Introduction
On 28 January 2022, the Securities and Futures Commission (the “SFC”) and the Hong Kong Monetary Authority (the “HKMA”) issued a joint circular (the “Joint Circular”) providing guidance to banks and SFC-licenced intermediaries intending to engage in virtual asset (“VA”)-related activities (the “VA-related activities”).
Indeed, we are seeing enormous development in the Hong Kong regulatory landscape. In late 2019, the SFC introduced its new opt-in regulatory framework of virtual asset trading platforms (see our news update). In May 2021, the Financial Services and the Treasury Bureau (the “FSTB”) issued consultation conclusions on implementing a licensing regime for virtual asset service providers (“VASP licensing regime”) (see our news update). More recently, in mid-January 2022, the HKMA issued a discussion paper on crypto-assets and stablecoins (see our news update).
The Joint Circular has three main focuses: (a) the distribution of VA-related products; (b) the provision of VA dealing services (the “VA dealing services”); and (c) the offering of VA advisory services (the “VA advisory services”).
A. Distribution of VA-Related Products
VA-related products (the “VA-related products”) are likely to be considered complex products, due to their inherent risks which may not be easily understood by a retail investor. Thus, intermediaries distributing VA-related products should comply with the following additional requirements as appropriate.
Complex products requirements
Intermediaries should comply with the SFC’s requirements which govern the sale of complex products, including ensuring the suitability of VA-related products, minimum information and warning statements.[1]
“Professional investors only” selling restriction
VA-related products which are considered complex products should only be offered to “professional investors”[2] only. For example, an overseas VA non-derivative ETF would very likely be considered a complex product and it should only be offered to professional investors.
However, it is noted that there is a limited suite of VA-related derivative products traded on regulated exchanges as specified by the SFC and, in the case of exchange-traded VA derivative funds, authorised or approved for offering to retail investors in designated jurisdictions (including Australia, United Kingdom and United States of America). The “professional investors only” restriction is not imposed on the distribution of these products. Nevertheless, given such products are considered complex exchange-traded derivatives, they are still subject to derivative product requirement and VA knowledge test requirement.
It should be noted that the provisions under Part IV of the Securities and Futures Ordinance (Cap. 571) (the “SFO”) continue to apply, which prohibit the offering of investment products which have not been authorised by the SFC to the Hong Kong public. Where the VA-related products are distributed on an online platform, it must be properly designed and have appropriate access rights and controls to ensure compliance with the selling restrictions in Hong Kong and other jurisdictions and exchange, as appropriate.
VA knowledge test
Other than institutional professional investors and qualified corporate professional investors[3], intermediaries should assess whether their clients have knowledge of investing in VAs or VA-related products prior to effecting a transaction in VA-related products on their behalf. If not, intermediaries may only proceed if it acts in the client’s best interests and shall provide requisite training and sufficient information to ensure that the clients understand the VA-related products and are able to assume the related risks before making an investment decision.
Suitability obligation requirements
Intermediaries should ensure the suitability of VA-related products, including ensuring that any recommendations or solicitations made are suitable for clients in all circumstances and in their best interests, taking into account, among others, the clients’ risk tolerance and financial situation. Intermediaries should ensure that the aggregate amount to be invested in VA-related products is reasonable considering the clients’ net worth.
In addition, intermediaries should conduct proper due diligence on the products to understand their risks and features, the targeted investors and the products’ regulatory status. For an unauthorised VA fund, this means to conduct due diligence on the fund’s constitution, fund managers, operation, trading and custodian services providers and others.
Disclosure
Intermediaries should provide information to clients in relation to VA-related products and the underlying VA investments in a clear and easily comprehensible manner, together with warning statements specific to VAs.
Derivative products
Where the VA-related product is a derivative product, intermediaries are required to conduct additional know-your-client procedures pursuant to paragraphs 5.1A and 5.3 of the Code of Conduct, including to assess the clients’ knowledge of derivatives and characterize the clients based on their knowledge of derivatives and to ensure that the clients understand the nature and risks of the products and have sufficient net worth to be able to assume the risks and bear the potential losses.
Provision of financial accommodation
Intermediaries should be cautious in providing any financial accommodation. They should assure that the clients have the financial capacity to meet the obligations arising from leveraged or margin trading in VA-related products, including in a worst-case scenario.
B. Provision of VA Dealing Services
Currently, the SFC and the HKMA are only prepared to allow intermediaries licensed or registered for Type 1 (dealing in securities) regulated activity to provide VA dealing services. Accordingly, intermediaries are expected to comply with all the regulatory requirements imposed by the SFC and the HKMA when providing VA dealing services, irrespective of whether or not the virtual assets involved are securities. To ensure adequate investor protection, intermediaries wishing to provide VA dealing services are also subject to the following conditions/requirements:
SFC-licensed VA trading platforms only
Intermediaries are required to partner only with SFC-licensed VA trading platforms[4] (the “SFC-licensed platforms”) for provision of VA dealing services, either by way of acting as introducing agent (introducing clients to the platforms for direct trading) or establishing an omnibus account with the platform (acting as agent on behalf of the clients to execute instructions). These services should only be provided to professional investors.
Introducing agent
Where intermediaries are acting as introducing agents, they should only introduce professional investor clients to SFC-licensed platforms. They should not relay any orders on behalf of their clients to the platforms or hold any client assets for the introducing services.
Omnibus account
Intermediaries providing VA dealing services through operating an omnibus account established and maintained with an SFC-licensed platform shall comply with expected conduct requirements imposed by the SFC as licensing or registration conditions. One of the conditions is to adhere to the prescribed terms and conditions, which include the following:
1. Maintain in Hong Kong at all times excess liquid capital equivalent to at least 12 months of its actual operating expenses calculated on a rolling basis, in addition to the requirements under the Securities and Futures (Financial Resources) Rules (Cap. 571N).
2. Only permit clients to deposit or withdraw fiat currencies, instead of VAs, from their accounts.
3. Fully disclose the nature and risks that the clients may be exposed to when dealing in VAs in a clear and fair manner which is not misleading.
4. Not engage in VA market making activities on an SFC-licensed platform through which it provides to its clients the VA dealing services.
5. Establish and implement policies for preventing market manipulation or abusive trading activities.
6. Ensure that its anti-money laundering and counter-financing of terrorism systems can adequately manage the money laundering and terrorist financing risks.
C. Provision of VA Advisory Services
Intermediaries should comply with all the regulatory requirements imposed by the SFC and the HKMA when providing advisory services, irrespective of the nature of the VAs. Furthermore, such services should only be provided to intermediaries’ existing clients who are “professional investors” to which they provide services in Type 1 (dealing in securities) or Type 4 (advising on securities) regulated activities.
Where an intermediary provides advisory services in VA-related products, it should observe the same requirements as highlighted in section “Distribution of Virtual Asset-Related Products” above, which includes the professional investors selling restriction, VA knowledge test and suitability obligation requirements, and at the same time, it must ensure the suitability of its recommendations.
Transitional arrangements
The new regulatory regime is immediately applicable to new market entrants upon their engagement in VA-related activities. For market participants providing existing VA-related activities to clients, there is a 6-month transition period before this regime is implemented in full.
Analysis and Takeaways
Virtual assets are gaining popularity around the world. Nevertheless, the global regulatory landscape largely remains uneven. In light of the market’s growing interest in VA-related products, we see the Joint Circular as a big step in providing clarity and certainty for intermediaries involved or interested in distributing VA-related products or providing VA dealing services. Indeed, the Joint Circular does contextualise the principal requirements for intermediaries for the distribution of VA-related products, such as complex products, “professional investor only”, VA knowledge test and derivative product requirements, and their interaction and application thereon. Furthermore, the SFC and the HKMA have expressed their general stance that only Type 1 regulated activity licensed or registered intermediaries can provide VA dealing service.
We believe Hong Kong should leverage its position and expertise as the leading international finance hub in developing its emerging Fintech ecosystem. The Joint Circular issued by the SFC and HKMA, together with the FSTB’s proposal for a VASP licensing regime, as well as the HKMA discussion paper on crypto-assets and stablecoins, are proactive initiatives thereby enabling a regulatory framework with sufficient protection and safeguard in place, where investors, VA operators, intermediaries and other stakeholders can venture into and utilise VAs and the blockchain technology as a whole.
Please contact our Partner Mr. Rodney Teoh and associate Ms. Angela Lau for any enquiries or further information.
This news update is for information purposes only. Its content does not constitute legal advice and should not be treated as such. Stevenson, Wong & Co. will not be liable to you in respect of any special, indirect or consequential loss or damage arising from or in connection with any decision made, action or inaction taken in reliance on the information set out herein.
[1] See more discussion in the subsections headed “Suitability obligation requirements” and “Disclosure” below.
[2] The term “professional investor” is as defined in section 1 of Part 1 of Schedule 1 to the SFO (as defined below).
[3] “Institutional professional investors” is defined under paragraph 15.2 of the Code of Conduct for Persons Licensed by or Registered with the SFC (the “Code of Conduct”) as persons falling under paragraphs (a) to (i) of the definition of “professional investor” in section 1 of Part 1 of Schedule 1 to the SFO. “Qualified corporate professional investors” refers to corporate professional investors which have passed the assessment requirements under paragraph 15.3A and gone through the procedures under paragraph 15.3B of the Code of Conduct.
[4] VA trading platforms which are licensed pursuant to section 116 of the SFO under the 2019 regulatory framework for VA trading platforms.