Hong Kong’s securities regulator, the Securities and Futures Commission (SFC), issued a statement warning investors of cryptocurrency risks related to cryptocurrency exchange trading and buying into initial coin offerings (ICOs) on 9 February 2018.
Cryptocurrency Trading Exchanges
According to the statement, the SFC has sent letters to seven cryptocurrency exchanges in Hong Kong or connected to Hong Kong notifying them that they should not trade cryptocurrencies which are “securities” as defined under the Securities and Futures Ordinance (the SFO) unless they are licensed by the SFC. Most of the cryptocurrency exchanges contacted by the SFC have apparently either: (i) confirmed that they do not trade cryptocurrencies which are “securities” under the SFO; or (ii) immediately rectified the position and ceased trading in cryptocurrencies that are securities.
The SFC statement notes that it has received complaints from people who have been unable to withdraw fiat currencies and cryptocurrencies from their accounts with exchanges. Other complaints against cryptocurrency exchanges include allegations of asset misappropriation, market manipulation, and technical breakdowns of the exchanges’ platforms resulting in financial loss.
However, the licensing requirements for cryptocurrency trading platforms in Hong Kong are not clear cut. As noted in the SFC statement, the SFC’s oversight role is limited to exchanges which trade ICOs which constitute securities or futures. The SFC issued a Statement on ICOs on 5 September 2017 stating that while tokens issued in a typical ICO are regarded as “virtual commodities” which are not regulated under the SFO, where tokens have the characteristics of shares, debentures or interests in a collective investment scheme (CIS), they must be offered in compliance with the SFO. The SFC issued a circular on 11 December 2017 reminding investment intermediaries that while bitcoin transactions are not regulated under the SFO, the SFC regulates bitcoin futures contracts which are subject to the rules of a futures market, such as the bitcoin futures contracts launched on US exchanges in December 2017. The SFC will also regulate other cryptocurrency related investment products such as cryptocurrency options, swaps and contracts for differences which are securities or futures contracts under the SFO.
A number of cryptocurrency trading platforms are however licensed as “money service operators” (MSOs) under the Anti-Money Laundering and Counter-Terrorist Financing (Financial Institutions) Ordinance (Cap. 615 of the Laws of Hong Kong) (the AMLO). This is not because cryptocurrencies constitute money – they do not – the Money Service Supervision Bureau of the Customs and Excise Department (C&ED) which regulates MSOs issued a statement in April 2014 that bitcoin and similar virtual currencies are not money for the purposes of the AMLO and thus are outside the regulatory regime administered by the C&ED. The statement warns that an MSO licence granted by the C&ED “does not give any form of approval or recognition to a business related to Bitcoin or similar virtual commodities”. Which begs the question why cryptocurrency trading exchanges have obtained MSO licences. The answer lies in the intersection between cryptocurrency trading and dealing in fiat or real currencies. An MSO licence is needed by anyone operating a remittance service or a money changing business in Hong Kong. A remittance service is sending or receiving money to or from a place outside Hong Kong or arranging it. Thus a cryptocurrency exchange which receives fiat currency from outside Hong Kong for the purchase of cryptocurrencies, or sends it to a place outside Hong Kong, would require an MSO licence. A money changing service is a currency exchange business. While cryptocurrencies are not regarded as currencies, the sale of a cryptocurrency for fiat currency might be regarded as money changing since the seller receives currency. It is likely that the cryptocurrency exchanges which are licensed MSOs sought the licence primarily in order to be able to send and receive fiat currency to and from places outside Hong Kong. MSOs are required to conduct anti-money laundering and counter-terrorist financing procedures.
The latest SFC statement notes that it has written to seven ICO issuers and that most of them confirmed their compliance with the regulatory regime under the SFO, or immediately ceased to offer the tokens to Hong Kong investors. The SFC notes that it will closely monitor ICOs and will pursue regulatory action in appropriate cases.
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 is welcome to the extent it appears to acknowledge that digital tokens which are “utility tokens” are not “securities” under the SFO. There is no legal definition of “utility token” but the underlying concept would appear to be that a “utility token” is one that has an actual use and is not intended as an investment. An old-fashioned example would be fairground tokens used to purchase rides. In terms of ICOs, utility tokens (also called app coins or user tokens) represent access to a company’s products or services, or to future products or services. But this still leaves both ICO issuers and potential purchasers in a very grey area from a legal perspective. While a fairground token is clearly not a security – the picture for many ICO tokens is unclear.
The name given to any cryptocurrency, utility token, app coin or whatever, is irrelevant in reality. The legal classification depends on the economic reality of the token which, in the case of Hong Kong, means does the holder of the token receive or expect to receive a share of the “profits, income or other returns” or “a payment or other returns” from the acquisition, holding, management, or disposal of all or any part of the property the subject of the “arrangements” (under the ICO) or of “any right, interest, title or benefit” in that property or any part of it.
The following are examples of ICO tokens which would and would not be regarded as securities under the SFO. The examples are taken from the “Guide to Digital Token Offerings” published by Singapore’s Monetary Authority (the MAS), but adapted to reflect the position under Hong Kong law.
Example of an ICO not involving a securities offering
Company A plans to set up a platform to enable sharing and rental of computing power amongst the users of the platform. Company A intends to offer digital tokens (Token A) in Hong Kong to raise funds to develop the platform. Token A will give token holders access rights to use Company A’s platform. The token can be used to pay for renting computing power provided by other platform users. Token A will not have any other rights or functions attached to it. Company A intends to offer Token A to any person globally, including in Hong Kong.
Position under Hong Kong Securities Law
Holders of Token A only have rights to access and use Company A’s platform and the right to use Token A to pay for rental and computing power provided by other users. Token A does not provide its holders with any other rights or functions. Since holders will not receive any share of Company A’s revenues or profits or other return from the platform and has no right to repayment of the purchase price of Token A, it would not be a security under the SFO.
Example of an ICO which is a securities offering
Company B intends to offer digital tokens (Token B) to any person globally, including in Hong Kong. Company B will pool funds raised from the offer and use the funds to invest in a portfolio of shares in FinTech companies (Portfolio). Company B will also manage the Portfolio. Holders of Token B will not have any powers relating to the day-to-day operations of Company B or the management of the Portfolio. Profits arising from the Portfolio will be pooled and distributed as payments to the token holders. The purpose of the arrangement is to enable token holders to receive profits arising from the Portfolio.
Position under Hong Kong Securities Law
The arrangements established by Company B will be a collective investment scheme (CIS) under the SFO. Token B will be an interest in a CIS and will constitute a “security” under the SFO. The CIS must therefore by authorised by the SFC under section 104 of the SFO and Company B will require a licence to carry on business in asset management (Type 9). The Tokens may only be promoted to Hong Kong investors by Company B as a licensed asset manager or by another entity which is licensed or registered by the SFC for regulated activity Type 1 (dealing in securities).
In these examples the situation is straightforward – in example 2, the tokens are essentially digital units in a fund and are thus securities. In most cases, however, the position is far less clear and ultimately whether or not any particular ICO constitutes a securities offer will be one for determination by the courts on the basis of an analysis of the facts of the particular case. In many cases, there will be a fine line between an ICO which is a securities offer and one which is not.
The difficulty in classification is compounded by the uncertainty around the definition of “collective investment scheme” under the SFO, due in part to the fact that there are no reported cases on its scope. First, it is not clear what is the “property” to which the arrangements under an ICO relate. It could be the platform through which token holders will gain access to the company’s products or services – so that the ICO should only be a CIS where token holders will receive income or a return from the management or sale of the platform. Or it could be the tokens themselves, but then the other prong of the ICO test – that the participants must not have “day-to-day control over the management of the property” may not be met if token holders have the right to use the tokens for specific purposes, say to purchase goods or services available on the platform. In many ways it would be simpler if the Financial Secretary were to exercise its right to designate ICOs having certain features as securities using its powers under section 392 of the SFO.
Risks for Investors
The SFC statement warns potential cryptocurrency purchasers of the associated risks including fraud and the risk of loss due to hacking as was seen in the US$530 million theft of NEM coins from Japanese exchange, Coincheck. Another risk is extreme price volatility which has seen the price of bitcoin more than halve since its record high of US$19,511 on 18 December 2017. Risks relating to crypto trading exchanges also include technical problems on the platforms.
Yet the industry is very much in its infancy and with improved technology and security hopefully many of the issues around hacking can be resolved. Fraud is an enduring problem which dogs regulated securities and other investment forms. As alluded to in the statement, the SFC will refer to the Police cases where fraudulent activity is suspected.
The Role of Market Professionals
The latest warning from the SFC struck a surprising note in quoting SFC Chairman, Ashley Alder, as “urging market professionals to do proper gatekeeping to prevent frauds or dubious fundraising and to assist [the SFC] in ensuring compliance with the law”. The implications of the statement are unclear. Lawyers and other market professionals are required by law to conduct anti-money laundering and counter-terrorist financing procedures on their clients and to report suspicious transactions under a number of laws, including the Organized and Serious Crimes Ordinance and Drug Trafficking (Recovery of Proceeds) Ordinance, and are thus already bound to act to prevent “dubious fundraising”. The statement does not elaborate on what, if anything, is expected in terms of assisting in “ensuring compliance with the law” beyond the obligation to advise clients on what is and what is not permitted under Hong Kong law.
 Money Service Supervision Bureau of the Customs and Excise Department. “Statement – In relation to “Bitcoin and Money Service Operator Licence”. April 2014.
 Paragraph (iii) of the definition of “collective investment scheme” in Schedule 1 to the Securities and Futures Ordinance.
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