Much anticipated regulatory updates on virtual assets (“VAs”) and related activities were announced during the Hong Kong FinTech Week. The Financial Services and the Treasury Bureau (“FSTB”), Securities and Futures Commission (“SFC”) and the Hong Kong Monetary Authority (“HKMA”) debuted wide-ranging policy and regulatory initiatives – with Eddie Yue, the Chief Executive of the HKMA, being teleported on stage from the metaverse, no less – which underline Hong Kong’s ambitions to become a global hub for VA activities and businesses.
Most recently, the Government passed the Anti-Money Laundering and Counter-Terrorist Financing (Amendment) Bill 2022 (the “Amendment Bill”) on 7 December 2022. The licensing regime for virtual asset service providers (“VASPs”) and other amendments on the anti-money laundering and counter-terrorist financing (“AML/CTF”) requirements will come into force on 1 June 2023. The extension of the transitional period is expected to provide sufficient time for licence applicants in accordance with the regulatory regime.
The Government says “gm” to Web3 (as per greetings by Christopher Hui, the Secretary for Financial Services and the Treasury, in a fireside chat)
The FSTB’s “Policy Statement on the Development of Virtual Assets in Hong Kong” (the “Policy Statement”) highlighted the Government’s acknowledgment that VAs are here to stay and set out its approach towards developing a vibrant sector and ecosystem for VAs.
In particular, the Policy Statement introduces pilot projects testing the technological benefits of VAs and their further applications in financial markets. Such projects include:
- the tokenisation of the Government green bond issuance for institutional subscribers to test the use of distributed ledger technology in bond issuance; and
- the launch of e-HKD, a retail Central Bank Digital Currency with the potential to bridge legal tender and VAs. While the implementation of such projects on the public scale awaits, the pilot projects demonstrate the Government’s readiness to adopt FinTech solutions in Hong Kong’s financial system on a wider scale.
What do the regulators think?
The SFC and the HKMA expressed a supportive view on Hong Kong’s future as a global VA hub and provided helpful clarifications on regulatory principles and proposals going forward.
The HKMA emphasised the importance of establishing guardrails against the risks for setting a good regulatory foundation for a vibrant crypto and decentralised finance (DeFi) ecosystem, and fostering opportunities to connect with stakeholders in the international financial system. The launch of Commercial Data Interchange and the mBridge project demonstrate the HKMA’s objectives for increased efficiency and connectivity between traditional financial systems and new FinTech solutions.
The SFC reiterated the necessity of regulations (premised on the principle of “same risk, same regulations”) for enabling further applications of VAs and announced regulatory updates on:
- how retail investors may be able to trade VAs (reversing the proposed de facto “retail ban” which requires centralised VA exchanges to only provide services to professional investors), with the types of permissible VAs to be confirmed following a public consultation;
- the possibility of retail investors having access to VA futures exchange traded funds (“ETFs”) listed on the Chicago Mercantile Exchange (“CME”), subject to requirements related to investment strategy, disclosures and investor education; and
- the treatment of tokenised securities in a way similar to existing financial instruments (subject to their specific attributes) and not to classify them as “complex products” simply because they are issued or traded via distributed ledger technology (or, in other words, just because a financial instrument is “put on the blockchain” does not change its regulatory treatment).
It is expected that the SFC will actively seek views from industry stakeholders and the public on the new VASP regime before the Amendment Bill comes into force on 1 June 2023.
Devil is in the details (of regulatory proposals)
Licensing framework for centralised VA exchanges
The proposed regime for VASPs under the Amendment Bill regulates those who operate centralised VA exchanges, where VA transaction offers are regularly made or accepted, or where introductions are regularly made to negotiate or conclude VA transactions.
In particular, whether the current scope of “VASP” as defined in the Amendment Bill offers sufficient protection to retail investors remains to be seen, considering its limited coverage as regards the types of VA-related services under the Bill. Other jurisdictions have taken the approach of explicitly regulating a wider scope of “VASPs”, covering not only VA exchanges but also crypto-asset custodians and peer-to-peer exchange providers.
Industry participants have expressed concerns regarding the fact that other types of VA-related activities (e.g. VA custody and VA “interest accounts”) have not yet been addressed in the Amendment Bill or expressly governed by existing regulations. Given the pace at which the VA sector evolves, it is arguably prudent for regulations to be developed on an incremental basis – starting with a licensing framework designed to capture the largest VA businesses.
VA Futures ETFs
The SFC issued a circular (the “Circular”) on its openness to authorise ETFs that obtain exposure to VAs primarily through futures contracts (“VA Futures ETFs”) for public offering in Hong Kong, which is one of the more concrete developments that substantiate the Government’s policy objective for opening up retail access to VA-related products.
In gist, VA Futures ETFs must comply with the following requirements in addition to those 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:
- Management companies must have a good track record of regulatory compliance and at least 3 years’ proven experience in managing ETFs;
- Only Bitcoin futures and Ether futures traded on the CME are allowed;
- Active investment strategy should be adopted with the net derivative exposure (as defined in the UT Code) of a VA Futures ETF not exceeding 100% of its total net asset value;
- Product key facts statement of a VA Futures ETF shall contain upfront disclosure of investment objective and key risks associated with investment in VA futures;
- Intermediaries shall comply with conduct requirements of both derivatives and VA-related products; and
- Extensive investor education shall be carried out by the management company of a VA Futures ETF before the launch of the ETF in Hong Kong.
The Government’s cautious approach to regulation is demonstrated by the measures setting limits on the types of VA futures available for public offering and the net derivative exposure. While these measures offer a degree of protection to retail investors, additional guidance may be helpful for ensuring that appropriate measures have been put in place to ensure full compliance with the above requirements, particularly around the investor education to be conducted by applicants of VA Futures ETFs.
The regulatory updates have received a warm welcome from industry participants as they reflect the regulators’ acceptance of VA-related activities and investment products as a part of Hong Kong’s financial system. Considering recent incidents in the crypto market, the timing is critical for the Government to strike a balance in the next steps.
Over the past year, jurisdictions such as the UK, US and UAE have also begun to revisit their financial regulations to develop a more comprehensive regime for providing financial services inclusive of VA-related products and services. One example is the provisional Markets in Crypto Assets framework (“MiCA”) of the European Union (“EU”), which brings VAs, VA issuers and VASPs (or, crypto-asset service providers (“CASPs”)) across EU member states under one regulatory framework. MiCA applies proportionate rules to different types of CASPs and addresses consumer protection for crypto-assets that are not financial instruments. MiCA however is not all-encompassing regime as it does not capture anti-money laundering matters, which are governed under separate legislation. While further fine-tuning is expected, the current regulatory framework under the Amendment Bill sets a good start to the governance of VA exchanges and related services in Hong Kong.
- Law reform to come? The Policy Statement suggests that the Government is open to review property rights associated with VAs and the legality of smart contracts. By way of example, the Law Commission in the UK has held a consultation on creating a third category of property – “data objects” – in addition to traditional categories of property rights of “things in possession” and “things in action”. The aim is to ensure that virtual asset owners can be protected by property rights despite their assets lacking the characteristics of property (in the legal sense).
In Hong Kong, businesses and property owners are becoming increasingly keen on tokenising their assets for liquidity and access to new investor pools. We think that a law reform providing clarity in this respect is likely to increase the confidence of investors and attract more risk-averse institutions or even individuals to invest in or create tokenised assets.
- Investor education is also part of the equation. Allowing retail access to VA-related investment products is welcome news to industry stakeholders, particularly as regards democratisation of investments and Hong Kong’s competitiveness against overseas VA trading platforms. It goes without saying that the promotion and adoption of such retail access must come with a commensurate degree of investor education for the public. While setting regulatory restrictions is necessary, regulations need to be balanced, and the industry as a whole should make a collective effort in implementing investor protection measures on a wider scale.
References can be drawn from other jurisdictions that have launched a nation investor education on VAs – for example, the Canada Standards Association has launched social media campaigns for youths to educate them on the basic knowledge of crypto-assets. The Ontario Securities Commission launched a website that introduces basic crypto terms and provides advice on choosing crypto trading platforms. Bolstering the investor education on a public level is key to minimising “rug-pulls” and fraudulent activities before the retail access to VA-related products is allowed.
We have seen how regulated and established platforms can pose risks to investors in the most unexpected manner. Key measures to be considered include the details of disclosure of risks specific to different types of VA-related investment products (in addition to the existing SFC disclosure requirements and investor protection measures set out in the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615) and the Circular), and clarification on “investor education” to be provided by companies which plan to offer, deal in or advise on VA-related investment products. In light of the potentially volatile nature of VA-related investment products, the regulators may consider imposing stricter obligations as regards the ongoing monitoring of such products and provision of updated information to retail investors.
About our FinTech and Digital Assets practice
Our Fintech and Digital Assets practice advises on all aspects of the fintech ecosystem, from new fintech platforms to disruptive fintech models, as well as the protection and deployment of technology-driven products. We also advise established players on harnessing and leveraging technological innovation and offer strategic advice on the implementation of blockchain technology solutions and structuring of digital assets and emerging technologies (Web3, Metaverse and alternative payments). We also advise on licensing related matters and have a strong track record of successful SFC licence applications.
Our team has extensive experience advising, on a global basis, a wide range of clients including banks, challenger banks, private equity and venture capital investors, asset managers and funds, broker-dealers, trading platforms and exchanges, as well as other capital markets participants. We also have a widely acknowledged capability in advising major players across the financial services and technology industries including payment providers, fintech platform operators, new model finance providers and other fintech players leveraging disruptive technology or business models. We assist our clients to navigate the increasingly complex environment at the intersection of transactions, technology, and regulation.
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