Exploring Hong Kong's Digital Asset Regulation and Licensing
- Derek McGibney
- Sep 19, 2024
- 28 min read
Updated: Dec 20, 2024
Please note that we provide links to external sites which were correct at the time of publication, but they may be updated. Cognitive GRC provides advisory services to regulated firms in Hong Kong on international requirements and works with various service partners to deliver these services. Firms should obtain specific advice relating to matters that we highlight here. The following is neither legal, accounting or investment advice.
A Guide to Hong Kong’s Digital Asset Developments for firms contemplating licensing.
This page aims to provide an overview of the regulatory developments in Hong Kong’s digital asset space and highlight key changes that may influence a firm’s decision regarding licensing. It is not intended as investment advice. We have closely monitored technical developments and engaged in industry discussions to maintain a comprehensive understanding of relevant changes. Although few firms have ventured into this space, we believe it is crucial for all firms to stay informed about this dynamic regulatory and commercial environment. This guide is intended for industry participants and practitioners, not individual investors, who should seek advice from duly licensed and experienced firms who can provided advice on investments. We can assist with licensing and ongoing compliance for firms that are regulated.
Hong Kong's updated Anti-Money Laundering Ordinance ("AMLO") heralded the introduction of the Virtual Asset Service Provider ("VASP") regime commencing from 1st of April 2023 and ushered in a period of accelerated progress towards a balanced regulatory environment that feels like it was finally moving at pace that offered hope to participants that Hong Kong has now found its goldilocks speed.
The timing of market events in 2022 (e.g. FTX), almost blessed the Hong Kong regulator's cautious approach. It supports a need for a controlled lift off, over an overly exuberant evangelistic emergence of new market opportunities. When it comes to developing any such market, ensuring healthy scepticism without frustrating innovation is key. While many jurisdictions are seeking the lead, perhaps like the hare and tortoise race, Hong Kong's cautious but steady approach has managed to take a lead, although for market participants, it may feel like it is moving at glacial pace.
A key contributing innovation was the way the SFC neatly side stepped the thorny and litigious issue that has dogged other markets, in particular the US, regarding whether a coin should be regulated as a security or not by simply expecting all participants interested in offering access to digital asset exchange to hold or apply for licenses to cover both Securities and Futures Ordinance (SFO) activities under the existing securities regime, while also applying for licenses to cover the same activity for non-securities services activities under the Anti-Money Laundering Ordinance. {Not all firms in the market will need to facilitate the exchange of assets in the way a Virtual Asset Trading Platform (VATP) does and therefore some will only be required to uplift their current SFO licences in order to introduce clients to VASPs.}
The SFC register was updated in 2023 to reflect the new concepts and now recognises that firms need different types of licence if they are involved in exchanging virtual assets on behalf of clients.
The SFC provides a way to see who is doing what: and importantly under what conditions:
Operating a virtual asset trading platform
Managing portfolios that invest more than 10% in virtual assets
Providing virtual asset dealing services under an omnibus account arrangement
Providing virtual asset advisory services
Acting as an introducing agent for a virtual asset trading platform
The licencing conditions are important as the SFC has issued and updated the terms under which these firms will be granted licenses. While standard conditions have typically ranged from one line to seven, the new conditions that are being applied to firms seeking to provide services around virtual assets are more extensive and detailed.
Following market events in 2023, including some firms incorrectly asserting that they were registered to take advantage of the transitional period, the regulator published a list of applicants so that the public could see which firms had applied, which had been accepted as passing the initial external review of appropriateness, which firms had been asked to withdraw, and which firms had been asked to stop operating. (SFC VATP Applicants: Source SFC).
Reports of hundreds of applications had been overblown and while many firms contemplated a home in Hong Kong at the time, these numbers have dropped significantly as time has gone by.
The technical determination of which ordinance applies [i.e. SFO or AMLO] will remain something that labours us technical experts when writing out policy and procedures. It eliminates a mass of potential issues for the market by helping to manage the risk of having to deal with developing interpretations of whether an instrument is a security or not, as it prevents the transaction being found to be illegal due to its source of regulation due to difference of interpretation. [Clearly being seen in the US where commissioners still differ on many aspects of interpretation. See Statement on the matter of FlyFish Club, LLC. (Source SEC, Credit to Future of Money with Henri Arslanian for highlighting it)
As parties involved in trade settlement will need to be licensed under both the SFO and AMLO, the impact of a change of interpretation or status of a coin, will be less of an issue for service providers, and their counterparties, as the validity of the transaction, or the status of the agent/introducer will not be impacted by such technicalities at least, for now, in Hong Kong.
Click the following chevrons for more detail on areas of interest. Some are high level background, whereas some of the sections would be more for technical practitioners of compliance science. We also provide an overview of the developments over the last couple of years and cover the latest updates for Hong Kong.
Same Business, Same Risks, Same Rules - Where did that come from, rabbit hole? (Click on arrow to expand)
Where/when did this principle emerge, we took a look as it feels like it has creeped into the dialogue in senior regulatory discussions: Some potential (external) sources here: Monitoring, regulation and self-regulation in the European banking sector (europa.eu) 2015, Regulation, supervision and market discipline – striking a balance (europa.eu) 2017, PWG-Stablecoin-Statement-12-23-2020-CLEAN.pdf (treasury.gov) 2020, FSB issues statement on the international regulation and supervision of crypto-asset activities - Financial Stability Board 2022, AIMA-APAC-Annual-Forum-2022---Eng_20220906.pdf (sfc.hk), 2022.
We are drawn to the emergence of this principle because it is a neat way to address many a failing of previous regulatory engineering. The phrase has been given a thorough airing in justification for applying traditional regulation to new product types. If only this concept had emerged prior to the global financial crisis, perhaps the resulting pain could have been avoided. It is more likely that the concept arose because of that shared experience. You will find further meaning in the provided resources to give you a better grounding in the concept being discussed.
Briefing on AMLO changes relating to Virtual Assets (Video Update) (Click on arrow to expand)
For a bit more history you can see our earlier update on virtual asset regulation (here) when the draft rules were published or take a look our short briefing video on the new regime below.
Click below arrows for more detail on each topic below
Developing Ecosystem - Expand for Visualisation of developing market architecture (Click on arrow to expand)
There is still quite a bit to work out but see our visualisation regarding the developing ecosystem as different types of providers establish a presence in the market.
There is still quite a bit to work out as the market ecosystem emerges but see our visualisation regarding how different types of providers will establish a presence in the market. The recent addition of the sandbox for token interoperability will help fill some of the gaps (See latest developments below).
As a general rule, consumer and end user market participants should be trading through exchanges who will be handling wallets. However, the SFC has provided for certain firms who have the appropriate infrastructure to provide omnibus services to allow for larger brokers to offer access to virtual assets that can be "settled" through the new licensed exchange providers.
Brokers and wealth managers can set up with these new exchange facilitators, as clients, much like they do under the arrangements for securities, but they will need to apply for the uplift on their SFO license and adapt to the specified terms and conditions.
Managers will need to "notify" the SFC if the volume of activity means that they are investing in portfolios with over 10% direct exposure to the relevant assets, but we would invite managers to consider doing so well in advance of that stage as the notification process can take some time in order to ensure compliance with the established conditions.
We also noted a significant but subtle change in the updated terms published in February 2024 which changed the technical definition of virtual assets considered for that threshold, to exclude listed products or other securities that invest in non-securities digitals assets. (i.e. indirect exposure through securities products will not be considered within this threshold and this is an important change that may not of got sufficient notoriety at the time of the change.)
With further clarity in the rules, it is a little easier to determine which firms need to be licensed and which firms can act in a service support capacity.
Capital Requirements per type of licence (Click on arrow to expand)
Capital requirements increase depending on the level of operational risks. Trading platforms will take on the highest level of type 1 or type 7 licensee risk with typical minimum capital expectations, whereas other intermediaries are being asked to put a little bit more aside in order to address the additional perceived risks of their operations.
Licence Type Authorised Liquid (+ 20%) Operational
Type 1/7 HKD5,000,000 HKD3,000,000 12 Month Rolling Cover
Type 1 Omnibus HKD5,000,000 HKD3,000,000
Type 9 Uplifted HKD3,000,000
Retail Aspects introduced in 2024 (Click on arrow to expand)
The initial adoption of a retail standard was provided in a Joint Circular from SFC/HKMA October 2023 and followed up with a replacement in December to clarify certain conduct matters, and introducing updated terms and conditions for licensed intermediaries to deal with those changes. This section may be of interest for those interested in the technical aspects, but it may be too detailed for some. It is useful to understand the implications of the specific changes that were made but we do not typically provide services to retail focused firms.
While the SFC's first issue of the rules only discussed the potential for retail involvement, we believe it was understood, that in order to provide protection of retail investors, who were likely to be already exposed to non-security based digital assets, the SFC would need to provide for the ability of retail investors to get access to legitimate off ramps. As such, relatively quickly after the implementation of the new licencing regime, the SFC had already consulted on providing firms with the ability to provide services to retail investors. They proposed new terms and standards in October and re-issued them in December to align with their preparation for the launch of more Virtual Asset related products which were to have spot crypto exposure.
The SFC and HKMA updated their standards to allow for retail participation, but care and attention to those changes is also necessary for firms delivering products on a professional investor only basis.
In the October release they provided for different approaches to be applied between complex products and non-complex products and made a further distinction between complex products that were listed products and those that were authorised products. This was to provide for some of the soon to be authorised products that would have underlying exposure in digital assets.
The main difference is about how trading firms could apply suitability standards based on how those products could be sold to different types of investors depending on their categorisation, and the categorisation of the underlying assets.
The information in the circular is generally more important for advisors and brokers involved in direct sales and/or fund managers with authorised products but it will also be of interest to managers who may be interested in getting involved in accessing such markets and/or selling products only to professional investors.
All licensed firms involved in digital asset intermediation should be aware of the general changes that were introduced into the terms and conditions (i.e. the detailed licencing conditions that are applied to firms who apply for an uplift) as they would apply to them should they wish to participate in virtual asset markets, which is why we produced this update and took the time to consider the key issues that would be relevant whether you meet the thresholds or not.
Some key items from the circular regarding sales or distribution of VA products
Selling restrictions – Except for a limited suite of products (ETDs or SFC Authorised ETFs) which they allow to be sold to individuals under certain conditions, VA-related products which are considered complex products should only be offered to professional investors.
In simple terms execution only securities products available on defined liquid markets (See appendix 2 circular linked below) such as futures and certain types of non-derivative SFC authorised VA ETFs are available on an execution only basis to retail investors subject to standard controls.
Additional Controls
Virtual asset-knowledge test - Except for institutional professional investors and qualified corporate professional investors, intermediaries should assess whether clients have knowledge of investing in virtual assets or VA-related products prior to effecting a transaction in VA-related products on their behalf.
· Have they undergone training or attended courses on virtual assets or VA related products?
· Have they got current or prior work experience related to virtual assets or VA related products?
· Have they got prior trading experience in virtual assets or VA related products?
Source Appendix 1 of Circular openAppendix (sfc.hk)
If a client does not possess such knowledge, the intermediary may only proceed if it has provided adequate training to the client on the nature and risks of virtual assets.
This is something that we have seen before in foreign exchange markets but allows firms to implement training to help individuals who may be coming to the market for the first time, given that it would be impossible to expect individuals only to proceed on the basis that they had already had experience in a product that was not previously licensed.
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.
Paragraph 8 (October Circular) now 7 and 9 (December Circular) refers to a limited suite of VA-related derivative products traded on regulated exchanges specified by the SFC and, in the case of exchange-traded VA derivative funds, they are authorised or approved for offering to retail investors by the respective regulator in a designated jurisdiction.
For example, in the case of virtual asset futures contracts traded on a specified exchange which is a regulated futures market, trading is governed by conventional access rules as the product is treated as a future and as such available as an execution only product. Pricing transparency and potential market manipulation may be less of a concern. The same could be said of a public futures-based VA ETF authorised by the SFC and traded on the Stock Exchange of Hong Kong Limited or authorised or approved in a designated jurisdiction for offering to retail investors by the respective regulator and traded on a specified exchange.
As such, the “professional investors only” restriction is not imposed for the distribution of these “simpler” exchange listed products. Nonetheless, as such products are considered complex exchange-traded derivatives, under the existing complex product regime, where there has been no solicitation or recommendation, intermediaries may distribute them without the need to comply with the suitability requirement or the minimum information and warning statements requirement referred to in paragraph 14.1 (then 15) below, but must comply with the existing requirements for derivative products (see paragraphs 11.2 and 12 (then 12.2 and 13)).
Basically, this requires greater due diligence on complex products and their distributors, and this greater level of due diligence is laid out in Appendix 4 and additional disclosures are laid out in Appendix 5 of the circular.
Distinction between a recommendation or solicitation.
Where you recommend and sell a product, you are expected to ensure suitability in all circumstances for individual investors. Where you make a product available but do not sell it (however that logic is arrived at) you need to ensure that you only provide access to those for whom it is reasonably deemed suitable or appropriate. In the first instance you will be required to do complete due diligence on suitability as you are deemed to be providing advice, and that advice has to be suitable for your client in all circumstances and you need to be able to demonstrate that. In the second, you will need to do due diligence in order to establish some form of reasonable suitability, and the offering of the product needs to be reasonably suitable based on the clients’ circumstances in all circumstances but stops short of being advice. Individual investors should not have access to complex products without some form of check either way and if a broker is facilitating execution only, then they should only be providing execution only to persons who understand the risks of the products that are made available to them. If the product is a complex security or future, it needs to adhere to the additional safeguards already set up for those types of assets (e.g. including a virtual asset future or ETF) and is available to more than just the professional investors under those requirements. If it is not, it will not normally be available to individuals unless they have satisfied the professional investor standards. This is obviously more important to understand if you can only offer to deal with professional investors.
Intermediaries must also conduct a virtual asset-knowledge test as an additional safeguard.
There is a detailed chart provided in the circular to navigate this complex protective framework. For most of our asset manager clients, who might consider adding an unlisted product that invests in digital assets that are not securities or futures, and satisfy the criteria to apply the licence conditions, they will need to follow all aspects of the onboarding process once they start to invest of offer such products above the threshold ,i.e;
VA Knowledge Test and Risk Disclosures
Derivative Product Requirements (if also a derivative product, derivative knowledge assessment and net worth tests)
Complex Product Requirements (Suitability, Minimum Information and Warnings)
For Professional Investors only
While the terms are applied to those who apply for the uplift it would make most sense to adopt the same standards as if you have applied for the uplift, to ensure continuity and risk controls should your exposure to VA increase and you do need to comply in the future. In other words, don't wait for the uplift to complete as you will need to have the current investors onboarded to sell them more later when if you do get the uplift.
We note that due to the additional restrictions applied to firms subject to the terms if you conduct an uplift during the life of a fund, it may be difficult to utilise the performance data from prior to the applications of terms as the fundamental limits on what you can do and how you operate would significantly change through that transition as you may have greater freedom to invest when you limit your exposure to de minimis threshold. The “de minimis threshold” refers to the situation where either: (a) the stated investment objective of a fund is to invest in Virtual Assets or (b) the intention of a fund is to invest 10% or more of its gross asset value (GAV) in Virtual Assets.
The update in October and December 2023 changed the standard terms under which intermediaries will be required to operate, with respect to retail investors, and those terms should be considered in terms of seeking to uplift to a firm’s license whether for retail or otherwise.
Key change in scope or what constitutes relevant assets
As discussed above, one of the more subtle yet important changes of such terms, (in the original update October 2023) was the definition of what constitutes a virtual asset for the purposes of requiring an uplift. The initial terms referred to any exposure to digital assets irrespective of whether they may be securities or futures bringing firms under the potential radar. Whereas the updated terms scaled this back to products that are defined as virtual assets under the AMLO, importantly, now excluding assets which satisfy the securities or futures definitions. This is an important distinction that did not get as much prominence that it should of at the time of the update. Having delved into the expectations and looked at the uplift requirements managers need to be conscious of the notification requirements at the base level (even before the uplift notice) if they are looking to expand into digital assets, as this investment would still be likely to be considered a material change in their business that would require an initial notification to the SFC as well as their being considerations with regards to updating PPMs and risk disclosures relating to those assets which would simply require as result of investing in an asset that had not previously been contemplated. For most Hedge Fund managers, you might be able to argue that a securitised exposure to a non -securitised digital asset is not a material shift in investment target but given the change in risk exposure, we would probably argue that it would be best to highlight such activity to your investors and therefore also the regulator, even if it invited more questions.
To be clear, if you are a manager or adviser that is seeking to provide services relating to digital assets, this is likely to be something that is a change to your business plan, scope of business, product offering and risk profile, that would require regulatory notification, updates to your operational risk structure, cybersecurity stance, insurance policies and client documentation. For non-managers, any advisory or introduction activity would require an uplift, but for manager with a target of less than 10% exposure, the basic change of business plan notification under current expectations would be wise. If it is likely that you would have a product or products that become directly invested in digital assets, this would require you apply for the uplift should you then seek to approach the limit of 10% exposure.
In addition whether the level of virtual assets exposures were going to increase beyond the 10 per cent limit or not, firms would need to consider the impact of these new terms on their business plans and projections both before and after those uplifts as the terms that would be applied after the uplift may change the operational and cost profile of the fund under management to the extent that the performance profile before the uplift would need to be adjusted to the post uplift infrastructure. E.g. the cost of doing business could change enough to render the pre-uplift performance less meaningful, as past performance, even though as we know past performance is not indicative of future performance. This is a very subtle point.
Timing and development of the digital asset market ecosystem and licencing (Click on arrow to expand)
The costs of obtaining and maintaining a relevant licence Type 1 or Type 7 are not insignificant but the process is not insurmountable, even though it could not be said that there has not been a bit of bottlenecking despite efforts to avoid it by all parties.
VATPs who apply are required to have their applications pre-vetted by independent service providers who have expertise in their respective fields (Regulation, Custody, Crypto, Cybersecurity, Automated Trading Systems, DMA, Governance). They need to supply independent assessment reports by qualified and experienced service provider to ensure that the applicants and the application submission is fit for purpose. In our view, there are still many firms learning as they engage, and many that cannot deliver the required expertise in all regards to all activities that need to be covered under the assessment. In fairness to all, it is a very tall order, and the reality is that no-one firm yet has the optimum required level of experience even if they have submitted several applications before. The challenge of adapting existing traditional finance operational standards to the new technologies requires keen experience in the traditional finance world, and real-world experience in the digital one and not many can yet claim a mastery of both to the extent that they know it all (perhaps that can be said of most regulatory matters).
While the added efforts that have been introduced into the standard application process in order to achieve an VATP license, may seem to be an innovation, it merely recognises an existing regulatory expectation. Where new products are being introduced to a market, firms will need to do risk-based assessments on the potential impact of the introduction of those products on overall market objectives. Firms are required to satisfy regulators on issues such as stability, investor protection and overall market integrity. Quality regulators know that they should not bow to the commercial pressure of being a first mover, even if their financial development executive is pushing for it. Experience shows that being the first should not be the only criteria for the successful launch of a new product market. Other less cautious markets have found this out to their detriment.
Historically, before market developments take place, and get released into the greater market ecosystem, we would typically see multiple years of investigation and testing on market tolerance and systems by those that are able to absorb significant losses. Typically, the regulators will only allow those firms with institutional experience and risk tolerance to "play" around, as they would typically be able to absorb the loss potential. However, the emergence of systemically important volumes of credit derivatives snuck through easily enough at the turn of the century, without much objection or recognition of their potential market wide impact and we are still working through Dodd Frank, MiFID II proposed changes to regulation designed to address the risks of the development of credit default swaps, and their peers to this day, 15 years or more after that bubble burst.
In that context, the speed of virtual asset development has required a relatively aggressive regulatory reaction in order to keep a lid on the organic unbridled development of crypto markets, in an attempt to stay ahead of a potentially similar catastrophic shock to world order, if markets were to be allow a risk bubble to engorge itself because regulators were unable to stay at the same pace. Perhaps, we are finally collectively learning about our previous global regulatory governance mistakes and learning to adapt to risk development on a global basis that reacts more promptly to sharper shifts in the risk landscape. One can only hope but maybe some of us are just better at reading the tea leaves before the tea has been drunk.
This time, regulators, have seemingly accepted the fact that in fairness to any government organisation in the world they are not likely to have the time or resources to become as expert in the subject matter as those pioneering the market's development. The unfettered development has occurred at a speed the likes of which has not been seen before, and this has required that all applications for new exchanges in Hong Kong come with independently produced assessments, to ensure that the applicants meet the minimum criteria before they will even entertain the approval process, attempting to avoid a potential bottleneck at the decision-making end. Those assessments apply standards that also apply to securities markets and exchanges and are not new or innovative in many respects. They are the same standards that apply to any financial ecosystem that is looking to plug into the existing one. At whatever cost, new entrants to existing systems, must be tested until breaking point, in order to avoid the potential disruption of the current infrastructure, which is, at least, considered (arguably) to be holding up well, the current market order.
Maintaining control over an expanding bubble without frustrating development, is not something that is easily done, and in fairness to some of those who are still waiting for their licenses, is based on a moving/increasing standard/target, that is adjusted as each prior entrant is assessed, by the gatekeepers, who are also, learning just as much as they go, with respect to maintaining market control over a potential market disaster if not approached as cautiously as it has been.
The effort required is tremendous, the costs are astronomical, the risks are high, but the prize is likely to be invaluable. As we have observed the tracking of the crypto caravan, trekking across different jurisdictions, seeking the goldilocks outcome (not so restrictive an environment to strangle innovation but not so free as to allow bad actors or inadequate controls to destroy the reputation of the participants), Hong Kong offers a very unique position, and many have pitched their tents here and are truly giving it a "fair go" to try and accomplish some inertia so that they can lead the charge into the creation of a credible market location for trading digital assets in a somewhat controlled manner. Some have given up and moved on to other less restrictive pastures, but the tortoise seems to be steadily plodding along at a controlled and dignified pace and may yet ultimately win the race over the many hares seeking the same prize.
At the start of the application process, the required investment in the application was an unknown, but the expectations that have emerged are relatively high by necessity. Not so much higher than any other market exchange facility that exists at present, which is pretty high. The application of a traditional finance control environment has become a mandatory expectation following a few of the earlier market scandals, and the tightening international standards, in particular with regards to AML, has confirmed this "need" to conform to traditional market controls infrastructure is clearly a "must have".
The risk of market collapse is currently too high in the prevailing political and economic environment. The industry has had to step up its controls on the new technology risks, and to upskill on various aspects of the new ecosystem that had not been well understood, because the key driver of innovation has come from people with more of a technologically innovative background and perhaps a more entrepreneurial temperament. Whereas it is now very clear that all of this innovation will only work with strong technical understanding and control experience that has in fairness been brought in to achieve those goals. Like in all successful financial offerings, the commercial pull needs to be balanced by the control infrastructure as one will not exist without the other and those that survive understand these points very well (in all regulated markets). This is likely to also foster and encourage movement and cross pollination of control understanding across the private-public front to back-office universe because that is what is needed to get this project done. Visionaries, Leaders, Sale's Peoples, frustrated CEOs, often need an army to keep their vision from causing an implosion of impatience.
The other aspect of timing that has been observed is that the budgets, and survivability of the projects involved in the development, have been impacted by the value of the digital assets held by the sponsors, which has been relatively volatile in the last few years. Therefore, budgets have been squeezed to the maximum as we see significant hiring in the market when value is high, with retrenchment when they are low, and this has indeed impacted the pace at which the ecosystem develops.
Market opportunities and potential market access are also factors. Originally the potential of getting access to investors across China would have been a key factor in the attractiveness of Hong Kong as a market location but for now that access is being limited by the standard currency export controls that exist to prevent money egress and indeed a clear statement that exchanges operating in Hong Kong should not be circumventing any such controls. However, it is not likely to be the end of the story as some hope exists to consider Hong Kong being the sandbox to broader regional adoption as time goes by and therefore having a foot hold in the broader market may prove to be a future accelerator if the restrictive position becomes relaxed after a successful trial period in Hong Kong or indeed as Hong Kong morphs towards a greater bay cryptosystem (only time can tell).
In any and all cases, there are positives and negatives, there are winners and losers, but as with all technological success stories, failing faster, with limited consequences to the retail or broader market, and institutional involvement should be welcomed to seek this prize. The growing carrot is dangling from an ever-growing stick that swings the carrot closer day by day, yet it swings frustratingly backwards for every two step forwards we take.
VA ETFs bringing with them Custody and Suitability implications (Click on arrow to expand)
22nd December 2023 Joint circular on intermediaries’ virtual asset-related activities
As highlighted in the December circular, (Joint circular on intermediaries’ virtual asset-related activities) the SFC had already accepted applications for firms to launch ETFs that accessed to digital assets exposure through traditional products such as futures. December saw the expansion of such authorisation to allow SFC authorised funds to
(i) invest directly in the same spot VA tokens accessible to the Hong Kong public for trading on SFC-licensed VATPs (i.e., direct exposure); and/or
(ii) acquire indirect investment exposure to such VA (i.e., indirect exposure), for example, through futures traded on conventional regulated futures exchanges and other exchange-traded products.
Interestingly, while the SFC was trying to restrict ownership and custody in non-securities digital assets to the newly licensed VATPs, there was a hat tip to the fact that such asset custody and availability may not be exclusive to VATPs and provided for the expansion of custody to Authorised Institutions, which would be traditional providers of such services. This was a gap discovered in the prior regulation and paves the way for broader adoption as Authorised Institutions will be able to provide custody services as long as:
(a) VA holdings are segregated from its own assets and the assets it holds for its other clients;
(b) most of the VA holdings are held in a cold wallet. The amount and duration of VA holdings stored in the hot wallet should be minimised as much as possible, save for meeting the needs of subscriptions and redemptions; and
(c) it should ensure the seeds and private keys are
(i) securely stored in Hong Kong;
(ii) tightly restricted to authorised personnel;
(iii) sufficiently resistant to speculation (e.g., through generation in a non- deterministic manner) or collusion (through measures such as multi-signature and key sharding); and
(iv) properly backed up to mitigate any single point of failure.
Service providers should be properly reviewed, and investor disclosures should be adequate for investors to be able understand the new risks associated with various aspects of this new type of investment such as price risk, custody risk, cybersecurity risk, valuation risk and fork risk and involve certain aspects of investor education. Managers should be conscious of the 10% percent limits on their own authorisation in order to engage in such activity while considering these new risks.
VATPs can now serve retail investors, where licence conditions allow and the SFC has since authorised Virtual Asset Exchange Traded Funds (ETFs) and as such they have updated their policy and terms in several respects.
Virtual asset-related products, i.e., products which;
(a) have a principal investment objective or strategy to invest in virtual assets;
(b) derive their value principally from the value and characteristics of virtual assets; or
(c) track or replicate the investment results or returns which closely match or correspond to virtual assets (VA-related products)
are very likely considered complex and in general should only be sold while ensuring suitability under the SFC's requirements for the sale of complex products with a few additional controls.
As discussed in more detail above, except for a limited number of types of products, complex products should only be offered to professional investors. E.g. an overseas Virtual Asset Exchange Traded Products, and for individual PIs, intermediaries should assess whether clients have knowledge of trading in virtual assets or VA-related products prior to effecting a transaction for them. If not, then the transaction may only proceed if their clients have sufficient net worth to be able to assume the risks and bear the potential losses of trading VA-related products.
Latest Updates on Digital Assets in Hong Kong (Click on arrow to expand)
Speech by Christina Choi: Speech at the listing ceremony of first bitcoin and ether spot ETFs
Date: 30 April 2024
Ms Christina Choi delivered a speech at the listing ceremony of first bitcoin and ether spot ETFs. She expressed that the six listed VA spot ETFs show how the SFC facilitates long-term sustainable market developments with comprehensive regulation for investor protection. The SFC noted the demand from investors to invest in spot VAs through traditional brokers and exchange-traded products such as ETFs, therefore allows regulated VA spot ETFs in Hong Kong.
https://apps.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=24PR81
SFC briefs virtual asset trading platform applicants on regulatory expectations after transition period ends
Date: 12 June 2024
The SFC held a briefing session to explain its regulatory expectations to the VATP applicants that are now deemed to be licensed after 1 June.
Dr Eric Yip, Executive Director, and Ms Elizabeth Wong, Director of Licensing and Head of Fintech unit, gave a comprehensive overview on the competencies expected of these applicants and the licence application process. The SFC also introduced its on-site inspection programme.
The non-contravention period for VATPs operating in Hong Kong under the AMLO came to an end on 1 June 2024. All VATPs operating in Hong Kong must be either licensed by the SFC, or VATP applicants which are deemed-to-be-licensed by operation of the AMLO.
https://apps.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=24PR103
SFC welcomes launch of Project Ensemble Sandbox as key step in Hong Kong’s tokenisation development
28 Aug 2024
Project Ensemble Sandbox (the Sandbox) was launched and both the SFC and HKMA announced their pleasure in co-leading the tokenisation initiatives for the asset management industry to build and scale the tokenisation market in Hong Kong.
It was announced that through the various use cases, participating financial institutions would pilot-test interbank settlement of tokenised asset transactions with tokenised money.
They announced the intention that this will also help identify hurdles in reaping the full benefits of on-chain primary issuance, secondary market trading, custody and hypothecation during the full product life cycle.
This was a key missing link in development and has the promise to address some of the key bottlenecks in commercialising some of the other initiatives that have been ongoing but had left some of the mechanics of orderly markets unresolved.
Our journey within the industry since introduction of new AML requirements (Click on arrow to expand)
AIMA APAC Forum, Discussion on the development of regulations and overall market for digital assets with major industry participants
As part of the Annual AIMA APAC conference in October 2023, apart from re-affirming APAC’s emerging recovery from COVID, we were delighted to moderate the discussion with industry pioneers from the Digital Asset space, to discuss the developing regulatory landscape. It is indeed clear that the private public partnership is fostering an accelerated development and industry participation is fostering this effort.
We discussed the Crypto frontiers, and the integration of digital assets into private funds. We had a former partner of a leading international practice outlay the international developments and anchor a discussion by a VATP applicant, a Digital Asset Manager and one of the leading lawyers in applying for licenses, outlining how the quickly indeed the market, the ecosystem and industry was developing following the changes in regulation in APAC.
Generally, it was a very positive event for the APAC Industry post COVID, although at a time when Digital Asset values were rather depressed. Interest and FOMO (Fear of Missing Out) ebb and flow with the price of the underlying assets but some institutional investors and market pioneers have put their money where they mouth is by buying in. However, maybe more by those that have deeper pockets, diversified portfolios and longer liquidity horizons. (14) Post | LinkedIn.
Since then, we have participated in a number of discussions on market development within the Digital Asset Working Group (DAWG) at AIMA, working with a variable host of knowledgeable market participants in monitoring the global developments in a space that is beginning to capture more attention, as the regulations mature, and the opportunity set increases. Digital assets are a little bit like marmite, you either like them or you don't, but there is an in between. Whatever your view on the value of underlying assets, the technology used will have/is having an impact on financial services activities in the short to near term. AIMA is keeping itself at the forefront of the global developments as this endeavour is truly a curated rush to cautiously walk towards a global goal.
Regulation Asia Conference on Digital Assets
Blending Worlds, The Future of Traditional Tokenised Assets and Token Native Assets - Is a convergence closer than we think?
We moderated an interesting panel of knowledgeable people including Esme Pau, from EmergentX Labs, Strategy Lead and Co-Founder, Jonathan Sloane from GrtWines, Jonathan Gill from Hashkey, Senior Tokenisation Director & Legal Advisor, and Brian Chan from VSFG. Group Head of Investment and Products, VSFG - Venture Smart Financial or Finance 2.0. one of the first Traditional Wealth/Fund Managers to become approved for managing digital assets.
Like all good panels, the topic was one with different views, with financial services participants feeling that convergence is occurring right now, in so far as we are seeing lots of examples of traditional assets being tokenised, while perhaps the native community not really seeing that the opportunities that the technology presents being utilised as much as they would like. I would go as far as to say that while the functionality being explored in the financial services world to perhaps replace, or re-engineer for old problems, like interoperability, is to a native tokeniser (or person with more of fundamental technology focus) a small fraction of the functionality/opportunity that exists. Some of the limitations being imposed by the gatekeepers of traditional finance have been erected to avoid contagion by connecting up untested dynamic economic ecosystems to the existing ones, which for the most part still work, while not offering much more scope for innovation in their current form.
We explored logistic chain solutions like GrtWines, Web3 applications and other distributed use cases, as well as the state of regulation in Hong Kong and a myriad of financial solutions from private equity, e-money, property, and real-world assets. In some cases, maybe suggesting that the traditional model remains the more appropriate one, while some development still remained in order for others to take off.
This conference was delivered by Regulation Asia and brought together a lot of leading minds in the digital asset space, providing an opportunity to speak with regulators in a workshop format to discuss evolving and current issues. In addition, to moderating a panel, we enjoyed the opportunity to discuss local and global challenges with local and global regulators and as such the event was hugely appreciated by participants. Watch out of for this event next year as there were certain elements of it that were innovative and certainly very well managed.
We continue to work with Regulation Asia as part of the RegTech Awards for Excellence judging Panel looking at new technologies, new applications that are being introduced into Asia and look forward to this year's awards.
Our digital assets team have experience working for licensed providers and assisting firms assess their compliance requirements.
While there are still many issues to address, we recognise that the challenges in the digital asset markets, are not particularly new, and experts from traditional finance markets are well equipped to curate the new innovations in decentralised finance technologies in a way that avoids the potential pitfalls when the uninitiated are allowed to grow businesses without considerations of the potential risks that are generated due to the interconnectivity of our global market dependency.
This new regulatory architecture facilitates an efficient achievement of stakeholders' goals and paves the way to provide cautious improvement to the broader market ecosystem by balancing the innovation of new technologies with the experience of the old.