THE SECURITIES AND FUTURES COMMISSION PUBLISHED CIRCULAR ON INTERMEDIARIES ENGAGING IN TOKENISED SECURITIES-RELATED ACTIVITIES

Introduction

On 2 November 2023, the Securities and Futures Commission (the “SFC”) published a Circular on intermediaries engaging in tokenised securities-related activities (the “Circular”) to clarify regulatory expectations for intermediaries engaged in the said activities. This Circular will supersede the Statement on Security Token Offerings published (the “Statement”) by the SFC on 28 March 2019.

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The Circular first distinguished between “Digital Securities” and “Tokenised Securities”. “Digital Securities” are defined as “securities” under section 1 of Part 1 of Schedule 1 to the Securities and Futures Ordinance (Cap. 571) (the “SFO”) which adopt distributed ledger technology (“DLT”) or similar technology in their lifecycle; while the SFC classifies “Tokenised Securities” as a subset of “Digital Securities”, encompassing traditional financial instruments (like bonds or funds) which are also “securities” that utilise DLT or similar technology in their lifecycle. Examples of “Digital Securities” which are not “Tokenised Securities” include tokenisation of fractionalised interests in real world or digital assets such that the arrangement would amount to collective investments schemes (“CIS”).

Key points from the Circular

Nature of Tokenised Securities	· Existing legal and regulatory requirements governing traditional securities market continue to apply to Tokenised Securities · Offerings of Tokenised Securities would be subject to the prospectus regime under the Companies (Winding up and Miscellaneous Provisions) Ordinance (Cap. 32) (the “C(WUMP)O”) and the offers of investments regime under Part IV of the SFO · Conduct of intermediaries are also governed by existing conduct requirements for securities related activities
New risks arising from tokenisation	· SFC reaffirms its overarching approach of “same business, same risks, same rules” when dealing with tokenisation of securities · SFC also reminded intermediaries to manage new risks associated with tokenisation of securities, including: o ownership risks (i.e. transfer and record of ownership interest in tokenised securities, etc.); and o technology risks (i.e. forking, blockchain network outages and cybersecurity risks, etc.)
Considerations for engaging in Tokenised Securities-related activities	Intermediaries should act with due skill, care and diligence, and perform due diligence on the Tokenised Securities based on all the available information to identify the key features and risks Issuance of Tokenised Securities · Intermediaries (where they issue or are substantially involved in the issuance of Tokenised Securities they intend to deal in or advise on) remain responsible for the overall operation of the tokenisation arrangement notwithstanding any outsourcing to third-party vendors/service providers · Intermediaries to take into account the list of non-exhaustive factors set out in Part A of the appendix to the Circular · Intermediaries to take into account the features and risks of the Tokenised Securities in considering the most appropriate custodial arrangement for the Tokenised Securities Dealing in, advising on, or managing portfolios investing in Tokenised Securities · Intermediaries to conduct due diligence on the issuers and their third-party vendors/service providers involved in the tokenisation arrangement as well as the features and risks arising from the tokenisation arrangement · Intermediaries to understand and be satisfied with the controls implemented by the issuers and their third-party vendors/service providers
Information for clients	· Intermediaries to make adequate disclosure of relevant material information specific to Tokenised Securities (including the risks of the Tokenised Securities) and communicate such information in a clear and easily comprehensible manner · Intermediaries to provide clients with material information on the tokenisation arrangement, e.g.: o whether off-chain or on-chain settlement is final; o the limitations imposed on transfers of the Tokenised Securities (if any); o whether a smart contract audit has been conducted before deployment of the smart contract (if any); o key administrative controls and business continuity planning for DLT-related events; and o the custodial arrangement (if applicable).
Clarifications regarding SFC’s previous Statement on Security Token Offerings	Complex product categorisation · Whether a Tokenised Security is a complex product or not is based on an assessment of the complexity of its underlying traditional security (i.e., a see-through approach should be adopted in assessing complexity) · Intermediaries should determine whether a Tokenised Security is complex or not by assessing the underlying traditional security having regard to the factors set out in: o Chapter 6 of the Guidelines on Online Distribution and Advisory Platforms; and o Paragraph 5.5 of the Code of Conduct for Persons Licensed by or Registered with the SFC Professional investors (“PI”)-only restriction · The SFC is of the view that there would be no need to impose a mandatory PI-only restriction · Intermediaries are reminded that the requirements of the prospectus regime under the C(WUMP)O and the offers of investments regime under Part IV of the SFO would apply to the offering of Tokenised Securities to the public of Hong Kong (the “Public Offering Regimes”) · Offer of Tokenised Securities that is not authorised under the Public Offering Regimes could only be made to PIs or pursuant to any other applicable exemption
Clarifications of other requirements	Fund managers managing portfolios which may invest in Tokenised Securities · “De minimis threshold” under the Terms and Conditions only applies to virtual assets as defined in section 53ZRA of the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615) · The SFC would not impose the terms and conditions for licensed corporations or registered institutions which manage portfolios that invest in virtual assets on fund managers managing portfolios investing in Tokenised Securities meeting the “de minimis threshold” unless the portfolios also invest in virtual assets meeting the “de minimis threshold” Virtual asset trading platform operators (“VATPs”) licensed by the SFC and the applicable insurance/compensation arrangement · VATPs are required to put in place a compensation arrangement approved by the SFC to cover the potential loss of security tokens in compliance with paragraph 10.22 of the Guidelines for Virtual Asset Trading Platform Operators. The SFC may exclude certain Tokenised Securities from the required coverage by VATPs on a case-by-case basis · VATPs will need to demonstrate to the SFC’s satisfaction that the risk of financial loss to its clients holding those Tokenised Securities can be effectively mitigated if the Tokenised Securities become lost
Digital Securities-related activities	· Where Digital Securities are distributed on an online platform, it must be properly designed and have appropriate access rights and controls to ensure compliance with selling restrictions which may be applicable to those Digital Securities · Digital Securities which are not Tokenised Securities are likely to be regarded as “complex products” · Intermediaries to implement adequate systems and controls to ensure compliance with the applicable legal and regulatory requirements before they engage in activities relating to Digital Securities
Notification and provision of information to the SFC	· Intermediaries which are interested in engaging in any activities involving any Digital Securities (including Tokenised Securities) should notify and discuss their business plans with their case officer in the SFC in advance

Analysis and takeaways

As reflected in the Circular, the SFC acknowledges the growing interest and potential benefits of tokenisation in the financial market. With more intermediaries exploring the tokenisation of securities and the distribution of tokenised assets, there is a need for guidance and regulatory certainty to manage the associated risks. By providing guidance on addressing new risks and ensuring investor protection, the SFC aims to foster a healthy tokenisation marketplace.

Please contact our Partner Mr. Rodney Teoh 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.

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