SFC and HKMA Joint Circular on intermediaries' virtual asset-related activities

On 28 January 2022, the Securities and Futures Commission (SFC) and the Hong Kong Monetary Authority (HKMA) issued the Joint Circular on intermediaries’ virtual asset-related activities (Joint Circular)¹. The Joint Circular provides guidance on the approach to be taken by SFC-licensed or registered intermediaries²  that wish to engage in activities relating to virtual assets (VAs, which may include utility tokens, security- or asset-backed tokens, stablecoins and other crypto assets), including various new requirements to be complied with and best practices.

On the same day, the HKMA published an additional circular³ to provide broad guidance to authorised institutions when dealing with matters relating to VAs and virtual asset service providers (VASPs).

In our view, the further guidance in the Joint Circular provides clarity on the key concerns of the SFC and HKMA regarding VA-related activities, and the regulatory roadmap going forward.

Development of VA-related regulatory guidance in Hong Kong

While Hong Kong’s VA-related regulatory framework is still in development, both the SFC and HKMA have been actively issuing publications and providing guidance on various VA-related matters to industry participants. In the past two years, key publications include:

• Proforma Terms and Conditions for Licensed Corporations which Manage Portfolios that Invest in Virtual Assets issued by the SFC in October 2019 (link);
• Position Paper on regulation of virtual asset trading platforms issued by the SFC in November 2019 (link) – which sets out robust regulatory standards for virtual asset trading platforms comparable to those which apply to licensed securities brokers and automated trading venues, as well as the terms and conditions that will apply to licensed trading platform operators;
• Conclusions to the Public Consultation on Legislative Proposals to Enhance Anti-Money Laundering and Counter-Terrorist Financing Regulation in Hong Kong issued by the Financial Services and the Treasury Bureau (FSTB) on 21 May 2021 (link) – which proposes a licensing regime for VASPs (e.g. VA exchanges) in respect of AML/KYC compliance; and
• Discussion Paper on Crypto-assets and Stablecoins issued by the HKMA on 12 January 2022 (link) – which is open to public consultation until 31 March 2022;

The Joint Circular was published against the backdrop of increasing interest in VA-related products and services and expansion of the same into mainstream financial services in Hong Kong. In addition to bolstered protection for investors, the Joint Circular brings transparency to the eligibility of VA-related product and service providers and regulatory requirements for both existing and prospective players.

Summary of the Joint Circular

The Joint Circular sets out the requirements for intermediaries (e.g. SFC-licensed corporations and authorised institutions) that wish to engage in the distribution of VA-related products and the provision of VA dealing and advisory services. Intermediaries that are currently providing these services have a six-month transition period to fully implement the requirements set out in the Joint Circular. Intermediaries not currently engaged in these VA-related activities should ensure they comply with relevant requirements in the Joint Circular and give prior notice to the SFC (and the HKMA, where applicable) if they intend to do so.

The Joint Circular supersedes previous circulars on VAs issued by the SFC and the HKMA (where applicable).

The key requirements set out in the Joint Circular are summarised as below:

A. Distribution of VA-related products

VA-related products include investment products which: (a) have a principal investment objective or strategy to invest in VAs; (b) derive their value principally from the value and characteristics of VAs; or (c) track or replicate the investment results or returns which closely match or correspond to VAs.

In general, VA-related products are likely to be considered complex products⁴ due to risks which may not be understood by retail investors. Therefore, intermediaries distributing VA-related products should comply with the SFC’s requirements for the sale of complex products, as well as additional investor protection measures as below:

• Professional investors only – VA-related products which are considered complex products should only be offered to professional investors. However, this restriction does not apply to VA-related derivative products that are traded on specified exchanges set out in Schedule 3 to the Securities and Futures (Financial Resources) Rules (Cap. 571N), such as:

• exchange-traded VA derivative funds that are authorised or approved for offering to retail investors by the respective regulator in a designated jurisdiction; or
• public futures-based VA exchange-traded funds that are authorised or approved in a designated jurisdiction for offering to retail investors by the respective regulator and traded on a specified exchange.

While intermediaries may distribute such complex exchange-traded derivatives without complying with the suitability requirement in the absence of solicitation or recommendation, they must comply with the existing requirements for derivative products and conduct a VA knowledge test.

Aside from the complex product requirements, intermediaries should also observe the selling restrictions in Hong Kong and other jurisdictions which may be applicable to a particular VA-related product, especially the provisions in Part IV of the SFO which prohibits the offering to the Hong Kong public of investments which have not been authorised by the SFC.

• Conducting VA knowledge test – intermediaries should assess whether clients (who are not institutional professional investors or qualified corporate professional investors) have knowledge of investing in VAs or VA-related products prior to effecting a transaction in VA-related products on their behalf.⁵

A client will be considered as having knowledge of virtual assets if the client has executed five or more transactions in any VA or VA-related product within the past three years. 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 VAs. Intermediaries should also ensure that their clients have sufficient net worth to be able to assume the risks and bear the potential losses of trading VA-related products.

• Ensuring the suitability of VA-related products – intermediaries, when making recommendations or solicitations, should assess whether the nature and features of the VA-related product (including the effects of gearing and the risks of the underlying VAs) are suitable for, and are in the best interests of the client, taking into account factors such as the client’s risk tolerance and financial situation. Further, intermediaries should ensure compliance with paragraphs 5.1A and 5.3 of the SFC Code of Conduct where the VA-related product is a derivative product and conduct proper due diligence⁶ on the products.
• Providing clear and easily comprehensible information in relation to VA-related products and underlying VA investments.
• Providing warning statements specific to VAs.⁷

B. Provision of VA dealing services

Intermediaries must partner only with SFC-licensed VA trading platforms (“SFC-licensed platforms”) for the provision of VA dealing services, whether by way of introducing clients to the platforms for direct trading or establishing an omnibus account with the platforms. Such services should only be provided to professional investors.

• Whether or not the VAs involved are securities, intermediaries are expected to comply with all the regulatory requirements imposed by the SFC and the HKMA when providing VA dealing services.
• VA dealing services should only be provided to the intermediaries’ existing clients to which they provide services in Type 1 regulated activity.
• The expected conduct requirements for intermediaries’ provision of VA dealing services under an omnibus account arrangement will be imposed by the SFC (and in consultation with the HKMA, where applicable) as licensing or registration conditions. These include, among others, the intermediaries’ compliance with the prescribed terms and conditions⁸.

C. Provision of VA advisory services

• Intermediaries are expected to comply with all the regulatory requirements⁹ imposed by the SFC and the HKMA when providing advisory services irrespective of the nature of the VAs (e.g. whether or not the VAs involved are securities).
• VA advisory services should only be provided to intermediaries’ existing clients to which they provide services in Type 1 or Type 4 regulated activities. Such intermediaries should offer such services only to professional investors and conduct a VA knowledge test before providing them.
• Intermediaries providing advisory services in VA-related products should observe the same requirements as those for the distribution of VA-related products and must ensure the suitability of its recommendations at the same time.

Implications

The Joint Circular provides further clarity on the regulation of VA-related activities in Hong Kong, particularly as regards the licensing requirements and relevant terms and conditions in order to engage in VA dealing and advisory services. The Joint Circular also leaves room for a wait-and-see approach by the SFC, which suggests that further guidance may be provided in the six-month transition period on the approval of, and application for, licenses for Type 1 and Type 4 regulated activities for prospective intermediaries in light of the new regulatory requirements. Additional guidance is also expected in respect of the practical steps to be taken by the intermediaries already engaging in VA-related activities to update their internal policies and procedures in compliance with the new regulatory requirements.

While it remains to be seen how unregulated VA exchanges and service providers catering to retail investors may be subject to further regulations down the road, the role of such unregulated players is likely to be reduced as intermediaries increasingly partner with licensed trading platforms and minimise interactions with unregulated players, both themselves and in respect of their customers. The Joint Circular may therefore effectively restrict VA dealing and advisory services to be mainly provided by licensed intermediaries, which allows for the SFC and HKMA to exercise its supervision powers to monitor developments in this fast-evolving industry.

 

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¹ https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/intermediaries/supervision/doc?refNo=22EC10
² SFC licensed corporations or registered institutions that may conduct regulated activities.
³ https://www.hkma.gov.hk/media/eng/doc/key-information/guidelines-and-circular/2022/20220128e3.pdf
⁴ See Appendix 3 to the Joint Circular, which sets out the factors for determining whether or not a VA-related product is a complex product.
⁵ See Appendix 1 to the Joint Circular, which sets out non-exhaustive criteria for this assessment.
⁶ Such due diligence should include understanding their risks and features (in particular the inherent high-risk nature of the underlying virtual assets), the targeted investors (including any applicable selling restrictions) and the products’ regulatory status. See Appendix 4 to the Joint Circular, which sets out additional due diligence requirements for unauthorised VA funds.
⁷ See Appendix 5 to the Joint Circular for relevant scope of warning statements.
⁸ See Appendix 6 to the Joint Circular for the prescribed terms and conditions.
⁹ See Appendix 6 to the Joint Circular for details of the requirements.