Regulatory Status of Cryptocurrencies
1. REGULATORY STATUS OF CRYPTOCURRENCIES
Hong Kong’s regulators generally consider cryptocurrencies such as Bitcoin and Ether to be “virtual commodities” which are not regulated in Hong Kong. However, as noted in its September 2017 Statement on initial coin offerings, the SFC determines the regulatory status of cryptocurrencies on a case-by-case basis depending on whether they carry rights equivalent to traditional securities, for example if:
- they carry rights similar to those provided by shares, such as a right to a portion of the issuing company’s profits or surplus assets on winding up;
- they have rights similar to debentures such as a right to repayment of the purchase price; or
- they are similar in nature to an interest in a Collective Investment Scheme (or CIS) where the purchase price will be invested in assets or projects and any return will be distributed to the holders.
Very few cryptocurrencies have features similar to shares or debentures.
There is a question mark as to whether cryptocurrencies could be considered to be interests in a CIS, particularly given the lack of Hong Kong case law on the SFO’s definition of a “collective investment scheme”. The essential features of a CIS under the SFO are that:
- it must involve an arrangement in respect of property (property is broadly defined);
- the 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 must be 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 of the arrangement should be to provide participants with profits, income or other returns from the acquisition or management of the property.
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.
Most ICOs in Hong Kong, as elsewhere, have typically been structured as offers of “utility tokens”, (tokens which give holders rights to access a product or service provided by the platform either now or in the future) which the SFC’s February 2018 statement  suggested are outside the scope of Hong Kong’s securities legislation. The SFC noted that ICO issuers it had contacted either confirmed that their tokens did not constitute securities or ceased to offer tokens in Hong Kong. Similarly, crypto exchanges contacted by the SFC reportedly also confirmed that they only trade non-security tokens or ceased to sell tokens which could be securities. The SFC has not published the names of the relevant ICO issuers or provided any further guidance on the features of an ICO token which are likely to render it a security.
Despite writing to a number of ICO issuers asking for confirmation that their ICO tokens were not securities, the SFC has only put a stop to one ICO – Black Cell Technology’s ICO in March 2018 on the basis that the offering may have been a collective investment scheme. However, this was an extreme case since the tokens sold in the ICO were redeemable for equity shares in the ICO issuer, Black Cell. The SFC’s regulatory action resulted from concerns that Black Cell had engaged in potential unauthorised advertising activities in contravention of Section 103 of the SFO and may have breached the SFO’s licensing requirements, although it did not specify which regulated activity was involved. Black Cell stopped ICO transactions with Hong Kong investors and undertook not to establish or market any CIS except in compliance with the SFO.
While Hong Kong saw a number of ICOs in 2017 and 2018, ICO activity in Hong Kong has virtually ceased in 2019 and 2020 following repeated warnings from the SFC. The lack of activity may also be due to the lack of clarity as to the features of an ICO token which would bring it within the definition of a security, which is also true in many other jurisdictions.
1.2 Securities Token Offerings (STOs)
STOs emerged in 2017 (with two STOs raising collectively US$22 million) and began to pick up in 2018 (with a total of 28 STOs raising US$442 million) and 55 in 2019 (raising US$452 million). Security tokens were then heralded in some quarters as the “next big megatrend” in the blockchain revolution, however this is yet to materialise, with some citing the lack of a secondary market for tokenised securities, an undeveloped regulatory environment and high upfront costs. However, there has been steady growth. The value of the STO market is expected to grow from US$983 million in 2018 to US$2.6 billion by 2023, particularly in view of the institutionalisation of the digital asset ecosystem.
STOs can be differentiated from ICOs however as while ICOs sought to position themselves outside the securities regulatory framework, STOs are being used in some jurisdictions, notably the US, to bring crypto assets within the regulatory net as a means to achieve regulatory certainty, which means greater certainty for fundraisers and investors alike. Despite this, STOs have not been popular in Hong Kong as yet as it is still very uncertain how the Hong Kong regulatory framework applies to security token offerings, and more fundamentally, as to the characteristics which make a cryptocurrency a security token in the first place.
(a) SFC Statement on Security Token Offerings
The SFC issued a Statement on Security Token Offerings  (or STOs) on 28 March 2019 setting out the regulatory requirements applicable to STOs and reiterating the SFC’s earlier warnings to the public of the potential risks involved in investing in digital assets.
What does the SFC consider to be a security token?
The SFC describes security tokens as digital assets which have the features of traditional securities, including tokens which represent economic rights such as a share of profits or revenue. Thus, tokens which are essentially tokenised shares (e.g., entitling holders to a share of profits in the form of a dividend or to participate in the distribution of the issuer’s assets on winding up) will be a security token, and thus a security under Hong Kong law. Similarly, a token which has the features of a debt or liability owed by the issuer, will likely be a “debenture” for the purposes of Hong Kong’s securities laws.
According to the SFC’s March 2019 statement, a token representing ownership of assets, such as gold or real estate, would also amount to a security token, although the SFC does not elaborate on why this should be the case. The SFC may be alluding to what is essentially a tokenised real estate or gold fund – where money raised from a token offering is invested in gold or real estate on the understanding that token holders will receive a share of the future proceeds of sale of the gold/real estate when sold at a profit. In that case, the tokens would likely constitute securities as interests in a collective investment scheme under the SFO.
Alternatively, the SFC could be suggesting that tokens whose value/price is linked to the value/price of an underlying commodity such as gold or real property constitute either “regulated investment agreements” or “structured products” under the SFO definitions.
Structured products are defined broadly and include 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; or
- 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.
The SFC’s March 2019 statement suggests that, depending on how the tokens are structured, tokens representing an underlying asset could constitute structured products subject to Hong Kong’s securities laws. There has been no official guidance from the SFC on how it would regard stablecoins that are pegged to the price of assets such as gold or fiat currencies whose value may appreciate or not. Unlike jurisdictions such as the US, Hong Kong does not regulate commodities such as gold. It would therefore be illogical for a token representing a commodity, which is more akin to a deposit slip than a security, to be regarded as a security subject to Hong Kong’s securities regulatory regime. The Financial Services and Treasury Bureau’s (the FSTB) November 2020 Consultation Paper proposing a licensing regime for exchanges trading non-security cryptocurrencies confirmed that cryptocurrencies that are backed by assets for the purpose of stabilising their value are virtual assets for the purposes of the proposed new licensing regime. Thus, an exchange trading stablecoins which are not securities will need to be licensed under the new AMLO licensing regime when it is implemented.
Regulated investment agreements
A ‘regulated investment agreement’ is an agreement, the purpose or effect 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).
Unless a security token offering is essentially a tokenised fund offering which is a collective investment scheme, there seems to be little support for the SFC’s statement that tokens representing digital ownership of assets such as gold or real estate constitute securities under the SFO. Further guidance on this from the SFC would be welcome.
- SFC. “Statement on Initial Coin Offerings”. 5 September 2017
- SFC. “SFC warns of cryptocurrency risks”. 9 February 2018
- SFC. “SFC’s regulatory action halts ICO to Hong Kong public”. 19 March 2018
- Cointelegraph. “What’s happened with the so-called next big thing in fintech?” 13 July 2020. Available at: https://cointelegraph.com/news/sto-whats-happened-with-the-so-called-next-big-thing-in-fintech
- SFC. Statement on Security Token Offerings. 28 March 2019. Available at: https://www.sfc.hk/en/News-and-announcements/Policy-statements-and-announcements/Statement-on-Security-Token-Offerings
(b) Regulatory Implications of STOs being “securities” under the SFO
The SFC’s March 2019 statement on STOs provides that where an intermediary markets or distributes security tokens, it should only offer them to professional investors. An offer of security tokens only to professional investors as defined in the SFO has the advantage of being exempt from the requirement for SFC authorisation of any advertisement or invitation issued in relation to an offer of securities (under section 103 SFO) where the security tokens are offered to more than 50 persons in Hong Kong.
Where STO tokens constitute interests in a collective investment scheme, restricting the offer to professional investors will mean that the stringent requirements of the SFC’s Code on Unit Trusts and Mutual Funds will not apply. Those requirements would likely render an STO unworkable given:
- the requirements for the appointment of a qualified fund manager and a custodian that is a bank or trust company registered under the Trustee Ordinance; and
- the investment restrictions applicable to retail funds which include a prohibition on real estate investment and a restriction on investing no more than 15% of the fund’s net asset value in investment products that are not listed on the HKEx or another recognised stock exchange.
Licensing Requirements for Intermediaries Marketing / Distributing Security Tokens
Where crypto assets are “securities” under the SFO, any exchange which provides trading in the security tokens and any intermediary which markets and distributes the security tokens must be licensed or registered by the SFC for Type 1 regulated activity (dealing in securities), and each of its staff members conducting trading or marketing of security tokens must also be licensed for Type 1. The SFC states in its March 2019 statement that security tokens should only be offered to professional investors.
Conduct Requirements for Licensed Intermediaries
STO suitability for intermediaries’ customers
Intermediaries which market and distribute security tokens must comply with the conduct provisions of the SFC’s Code of Conduct, in particular the requirement under paragraph 5.2 to ensure that customer recommendations and solicitations with respect to security tokens are reasonably suitable for the particular customer, given the information about the particular customer of which the intermediary is or should be aware through the conduct of due diligence.
Intermediaries should also refer to the SFC’s Suitability FAQs and FAQs on Triggering the Suitability Obligations. Although not referred to in the SFC statement, all licensed intermediaries are also under an obligation to conduct customer due diligence and anti-money laundering checks on their customers and these apply irrespective of the type of product being recommended or the subject of a customer solicitation.
STOs as Complex Products
The SFC regards security tokens as “complex products” as defined under paragraph 5.5 of the Code of Conduct. Paragraph 5.5 imposes additional obligations on licensed intermediaries which make recommendations or solicit investors with respect to complex products. In particular, licensed intermediaries and their licensed staff are required to ensure that:
- the security token is suitable for the client in all the circumstances;
- the client is provided with sufficient information on the key nature, features and risks of the security token to understand it before making an investment decision; and
- the client is provided with clear warning statements about the security token’s distribution.
Intermediaries’ Due Diligence Obligations
The SFC’s March 2019 statement mentions the need for intermediaries who market or distribute security tokens to conduct proper due diligence on the offering which should cover (among others):
- the background and financial soundness of the management, development team and the issuer of the security token; and
- the existence of and rights attached to the assets which back the security token.
Licensed intermediaries are also required to study security tokens’ whitepapers and all relevant marketing materials and other published information. The SFC’s March 2019 statement also notes intermediaries’ obligation to ensure that information provided to customers in respect of an STO is accurate and not misleading. This is the first time the SFC has raised the issue of the standard of due diligence it expects in relation to security token offerings and intermediaries’ responsibility for the accuracy of information.
Information to be Provided to Customers
Intermediaries should provide their customers with clear and comprehensible information on STOs which should include prominent warning statements alerting potential investors to the risks associated with digital assets. The SFC reminds licensed intermediaries to implement adequate systems and controls to ensure compliance with their regulatory obligations prior to engaging in security token distribution.
Requirement to Notify the SFC before Dealing in Security Tokens
The SFC also requires licensed intermediaries to notify it in advance prior to conducting any business in security tokens.
Shortcomings of the SFC’s Regulatory Approach
A loophole in the SFC’s regulatory approach to security token offerings is that the investor protection driven measures of the SFC Code of Conduct (the obligation to ensure the suitability of investment products for individual clients, anti-money laundering and counter-terrorist financing obligations etc.) only apply where a traditional intermediary is involved. The SFC Code of Conduct does not apply to issuers of securities and thus, on a typical security token offering, there is no obligation on the issuer to ensure the accuracy of the information provided in its marketing documents nor to assess the suitability of its tokens for prospective purchasers.
Additionally, token issuers and their designers and developers are typically based offshore, outside the regulatory remit of the SFC, and so, protection for Hong Kong investors against fraudulent or incompetent issuers is scant. The SFC Code of Conduct requirements referred to in the SFC’s March 2019 Statement will only ever apply where a Hong Kong SFC licensed or registered intermediary is engaged to market the tokens to Hong Kong investors – a scenario which has not yet occurred in Hong Kong. However, if security tokens are to be traded on a Hong Kong crypto exchange, the operator of the exchange will need to be licensed and thus secondary market trading will be subject to SFC regulation.
Under the SFO, security tokens, in the same way as traditional securities, cannot be marketed to Hong Kong investors except by an SFC Type 1-licensed entity. However, if security tokens are not “actively marketed” to the Hong Kong public, there is nothing to prevent Hong Kong investors from subscribing for tokens via an offshore platform and in this situation, none of the SFC Code of Conduct’s investor protection mechanisms will apply. Further, if the offering turns out to be a scam, Hong Kong investors have no means of redress other than a contractual claim or common law action against the token issuer. Given that whitepapers generally do not even contain the issuer’s legal name and registered address, this route to recovering losses will not be straightforward.
These issues are of course by no means unique to Hong Kong and regulators worldwide face similar challenges.
1.3 Virtual Asset Futures and CME and CBOE Bitcoin Futures
Virtual asset futures contracts are largely unregulated, highly leveraged and subject to extreme price volatility which urged the SFC to issue a statement warning investors of the risks in November 2019. The SFC noted in the same statement that trading platforms or persons which offer and/or provide trading services in virtual asset futures contracts without being licensed under the SFO may be in breach of the SFO. Virtual asset futures contracts may also constitute “contracts for differences” under the Gambling Ordinance which may be illegal unless authorised under that ordinance.
Further, according to the SFC Circular on Bitcoin futures contracts and cryptocurrency-related investment products of December 2017,  a Hong Kong entity which enables Hong Kong investors to trade Bitcoin futures contracts which are traded on the Chicago Mercantile Exchange (the CME) or Chicago Board Options Exchange (the CBOE), including by relaying or routing orders for these Bitcoin futures contracts, will need to be licensed by the SFC for Regulated Activity Type 2 (dealing in futures contracts). These intermediaries are also expected to strictly observe the suitability requirement of paragraph 5.2 of the SFC Code of Conduct and the conduct requirements in relation to providing services in derivative products to clients under paragraphs 5.1A and 5.3 of that Code.
- SFC. SFC issues warnings on virtual asset futures contracts. 6 November 2019. Available at: https://www.sfc.hk/en/News-and-announcements/Policy-statements-and-announcements/SFC-issues-warnings-on-virtual-asset-futures-contracts
- SFC. Circular to licensed corporations and registered institutions on Bitcoin futures contracts and cryptocurrency-related investment products. 11 December 2017. Available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=17EC79