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On January 28, 2022, the Securities and Futures Commission (“SFC”) and the Hong Kong Monetary Authority (“HKMA”) issued a “Joint Circular on Intermediaries’ Virtual Asset Related Activities” (“2022 Crypto Regulation Circular”). This circular sets out the approach to regulating the distribution of crypto assets, comprising of what the circular calls “virtual assets” and “virtual asset related products”, as well as the provision of dealing and advisory services in respect of such assets. In this article, we provide an overview of the updated requirements. If you’d like more information, please contact one of our DLT & Fintech lawyers.
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The landscape for crypto regulation is changing rapidly. In November, 2018, the SFC issued a statement outlining the introduction of the SFC Regulatory Sandbox for crypto trading platform operators, adopting an opt-in approach for operators who are committed to adhere to the SFC’s regulatory standards.
Some two and a half years later, in May, 2021, the Hong Kong Government concluded a consultation on a proposal to introduce a new licensing regime for crypto exchanges, the purpose of which is extend anti-money laundering and counter-terrorist financing controls to this emerging area.
The newly introduced 2022 Crypto Regulation Circular targets the provision of distribution, dealing and advisory services by intermediaries licensed by or registered with the SFC in respect of crypto assets. It will supersede the circular to intermediaries on the distribution of virtual asset funds issued by the SFC on November 1, 2018.
Though not entirely clear, the Circular appears to govern 2 different types of crypto assets, namely virtual assets and virtual asset related products.
“Virtual assets” are digital representations of value which may be in the form of digital tokens (such as utility tokens, stablecoins or tokens backed by securities or assets) or any other virtual commodities. For this purpose, an asset may be a virtual asset within the scope of the Crypto Regulation Circular irrespective of whether or not it amounts to “securities” or “futures contracts” as defined under the Securities and Futures Ordinance (“SFO”). However, a virtual asset excludes digital representations of fiat currencies issued by central banks.
The Circular defines “virtual asset related products” as investment products which:
have a principal investment objective or strategy to invest in virtual assets;
derive their value principally from the value and characteristics of virtual assets; or
track or replicate the investment results or returns which closely match or correspond to virtual assets.
The 2022 Crypto Regulation Circular imposes a number of selling restrictions on the sale of virtual asset related products (but, though the position is unclear, apparently not virtual assets themselves) with a view to investor protection.
Though the circular does not indicate that virtual asset related products are invariably complex products under the Code of Conduct for Persons Licensed by or Registered with the SFC (“Code of Conduct”), it suggests that they will very likely be complex products because the risks associated with investing in such assets are not reasonably likely to be understood by a retail investor. This is so even where such virtual asset related products are traded on exchange.
Where such virtual assets are to be regarded as complex products, intermediaries licensed by or registered with the SFC should apply the complex product regime, as set out under the Code of Conduct, in the distribution of such assets.
Under the existing complex product regime, except for derivative products traded on an exchange in Hong Kong or in a specified jurisdiction, where there has been no solicitation or recommendation, an intermediary should comply with enhanced suitability requirements, meaning they should:
Suitability – Ensure the virtual asset or virtual asset related product is suitable for a client in all the circumstances,
Information – Provide sufficient information on the key nature, features and risks of the assets so as to enable a client to under the product before making an investment decision; and
Warning Statement – Provide a warning statement to the client.
Quite apart from enhanced suitability requirements which apply where virtual asset related products are classified as complex products, intermediaries licensed by or registered with the SFC should:
Suitability of Recommendations – Ensure that any recommendations or solicitations made are suitable for clients in all circumstances. In this regard intermediaries should assess the nature and features of the virtual asset related product to ensue their suitability, taking into account the individual circumstances of the client, such as its risk tolerance and finance situation.
Derivative Products – Where the virtual asset related product is to be regarded as a derivative, assess the client’s knowledge of derivatives. If the client lacks derivative knowledge but wishes to purchase a derivative, the derivative is exchange traded and the intermediary has not solicited the client, the intermediary should explain the risks of the derivative. In all other cases where the virtual asset related product is a derivative, the intermediary should warn the client and advise the client as to whether or not the derivative is suitable for the client. If the derivative is assessed to be unsuitable for the client, the intermediary may only effect the dealing if it is in the best interests of the client.
Due Diligence – Conduct proper due diligence on the virtual asset related products to understand, amongst other things, their risks and features, targeted investors and regulatory status. Intermediaries distributing virtual asset funds which are not authorized by the SFC should conduct additional due diligence on the funds, the fund managers and the parties which provide trading and custodian services for the funds.
Intermediaries should also be cautious in providing any financial accommodation for investing in virtual asset related products to clients. Where an intermediary provides accommodation to a client, it should assure itself that the client has the financial capacity to meet the obligations arising from leveraged or margin trading in virtual asset related products, including in a worst-case scenario. The intermediary should not accept instructions from the client without such assurance.
The 2022 Crypto Regulation Circular requires intermediaries to provide clients with warning statements in a prescribed form and to provide information to clients in relation to virtual asset related products in a clear and easily comprehensible manner.
Except for institutional professional investors and qualified corporate professional investors, the 2022 Crypto Regulation Circular appears to provide that in the distribution of virtual asset related products, whether or not they are complex products, intermediaries should assess clients’ knowledge of such products before effecting transactions in those products on their behalf.
Virtual Asset Knowledge – A client will be considered as having knowledge of virtual assets if the client has executed 5 or more transactions in any virtual asset or virtual asset related product within the past 3 years.
Virtual Asset Training – If a client does not possess such knowledge, the intermediary may only proceed if, by doing so, it would be acting in the client’s best interests and it has provided training to the client on the nature and risks of virtual assets.
Net Worth – Intermediaries, meaning SFC licensed corporations and banks regulated by the HKMA should also ensure that their clients have sufficient net worth to bear the risks and potential losses of trading virtual asset related products.
Moreover, as virtual asset related products are likely to be derivatives, under the Code of Conduct, the intermediary should ensure the client understands the nature and risks of the derivative and has sufficient net worth to assume the risks and bear the potential losses of trading in the derivative.
Under the 2022 Crypto Regulation Circular, subject to the exemption to be discussed below, intermediaries licensed or registered with the SFC should only offer virtual assets and virtual asset related products which are considered complex products to professional investors.
The 2022 Crypto Regulation Circular exempts intermediaries licensed or registered with the SFC from the professional investor requirement in respect of the distribution of virtual asset related derivative products where:
such products are traded on “specified exchanges” and,
in the case where such products are virtual asset derivative funds, such funds are authorized for offer to retail investors by the relevant regulator in a “designated jurisdiction” (i.e. Australia; France; Germany; Ireland; Luxembourg; Malaysia; the Netherlands; Switzerland; Taiwan; Thailand; the UK and the US).
For this purpose, “specified exchanges” includes the Hong Kong Futures Exchange, the Shanghai Futures Exchange, the Singapore Exchange and the New York Mercantile Exchange.
Since the majority of virtual asset trading platforms in Hong Kong and overseas are unregulated or regulated only for anti-money laundering and counter-terrorist financing (“AML/CFT”) purposes, the SFC and the HKMA are concerned that such platforms may fall below the regulatory standards set out by the SFC under its Position Paper on Regulation of Virtual Asset Trading Platforms for SFC-licensed virtual asset trading platforms. As a result, in order to provide adequate investors protection, intermediaries licensed by or registered with the SFC are required to:
Execution via SFC Licensing Virtual Asset Trading Platforms – Partner only with the SFC-licensed virtual asset trading platforms for the provision of virtual asset dealing services, whether by way of introducing clients to the platforms for direct trading or establishing an omnibus account with the platforms;
Dealing Only for Professional Investors – provide virtual asset dealing services to professional investors only;
Dealing Only with Clients Trading Securities – provide virtual asset dealing services only to existing clients for whom they provide services in Type 1 regulated activity;
Meet Securities Regulatory Standards for All Virtual Assets – comply with all SFC and the HKMA regulatory requirements applicable to dealings in securities when providing dealing services in virtual assets, even where those virtual assets are not securities.
Where intermediaries provide virtual asset dealing services through an omnibus account arrangement, the SFC will impose licensing or registration conditions. One licensing or registration condition will require intermediaries to comply with the prescribed terms and conditions (“Terms and Conditions”).
These Terms and conditions include a requirement that intermediaries only permit clients to deposit or withdraw fiat currencies from their accounts, and should not allow the deposit or withdrawal of client virtual assets to minimize the risks associated with the transfer of virtual assets.
Where the intermediaries provide virtual asset dealing services as an introducing agent (i.e. clients of intermediaries will be onboarded by SFC-licensed virtual asset trading platforms and trade directly through trading accounts on the platform in the clients’ own names), the intermediaries:
should ensure that a written agreement is entered into with the platform to set out the respective responsibilities of the intermediary and the platform under the introducing arrangement;
should only introduce clients who are professional investors to the platform; and
should not relay any orders on behalf of their clients to the platforms or hold any client assets, including fiat currencies and client virtual assets (such requirements will be imposed as licensing or registration conditions).
The licensed corporations should comply with additional requirements set out in the SFC Proforma Terms and Conditions for Licensed Corporations which Manage Portfolios that Invest in Virtual Assets (“RA9 Terms and Conditions”) if they provide virtual asset discretionary account management services which meet the de minimis threshold (i.e. a stated investment objective of a portfolio to invest in virtual assets or an intention to invest 10% or more of the gross asset value of a portfolio in virtual assets). Under the RA9 Terms and Conditions, virtual asset discretionary account managers should, among other things:
provide services to professional investors only;
assess whether clients have knowledge of investing in virtual assets or virtual asset related products before providing discretionary account management services;
ensure that the mandate or predefined model investment portfolio in respect of a client is suitable for that client based on the client’s personal circumstances, and that the aggregate amount to be invested by a client in the discretionary account is reasonable given the client’s net worth;
enter into a written agreement with a client before any services are provided to that client; and
conduct a performance review at least twice a year and provide valuation reports to the client no later than the end of the 10th business day after the end of the monthly accounting period (except as agreed otherwise in writing by the client).
Registered institutions wishing to provide such services should inform the SFC and the HKMA and should comply with the RA9 Terms and Conditions.
Where a Type 1 intermediary is authorized by its clients to provide virtual asset dealing services on a discretionary basis as an ancillary service, the intermediary should invest less than 10% of the gross asset value of the client’s portfolio in virtual assets.
When providing virtual asset advisory services, intermediaries are expected to comply with all the regulatory requirements, irrespective of whether or not the virtual assets involved are securities. Advisory services should only be provided to intermediaries’ existing clients to which they provide services in Type 1 or Type 4 regulated activities.
The expected conduct requirements for virtual asset advisory services include the following:
comply with the same requirements as apply to the distribution of virtual asset related products (as set out above);
observe suitability obligations in respect of any recommendation;
offer advisory services only to professional investors; and
conduct virtual asset-knowledge test before providing such services.
The SFC and the HKMA will grant a six-month transition period for intermediaries which already engaged in virtual asset related activities. Intermediaries which do not currently engage in virtual asset related activities should ensure compliance with the requirements in 2022 Crypto Regulation Circular before introducing such services.
Intermediaries are also reminded to notify the SFC (and the HKMA, where applicable) prior to their intended engagement in virtual asset related activities, including the distribution of virtual asset related products and the provision of virtual asset dealing services.
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