On 22 December 2023, the Securities and Futures Commission (the “SFC”) published a Circular on SFC-authorised funds with exposure to virtual assets (the “Circular”) to set out the requirements that the SFC would consider in authorising investment funds with exposure to virtual assets (“VA”) of more than 10% of their net asset value (“NAV”) for public offerings in Hong Kong. This Circular supersedes the circular on VA futures exchange traded funds (“ETFs”) issued on 31 October 2022.
The Circular takes note of SFC-authorised funds’ investment into VA both directly and indirectly and illustrates the requirements that the funds must comply with as part of SFC’s goal for appropriate investor protection. Alongside the requirements stated in the Overarching Principles Section and the Code on Unit Trusts and Mutual Funds (“UT Code”) in the SFC Handbook for Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted Structured Investment Products, the Circular also sets out other additional requirements to be read alongside the joint circular on intermediaries’ VA-related activities (see our news update of this joint circular here).
Management, personnel and service providers
Management companies of SFC-authorised VA Funds must have a good track record of regulatory compliance and at least one experienced and competent staff member in managing VA products specifically. To regulate such, management companies must abide by a set of additional terms and conditions by the Licensing Department (the “LD”).
Alongside ensuring their own, and the service providers’ competence in supporting the SFC-authorised VA funds, management companies are also responsible for carrying out investor education before launch in compliance with the existing requirements under the UT Code. This is adjacent to the product key facts statements with a disclosure of the funds’ investment limits and key risks that should be offered to investors on the offering documents.
Investment restrictions and strategies
SFC-authorised VA funds are free to invest directly or indirectly in VA tokens as long as they are accessible to the Hong Kong public for trading on SFC-licensed virtual asset trading platforms (“VATPs”). However, investment in VA futures is limited only to those that are traded on conventional regulated futures exchanges subject to the management company showing that (i) the relevant futures have adequate liquidity and (ii) the roll costs are manageable and how such roll costs will be managed. If the SFC-authorised VA fund primarily adopts an investment strategy that is futures-based, the SFC also expects much flexibility in the portfolio composition.
Moreover, funds receiving indirect exposure to VA are subject to requirements in the UT Code and other requirements which may be imposed by the SFC. At the base line, there should not be any leveraged exposure to VA at the fund level.
Transactions and direct acquisitions of spot VA
SFC-authorised VA Funds should only conduct transactions and acquisitions of spot VA through SFC-licensed VATPs or authorised financial institutions (“AI”) in compliance with the requirements of the Hong Kong Monetary Authority (the “HKMA”). Both in-kind and in-cash subscription and redemption are allowed for SFC-authorised spot VA ETFs. Further, for ETFs that invest in spot VA, their participating dealers should be SFC-licensed corporations or registered institutions, and are subject to additional terms and conditions imposed by the LD.
Custody
The trustee/custodian of an SFC-authorised VA Fund can delegate its VA custody function to an SFC-licensed VATP or an AI that meets the expected standards of VA custody imposed by the MA. The trustee/ custodian and any delegate should ensure that (i) the VA holdings are segregated from their own assets and those of other clients, (ii) most of the VA holdings are stored in a cold wallet, and duration of VA holdings stored in the hot wallet should be minimised, and (iii) the seeds and private keys are securely stored, restricted to authorised personnel, resistant to speculation or collusion, and properly backed up to avoid any single point of failure.
Analysis and takeaway
The Circular sets out the expectations and requirements under which the SFC would consider when approving investment funds with more than 10% of their NAV exposed to VA. The SFC’s evaluation and approval of VA-exposed SFC-authorised funds indicate the recognition of market potential in Hong Kong.
The SFC emphasises a balance between evolving the market to incorporate VA elements and protecting the interests of the investors. It is important that continued supervision and scrutiny is made towards this developing market to mitigate further risks in the future.
“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.”