Just as 2023 was coming to an end, Hong Kong announced a number of updates reflecting the latest regulatory position regarding the distribution and dealing of virtual asset (VA)1 -related products 2 (VA-related products) and tokenised securities-related activities, giving much to anticipate ahead in the financial markets on digitisation, VAs and asset tokenisation.
On 2 November 2023, the Securities and Futures Commission (SFC) published the “Circular on intermediaries engaging in tokenised securities-related activities” (the Activities Circular)3 and the “Circular on tokenisation of SFC-authorised investment products” (the Investment Products Circular)4 (collectively, the Tokenisation Circulars). The Tokenisation Circulars superseded the 28 March 2019 statement on security token offerings (STO) (the 2019 Position), reflecting the SFC’s evolved views on tokenised securities.
On 22 December 2023, the SFC further announced a greenlight for retail investors in relation to SFC-authorised VA funds, with the issuance of the “Circular on SFC-authorised funds with exposure to virtual assets” (the VA Funds Circular).5 On the same day, the “Joint circular on intermediaries’ virtual asset-related activities” (the Joint Circular)6 was jointly published by the SFC and the Hong Kong Monetary Authority (HKMA). The Joint Circular superseded the 28 January 2022 and 20 October 2023 joint circular on intermediaries’ VA-related activities, taking into account the latest market developments and regulatory landscape.
The Joint Circular provides updated guidance to intermediaries conducting VA activities and primarily applies to VAs that do not constitute securities or futures contracts. The Tokenisation Circulars supplement the Joint Circular by providing guidance for tokens that constitute “securities” under the Hong Kong regulatory regime.
Importantly, by explicitly superseding the 2019 Position which characterised security tokens as complex products requiring extra investment protection measures and the offering of which was therefore restricted to professional investors, in the Tokenisation Circulars, the SFC states that it considers tokenised securities to be traditional securities with a tokenisation wrapper, and notes that there is a growing interest in tokenising traditional financial instruments in the market, including the issuance and distribution of tokenised funds by fund managers and management of funds that invest in tokenised securities. The Tokenisation Circulars are issued with the aim of assisting intermediaries that are interested in exploring tokenisation by providing more guidance on regulatory expectations with respect to tokenised securities-related activities and how to address the risks specific to tokenised securities.
Tokenisation generally refers to the process of digitally representing an asset (tangible or intangible) using distributed ledger technology (DLT), through creating digital tokens on a blockchain to represent ownership of all or a fraction of an asset (which can be tangible or intangible) (and, for example, a record of ownership in an investment product).
Whilst there are currently no statutory definitions of “tokenisation” or “tokenised investment products” in Hong Kong, the SFC has described tokenisation as generally involving the process of “recording claims on assets that exist on a traditional ledger onto a programmable platform” which includes the use of DLT in the security lifecycle. In SFC’s own words, tokenised investment products are fundamentally traditional investment products with a “tokenisation wrapper”.
Accordingly, existing legal and regulatory requirements governing the underlying traditional investment products continue to apply to tokenised investment products. In this regard, depending on the economic benefits and rights attached to the tokens, fractional ownership of real-world assets achieved through tokenisation may trigger regulatory requirements applicable to offerings of securities, interests in collective investment schemes or structured products.
The SFC refers to the potential benefits of tokenisation, including increasing efficiency, enhancing transparency, reducing settlement time and lowering costs for traditional finance, but also recognises that the use of DLT can create additional risks. With the growing interests among intermediaries in tokenisation, the SFC has decided to provide additional guidance to the market.
As a starting point, the SFC notes that tokenised securities are in fact a subset of “digital securities”. Examples of tokenised assets include tokenised financial instruments like bonds and funds and also other real-world assets such as real property and artwork. In light of the new and heightened ownership and technical risks around tokenised securities owing to the use of DLT networks, the SFC requires intermediaries to consider the following factors when engaging in activities related to tokenised securities:
Importantly, financial market participants should note the SFC’s more welcoming attitude towards tokenised securities compared to the 2019 Position, with two significant implications as we outline below:
These updates suggest a clear message that Hong Kong is ready for a shift towards the financial markets taking further steps to digitisation and tokenisation, building on the blockchain and DLT infrastructure established so far in the ecosystem, and responding to the broader market interest and landscape. In 2023, following the introduction of the regulatory framework for licensing of VATPs operators, the SFC has to-date approved two operators and is currently processing around 10 applications. The SFC has also authorised VA futures exchange traded funds and has expressed that it is prepared to accept applications for the authorisation of other funds with exposure to VAs, including VA spot exchange traded funds.
At the same time, while the recent regulatory updates in these couple of years have expanded the scope of market activities and appetite on VAs, whether or not in the nature of securities, the updated Joint Circular outlines the regulatory expectations on financial market intermediaries in the distribution of VA-related products. In the Joint Circular, it is reiterated that the risks associated with investing in VAs identified by the SFC in 2018 continue to apply and, in general, VA-related products are very likely considered to be complex, except for a limited suite of products as specified by the SFC, such as those we described above, where appropriate, selling restrictions and suitability requirements would apply (including, where relevant, the need for VA-knowledge tests).
Intermediaries engaging in VA dealing services are subject to licensing or registration conditions, including prescribed terms and conditions, which are intended to align with the SFC’s regulatory framework for VATPs where relevant. For asset managers engaging in portfolio management involving VAs, unchanged to the de minimis threshold previously set in 2018, where the stated investment objective of a portfolio or the intention is to invest 10% or more of the portfolio in VAs, such asset managers are also subject to additional requirements referred to as the “RA9 terms and conditions”. Type 1 intermediaries providing ancillary discretionary account management services are required not to exceed 10% in VAs in the portfolio. Licensed intermediaries engaging in VA advisory services are also expected to comply with prescribed terms and conditions including, in particular, VA-related suitability obligations.
While there should remain appropriate caution and necessary due diligence and risk assessment, the market should welcome the updates to Hong Kong’s regulatory framework on VAs and tokenisation, with the potential and opportunities it presents in product innovation and digitisation, with anticipation for more VA-related launches ahead.
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