1 Nov 2018
The Securities and Futures Commission (SFC) notes with concern the growing investor interest in gaining exposure to virtual assets via funds and unlicensed trading platform operators in Hong Kong. The SFC has identified significant risks associated with investing in virtual assets and these are set out below. In order to address these risks, the SFC is issuing guidance on the regulatory standards expected of virtual asset portfolio managers and fund distributors. The SFC is also exploring a conceptual framework for the potential regulation of virtual asset trading platform operators.
Background
Technology is transforming the landscape of the financial industry. Distributed ledger technology offers an anonymous way to digitally record ownership of virtual assets and facilitates peer-to-peer trading. A virtual asset is a digital representation of value, which is also known as "cryptocurrency", "crypto-asset" or "digital token". The polymorphous and evolving features of virtual assets mean that they may be, or claim to be, a means of payment, may confer a right to present or future earnings or enable a token holder to access a product or service, or a combination of any of these functions.
Public interest in virtual assets has grown exponentially around the world since the creation of the most widely-known digital token, Bitcoin, in 2008. At its peak in early January 2018, the market capitalisation of Bitcoin and other digital tokens was estimated at more than US$800 billion1. Over 2,000 different digital tokens are currently traded around the world with an estimated total market capitalisation of over US$200 billion. Although the aggregated market capitalisation of digital tokens has fallen substantially from its peak, trading volumes remain substantial. There is also a growing demand for funds which invest in virtual assets.
While virtual assets have not posed a material risk to financial stability2, there is a broad consensus among securities regulators that they pose significant investor protection risks. The regulatory response to these risks varies in different jurisdictions, depending on the regulatory remit, the scale of the activities and their impact on investor interests and whether virtual assets are deemed financial products suitable for regulation.
Under existing regulatory remits in Hong Kong, markets for virtual assets may not be subject to the oversight of the SFC if the virtual assets involved fall outside the legal definition of "securities" or "futures contracts" (or equivalent financial instruments). Therefore, investors who trade in virtual assets through unregulated trading platforms or invest in virtual asset portfolios which are managed by unregulated portfolio managers do not enjoy the protections afforded under the Securities and Futures Ordinance (SFO), such as requirements which ensure safe custody of assets and fair and open markets. If platform operators and portfolio managers are not regulated, their fitness and properness, including their financial soundness and competence, have not been assessed, and their operations are not subject to any supervision.
Risks associated with investing in virtual assets
Virtual assets pose significant risks to investors. Some of these risks are inherent in the nature and characteristics of the virtual assets themselves and others stem from the operations of platforms or portfolio managers.
Valuation, volatility and liquidity
Virtual assets are generally not backed by physical assets or guaranteed by the government. They have no intrinsic value. There are currently no generally accepted valuation principles governing certain types of virtual assets. Prices on the secondary market are driven by supply and demand and are short-term and volatile by nature. The volatility faced by investors may be further magnified where liquidity pools for virtual assets are small and fragmented.
Accounting and auditing
Among the accounting profession, there are no agreed standards and practices for how an auditor can perform assurance procedures to obtain sufficient audit evidence for the existence and ownership of virtual assets, and ascertain the reasonableness of the valuations.
Cybersecurity and safe custody of assets
Trading platform operators and portfolio managers may store clients' assets in hot wallets (ie, online environments which provide an interface with the internet). These can be prone to hacking. Cyber-attacks resulting in the hacking of virtual asset trading platforms and thefts of virtual assets are common. Victims may have difficulty recovering losses from hackers or trading platforms, which can run to hundreds of millions of US dollars.
Virtual asset funds face a unique challenge due to the limited availability of qualified custodian solutions. Available solutions may not be totally effective.
Market integrity
Unlike regulated stock exchanges, the market for virtual assets is nascent and does not operate under a set of recognised and transparent rules. Outages are not uncommon, as are market manipulative and abusive activities, and these all result in investor losses.
Risk of money laundering and terrorist financing
Virtual assets are generally transacted or held on an anonymous basis. In particular, platforms which allow conversions between fiat currencies and virtual assets are inherently susceptible to higher risks of money laundering and terrorist financing. Where criminal activities are involved, investors may not be able to get back their investments as a result of law enforcement action.
Conflicts of interest
Virtual asset trading platform operators may act as agents for clients as well as principals. Virtual asset trading platforms may facilitate the initial distribution of virtual assets (eg, initial coin offerings), facilitate secondary market trading, or both, as in a traditional exchange, alternative trading system or securities broker. If these operators are not under the purview of any regulator, it would be difficult to detect, monitor and manage conflicts of interest.
Fraud
Virtual assets may be used as a means to defraud investors. Virtual asset trading platform operators or portfolio managers may not have conducted sufficient product due diligence before allowing a virtual asset to be traded on their platforms or investing in a virtual asset for their portfolios. As a result, investors may become victims of fraud and lose their investments.
Existing regulatory regime
The SFC has issued a number of circulars clarifying its regulatory stance on virtual assets3. Where virtual assets fall under the definition of "securities" or "futures contracts", these products and related activities may fall within the SFC's ambit. The SFC also reminded intermediaries in a circular dated 1 June 20184 about the notification requirements under the Securities and Futures (Licensing and Registration)(Information) Rules if they intend to provide trading and asset management services involving crypto-assets.
The SFC has undertaken a series of actions against those who may have breached its rules and regulations when carrying out activities related to virtual assets. These include providing regulatory guidance, issuing warning and compliance letters and taking regulatory action5.
However, many virtual assets do not amount to "securities" or "futures contracts". Moreover, managing funds solely investing in virtual assets which do not constitute "securities" or "futures contracts" does not amount to a "regulated activity" as specified under the SFO. Similarly, the operators of platforms which only provide trading services for virtual assets not falling within the definition of "securities" do not fall within the jurisdiction of the SFC. Notwithstanding the above, if firms are engaged in the distribution of funds which invest in virtual assets, irrespective of whether these assets constitute "securities" or "futures contracts", these firms are required to be licensed by or registered with the SFC.
I. Regulatory approach for virtual asset portfolio managers and fund distributors
In the application of the SFC's regulatory powers, many investors in virtual assets are left unprotected by the conventional approach where financial products are classified as "securities" or "futures contracts". The SFC has decided to adopt a way forward which will bring a significant portion of virtual asset portfolio management activities into its regulatory net. The overarching principles and regulatory standards of the regulatory framework are summarised below.
(a) Virtual asset portfolio managers
(i) Scope of supervision
The following types of virtual asset portfolio managers will be subject to the SFC's supervision:
- Firms managing funds which solely invest in virtual assets that do not constitute "securities" or "futures contracts" and distribute the same in Hong Kong
These firms will typically require a licence for Type 1 regulated activity (dealing in securities) because they distribute these funds in Hong Kong. The management of these funds will also be subject to the SFC's oversight through the imposition of licensing conditions; and
- Firms which are licensed or are to be licensed for Type 9 regulated activity (asset management) for managing portfolios in "securities", "futures contracts" or both
To the extent that these firms also manage portfolios which invest solely or partially (subject to a de minimis requirement6) in virtual assets that do not constitute "securities" or "futures contracts", such management will also be subject to the SFC's oversight through the imposition of licensing conditions.
(ii) Regulatory standards
In order to afford better protection to investors, the SFC considers that all licensed portfolio managers intending to invest in virtual assets should observe essentially the same regulatory requirements7 even if the portfolios (or portions of portfolios) under their management invest solely or partially in virtual assets, irrespective of whether these virtual assets amount to "securities" or "futures contracts"8.
For this purpose, the SFC has developed a set of standard terms and conditions (Terms and Conditions) which captures the essence of the Existing Requirements, adapted as needed to better address the risks associated with virtual assets. For example, only professional investors as defined under the SFO should be allowed to invest in any virtual asset portfolios (subject to the de minimis requirement). These Terms and Conditions are principles-based and should generally be appropriate to be imposed on virtual asset portfolio managers as licensing conditions, subject to minor variations and elaborations depending on the business model of the individual virtual asset portfolio manager. Some of the key terms and conditions are set out in Appendix 1, "Regulatory standards for licensed corporations managing virtual asset portfolios".
(iii) Licensing process
Licence applicants and licensed corporations are required to inform the SFC if they are presently managing or planning to manage one or more portfolios that invest in virtual assets9. Upon being so informed, the SFC will first seek to understand the firm's business activities. If the firm appears to be capable of meeting the expected regulatory standards, the proposed Terms and Conditions will be provided to the firm (where applicable) and the SFC will discuss them with the firm and vary them in light of its particular business model so as to ensure that they are reasonable and appropriate.
If a licence applicant does not agree to comply with the proposed Terms and Conditions, its licensing application will be rejected. Similarly, if an existing licensed corporation with a VA portfolio does not agree to comply with the proposed Terms and Conditions, it will be required to unwind that portfolio within a reasonable period of time.
After the licence applicant or licensed corporation has agreed with the proposed Terms and Conditions, they will be imposed as licensing conditions.
Failure to comply with any licensing condition is likely to be considered as misconduct under the SFO. This will reflect adversely on its fitness and properness and may result in the SFC taking regulatory action.
(b) Virtual asset fund distributors
Firms which distribute funds that invest (solely or partially) in virtual assets in Hong Kong will require a licence or registration for Type 1 regulated activity (dealing in securities). As such, these firms are required to comply with the Existing Requirements, including the suitability obligations, when distributing these funds. Given the significant risks posed to investors, further guidance on the expected standards and practices when distributing virtual asset funds is provided in the "Circular to intermediaries on the distribution of virtual asset funds" issued by the SFC on 1 November 2018.
Under this arrangement, if a virtual asset fund available in Hong Kong is not already managed by those firms mentioned under section I(a)(i), these funds will still be distributed by firms mentioned under section I(b), all of which are subject to the SFC's oversight. As such, the management or distribution of these funds would be regulated in one way or another by the SFC.
II. Exploring regulation of platform operators
Separately, the SFC is also setting out a conceptual framework for the potential regulation of virtual asset trading platforms in this statement, with a view to exploring (and forming a view after the exploratory stage) whether virtual asset trading platforms are suitable for regulation. If the SFC is minded to license any virtual asset trading platforms, it is proposed that the standards of conduct regulation for virtual asset trading platform operators should be comparable to those applicable to existing licensed providers of automated trading services.
The SFC considers that the regulatory approach under the conceptual framework (if implemented) could provide a path for compliance for those platform operators capable and willing to adhere to a high level of standards and practices, and set licensed operators apart from those which do not seek a licence.
Some of the world's largest virtual asset trading platforms have been seen operating in Hong Kong but they fall outside the regulatory remit of the SFC10 and any other regulators. Owing to the serious investor protection issues identified and having regard to international developments, the SFC considers it necessary to explore in earnest whether and if so, how it could regulate virtual asset trading platforms under its existing powers.
To conduct a meaningful study of the framework, the SFC will work with interested virtual asset trading platform operators that have demonstrated a commitment to adhering to the high expected standards by placing them in the SFC Regulatory Sandbox11.
In the initial exploratory stage, the SFC would not grant a licence to platform operators. Instead, it would discuss its expected regulatory standards with platform operators and observe the live operations of the virtual asset trading platforms in light of these standards. It will also consider the effectiveness of the proposed regulatory requirements in addressing risks and providing adequate investor protection. The SFC will critically consider whether the virtual asset trading platforms are, in fact, appropriate to be regulated by the SFC in light of the performance of these trading platforms in the Sandbox. Factors to be considered include the adequacy and effectiveness of the proposed conceptual framework; ability to comply with the terms and conditions; investors' interests; as well as local market and international regulatory developments.
It may be a possibility that due to the inherent characteristics of the underlying technology or business models of platform operators, the SFC will conclude that risks involved cannot be properly dealt with under the standards it would expect, and that investor protection still cannot be ensured. In that case, the SFC may decide that platform operators should not be regulated by the SFC. For instance, the SFC is not certain at this stage whether platform operators would satisfy the expected anti-money laundering standards, given that anonymity is the core feature of blockchain, which is the underlying technology for virtual assets. The SFC also has to take into account the rapid evolution of the whole virtual asset industry as well as development in the international regulatory community, including the work being done in International Organization of Securities Commissions (IOSCO).
The exploratory stage is crucial for the SFC to understand the actual operations of platform operators to determine whether these platforms are suitable for regulation. If the SFC makes a positive determination at the end of this stage, it would then consider granting a licence to a qualified platform operator. In order not to confuse the public about the regulatory status of platform operators, the identity of the Sandbox applicants in this stage and the discussions will be kept confidential.
If the SFC grants a licence to a qualified platform operator, it will impose appropriate licensing conditions and the operator will proceed to the next stage of the Sandbox. This would typically mean more frequent reporting, monitoring and reviews so that through close supervision by the SFC, operators could put in place robust internal controls and address any of the SFC's concerns arising from the conduct of their business. The SFC may also further consider or refine its regulatory and supervisory approach through intensive dialogue with operators when they are operating in the Sandbox. After a minimum 12-month period, the virtual asset trading platform operator may apply to the SFC for removal12 or variation of some licensing conditions and exit the Sandbox. Licensing conditions (and terms and conditions) imposed in this stage would be made public in the usual way.
Details of the conceptual framework are set out in Appendix 2, "Conceptual framework for the potential regulation of virtual asset trading platform operators".
The SFC will keep the development of activities related to virtual assets in view and may issue further guidance where appropriate.
Market participants are welcome to contact the Fintech Contact Point at fintech@sfc.hk if they have any questions.
Intermediaries Division
Securities and Futures Commission
1 Website of CoinMarketCap: https://coinmarketcap.com/charts/.
2 Report entitled "Crypto-asset markets - potential channels for future financial stability implications" published by the Financial Stability Board on 10 October 2018: http://www.fsb.org/wp-content/uploads/P101018.pdf.
3 These include the Statement on initial coin offerings dated 5 September 2017, Circular to Licensed Corporations and Registered Institutions on Bitcoin futures contracts and cryptocurrency-related investment products dated 11 December 2017, and the press release, "SFC warns of cryptocurrency risks", dated 9 February 2018.
4 Please refer to the Circular to intermediaries on compliance with notification requirements dated 1 June 2018 for details.
5 For details, please refer to the press release, "SFC's regulatory action halts ICO to Hong Kong public", dated 19 March 2018.
6 That is, only virtual asset portfolio managers which intend to invest 10% or more of the gross asset value (GAV) of the portfolios under its management in virtual assets will be subject to the SFC's oversight in this way.
7 This refers to existing legal and regulatory requirements set out under the subsidiary legislation, the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission, the Fund Manager Code of Conduct and guidelines, circulars and frequently asked questions issued by the SFC from time to time (collectively referred to as "Existing Requirements").
8 This is on the premise that virtual assets, as an asset class, have similar features and risk characteristics, whether or not they amount to "securities" or "futures contracts".
9 For the avoidance of doubt, this notification requirement applies even if (i) the licence applicant or licensed corporation manages or plans to manage virtual asset portfolios with an intention to invest less than 10% of the GAV of the portfolio in virtual assets; or (ii) the virtual assets involved have features of "securities" or "futures contracts" as defined under the SFO.
10 Platforms which offer trading of virtual assets that are not "securities" or "futures contracts" are not subject to the purview of the SFC.
11 Please refer to the press release, "Launch of the SFC Regulatory Sandbox", dated 29 September 2017 for details.
12 For example, the licensing condition on ongoing reporting obligations.
Last update: 1 Nov 2018