conduct) and the requirements for providing services in derivative products to clients under paragraphs 5.1A and 5.3 of the Code of Conduct.
Note: The above represents Charltons’ current understanding of the regulation of ICOs in different jurisdictions. Charltons advises only on Hong Kong law and while the above represents our understanding of the legal position in certain other jurisdictions, legal advice from qualified lawyers in the relevant jurisdictions should be sought in relation to any particular transaction or situation. Further, this note is intended for educational purposes and it does not constitute Hong Kong legal advice. Specific advice must be sought in relation to any particular situation.
- SFC. “SFC’s regulatory action halts ICO to Hong Kong public”. 19 March 2018. <https://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=18PR29>
- SFC. “SFC warns of cryptocurrency risks”. 9 February, 2018. <http://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=18PR13>
- Swiss Financial Market Supervisory Authority. “Guidelines for enquiries regarding the regulatory framework for initial coin offerings”. 16 February 2018.
- Section 1A of Schedule 1 to the Securities and Futures Ordinance.
- SFC. “Circular to Licensed Corporations and Registered Institutions on Bitcoin futures contracts and cryptocurrency-related investment products”. 11 December 2017. <https://www.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=17EC79>
- The list of automated trading services authorised under Part III SFO is available on the SFC website at <https://www.sfc.hk/web/EN/regulatory-functions/market-infrastructure-and-trading/approved-or-authorized- entities/register-of-automated-trading-services-authorized-under-part-iii-of-the-sfo/>