On October 4th, 2019, Hong Kong’s Securities and Futures Commission (SFC) released the Terms and Conditions for its 2018 statement on the regulation of virtual asset trading. The 2018 statement cautions investors against the risks posed by virtual assets in terms of volatility, auditing, market integrity and security, while establishing regulatory standards. The term ‘Virtual Assets’ most popularly refers to blockchain based cryptocurrencies. Bitcoin and Facebook’s recent attempt to launch its own currency, Libra, are some of the more well-known examples of cryptocurrencies. However, not all digital currencies require encryption, nor are all crypto assets currencies. Virtual assets defined as “securities” or “futures contracts” fall under the regulatory authority of the SFC, and any entity that distributes such assets (or funds invested in related ventures) is required to be licensed or registered.
Some virtual assets may not fit the definition of “securities” or “futures contracts”, and as such need to be brought under the SFC’s control. In order to provide broader protections for investors, the SFC has issued several clarifications on its position.
The 2018 Regulatory Framework Statement established that companies that only invest in virtual assets which are not considered futures contracts or securities must acquire a Type 1 (trading, stockbroking and fund trading) regulated activity license. Companies that trade in securities and futures contracts are required to be licensed for Type 9 (asset management) regulated activity. All licensed portfolio managers that plan to invest in virtual assets are required to follow the same regulations, regardless of whether the fund focuses entirely on virtual assets, or whether the assets are considered securities or futures contracts. All license holders and applicants are required to notify the SFC if they intend to trade in virtual asset portfolios, so that their business operations can be evaluated for regulation and compliance purposes.
This extends the scope of SFC supervision, bringing previously unregulated entities trading in virtual assets under its control. The SFC is also developing a conceptual framework to regulate trading platforms, with an opt-in policy for platform operators that are willing to commit to regulatory standards.
The Terms and Conditions released in October 2019 specify that the definition of Virtual Assets covers digital representations of value (including digital tokens, payment tokens, cryptocurrencies and crypto assets) even if they are not considered securities or futures contracts under the Securities and Futures Ordinance.
Although some virtual assets may not constitute securities and futures, the SFC brings them under their control by regulating fund managers that state an objective to invest in virtual assets or intend to invest 10% or more of their gross asset value in virtual assets. The SFC does allow the value of virtual asset holdings to temporarily increase beyond 10% of gross asset value in some situations.
Such fund managers trading in virtual assets will be subject to checks on gross asset value proportion and sales restrictions. They will also be required to perform due diligence on virtual asset funds which have not been authorized by the SFC and provide clients with information on virtual asset products.
The SFC recognizes different modes of custody of virtual assets. For example, cryptocurrencies can be held in self custody, hot storage (instantly accessible online for transactions) and cold storage (held offline, not immediately accessible for transactions). Fund managers are required to choose the most appropriate holding configuration after a detailed assessment that considers the hardware and software, controls over digital access, long term security and divergences in cryptocurrency network administration known as forks, such as the 2017 emergence of Bitcoin Cash, a user activated split in the Bitcoin blockchain, that resulted in a new protocol backed by cryptocurrency exchanges in China seeking to make the data mining process more efficient.
Fund managers that trade in virtual assets now face requirements to manage discretionary accounts with their clients’ individual circumstances, without investing a disproportionate amount of client funds in virtual assets and considering individual net worth.
Virtual Assets continue to develop in complexity and are increasingly common as mainstream investment products. The World Economic Forum’s 2018 report forecasting the state of the global financial and monetary landscape in 2030 states that financial technology such as cryptocurrencies are set to connect infrastructure, markets, governments and organizations. By ensuring that the trading operations are properly governed, and that the public is well educated on the details of such assets, government institutions and international policy originations can help ensure that virtual assets bring wealth and development as they proliferate worldwide.