Background 

Tokenisation of investment products is a process that leverages blockchain technology to represent ownership in traditional investment assets, such as real estate, stocks, bonds, or funds, through digital tokens.  Please also see our news update in relation to the Guide to Digital Assets and Tokens in Hong Kong.  These tokens are created on a blockchain network and serve as digital representations of the underlying assets, made available directly to individual investors, distributed by the intermediaries who are licensed by the SFC, or traded among the blockchain participants, in accordance with applicable regulations.

In Hong Kong, certain stakeholders have already initiated or are actively exploring the tokenisation of securities and other investment products in which the tokenisation is expected to be capable of enhancing product efficiency, lowering operational expenses by decreasing dependence on intermediaries, and accessing the end-investors through new channels.

To meet market demand and support the growth of the market, the SFC has been evaluating different suggestions related to the tokenisation of investment products.  These proposals encompass a range of activities, including primary transactions involving tokenised products such as subscriptions and redemptions, as well as secondary trading of tokenised products on virtual asset trading platforms licensed by the SFC.  The SFC believes that employing a see-through approach is suitable to permit primary dealing of tokenised SFC-authorised investment products.  Nevertheless, this is contingent upon the underlying product meeting all the relevant requirements for product authorisation and the implementation of additional safeguards to address the potential risks associated with the tokenisation arrangement.

Conversely, the secondary trading of SFC-authorised investment products that have been tokenised requires greater caution and meticulous evaluation to ensure that investors receive a level of protection that is substantially equivalent to that provided for non-tokenised products.  Several factors need to be considered, including maintaining accurate and immediate records of token ownership, the preparedness of trading infrastructure and market participants to facilitate liquidity, and the equitable pricing of tokenised products, among other considerations.

Guidelines pertaining to the primary dealing of tokenised SFC-authorised investment products 

Product providers of tokenised SFC-authorised investment products must ensure that the underlying products comply with the applicable requirements outlined in relevant rules, regulations and product codes.  These requirements encompass various aspects, including the eligibility of product providers, product structure, investment and operational criteria, disclosure obligations, and ongoing compliance responsibilities.  In addition, requirements in the Circular on intermediaries engaging in tokenised securities-related activities released by the SFC on 2 November 2023 (the “Tokenised Securities Circular”) should also be satisfied (please see our news update on the Tokenised Securities Circular). 

1.      Tokenisation arrangement

Considering that tokenised products are publicly offered in Hong Kong and the significance of accurately reflecting investors’ ownership through proper records, product providers have a ultimate responsibility for the management and operational soundness of the tokenisation arrangement adopted, as well as the accurate record-keeping of ownership, regardless of any outsourcing arrangements.  They should ensure the proper maintenance of records regarding token holders’ ownership interests in the product, while ensuring operational compatibility with the involved service providers.  Further, they must also implement suitable measures to identify, manage, and mitigate cybersecurity risks, ensure data privacy, address system outages and recovery, and maintain a comprehensive and robust business continuity plan.

When utilising blockchain networks, product providers should avoid using public-permissionless networks without adequate controls. Instead, they should impose additional control by employing a permissioned token.  Product Providers are required to, confirm and, when requested by the SFC, demonstrate to the satisfaction of the SFC the management and operational soundness of the tokenisation arrangement, record-keeping of ownership, and the integrity of smart contracts.

Upon request from the SFC, product providers should obtain third-party audits or verifications to assess the management and operational soundness of the tokenisation arrangement, record-keeping of ownership, and integrity of smart contracts.  Furthermore, product providers should obtain satisfactory legal opinions to support their applications upon SFC’s request.

2.      Disclosure

The offering documents for a tokenised SFC-authorised investment product should provide clear information on the following:

(i)               the tokenisation arrangement, including explicit disclosure regarding whether off-chain or on-chain settlement is considered final;

(ii)              the ownership representation of the tokens, such as details about legal and beneficial title, as well as ownership of or interests in the product; and

(iii)             the risks associated with the tokenisation arrangement, for instance, cybersecurity vulnerabilities, system outages, the potential existence of undiscovered technical flaws, the evolving regulatory landscape, and potential challenges related to the application of existing laws.

For more disclosure requirements, please also refer to paragraphs 19 to 20 of the Tokenised Securities Circular.

3.      Intermediaries and staff competence

Distributors of tokenised SFC-authorised investment products as well as product providers who distribute their own products must be regulated intermediaries such as SFC-licensed corporations or registered institutions.  They are required to adhere to the relevant requirements outlined in existing rules, codes, and guidelines.  This includes meeting obligations related to client onboarding requirements and conducting suitability assessments on their investors.  Product providers are also required to provide confirmation to the SFC that they have at least one competent staff member with relevant experience and expertise to operate and/or supervise the tokenisation arrangement and to manage the new risks associated with ownership and technology in an appropriate manner.

Prior consultation and approval

For investment products with tokenisation features that intend to seek authorisation from the SFC, prior consultation with the SFC is necessary. The same applies to the tokenisation of existing SFC-authorised investment products, which may require prior approval, for instance, approval should be obtained before adding the disclosure of new tokenised unit/share class of an SFC-authorised fund in the Hong Kong offering documents and offering it to the public in Hong Kong.

Considering the dynamic nature of this field, the SFC reserves the right to provide additional guidance or impose further requirements specific to tokenised SFC-authorised investment products as deemed appropriate.

Analysis and takeaway

The Circular sets out the requirements under which the SFC would consider allowing tokenisation of SFC-authorised investment products for offering to the public in Hong Kong.  The SFC’s evaluation of proposals and support for the tokenisation of investment products indicates the recognition of the market potential in Hong Kong.  Tokenisation can provide opportunities for increased market efficiency, reduced costs, and expanded access to investment products for investors.  Also, it may facilitate streamlining of processes and reduce reliance on intermediaries.

While the SFC recognises the potential benefits of tokenisation, it also places emphasis on investor protection and regulatory oversight.  The SFC aims to strike a balance between accelerating the growth of tokenised investment products and ensuring that market participants adhere to the necessary requirements and safeguards.  Ongoing communication among market participants, investors and the regulatory, and vigilance in mitigating risks, would be crucial in this evolving landscape.

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.

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

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.

Garden Stage through its wholly-owned operating subsidiaries, are licensed to conduct Type 1 (dealing in securities) regulated activities, Type 4 (Advising on Securities) regulated activities and Type 9 (Asset Management) regulated activities under the Securities and Futures Ordinance (Chapter 571 of the Laws of Hong Kong). The operating subsidiaries are Hong Kong-based financial services’ roviders principally engaged in the provision of (i) placing and underwriting services; (ii) securities dealing and brokerage services; and (iii) asset management services.

Our Partners, Hank Lo and Gordon Tsang, together with Associate Gary Kwok, acted as the Hong Kong legal counsel for Garden Stage in the Nasdaq Listing.

Please contact Hank Lo or Gordon Tsang for any enquiries or further information about this transaction.