Introduction

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 The Tokenisation Circulars superseded the 28 March 2019 statement on security token offerings (STO) (the 2019 Position), reflecting the SFC’s evolved views on tokenised securities.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 The Joint Circular superseded the 28 January 2022 and 20 October 2023 joint circular on intermediaries’ VA-related activities, taking into account the latest market developments and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.

A key update

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

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.

Key regulatory measures

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:

• “See-through” approach: As the SFC regards tokenised securities as being fundamentally traditional securities with a tokenisation wrapper, in line with the SFC’s “same business, same risks, same rules” regulatory principle, existing securities offerings and prospectus regime would apply to tokenised securities where relevant. For example, unless as otherwise exempted:
  • offerings of tokenised shares or debentures are subject to the prospectus regime under the Hong Kong Companies (Winding up and Miscellaneous Provisions) Ordinance; and
  • offerings of other tokenised securities are subject to the offers of investments regime under Part IV of the Securities and Futures Ordinance.

• General principle on compliance obligations: When engaging in activities related to any type of tokenised securities, intermediaries should have the necessary manpower and expertise, and act with appropriate skill, care and diligence to understand the tokenised securities.
• Issuance of tokenised securities: When intermediaries issue or are substantially involved in the issuance of tokenised securities that they will deal in or advise on, whether or not the same has been outsourced to third-party service providers (e.g. technology developers, platform providers, wallet service providers, custodians and anti-money laundering solutions providers), the intermediaries should (i) remain responsible for the overall operation of the tokenisation arrangement and (ii) consider and analyse features and risks of the relevant tokenised securities in order to arrange for the most appropriate custodial arrangement to manage such risks.
• Dealing in, advising on or managing portfolios involving tokenised securities: Intermediaries should (i) conduct due diligence on issuers and their third-party service providers involved in the tokenisation arrangement and (ii) understand and ensure appropriate controls have been implemented by such issuers and their third-party service providers to ensure that ownership and technology risks of tokenised securities are effectively managed.
• Client information: Intermediaries should adequately disclose material information that is specific to the relevant tokenised securities to investors. Such material information on the tokenisation arrangement should include, non-exhaustively, associated risks, settlement finality, transfer restrictions, smart contract audits, administrative controls, business continuity planning and custodial arrangements etc.

Significance of SFC’s latest position

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:

• Tokenised securities are not limited to professional investors: First, compared to the 2019 Position where the SFC stated that STO should only be offered to professional investors, following the latest view which considers tokenised securities as traditional securities with a tokenisation wrapper, the SFC believes that it is no longer necessary to impose the mandatory professional investors restriction. In other words, subject to the applicable securities regulatory and prospectus regime, tokenised securities can be offered, marketed and distributed to non-professional investors.
• Tokenised securities are not automatically classified as complex products: Second, whilst the SFC’s previous approach in the 2019 Position was to treat all security tokens as “complex products”, as the SFC now views tokenisation as a mere “wrapper”, a “see-through” approach should be adopted to look at the profile of the underlying assets to determine whether the tokenised security is a “complex product” for suitability purposes. In other words, tokenised securities will no longer be automatically classified as complex products. Instead, they may well not be regarded as complex products if, under the “see-through” approach, it is considered that the underlying assets are traditional financial instruments not otherwise considered as being in the nature of complex products.

VA funds authorisation

• In addition to the above, following the VA Funds Circular, the SFC will now be accepting applications for authorisation of funds that: (i) invest directly in the same spot VA tokens accessible to the Hong Kong public for trading on SFC-licensed VA trading platforms (VATPs), and/or (ii) acquire indirect investment exposure to such VAs (for example, through futures traded on conventional regulated futures exchanges and other exchange-traded products). The new circular sets out the new requirements that the SFC will impose.
• Consequentially, the Joint Circular has been issued to supersede and supplement the former joint circular published on 20 October 2023 in order to expand its scope to also cover VA funds. In particular, a VA fund will not necessarily be restricted to “professional investors” only, such as illustrated below:
  • for the distribution of VA funds that are listed and traded on the Stock Exchange of Hong Kong and where there has been no solicitation or recommendation, the intermediaries may execute client orders in them on exchange without being subject to the suitability requirement, the minimum information requirement and the warning statements requirement, but the intermediaries should still conduct a VA-knowledge test on the client concerned;
  • for the distribution of VA funds that are not listed, or listed but with trading in their fund units conducted off exchange, intermediaries should comply with the suitability requirement, the minimum information requirement and the warning statements requirement and, as usual, the intermediaries should conduct a VA-knowledge test on the client concerned; and
  • for VA derivative funds, the intermediaries must also comply with the existing requirements for derivative products.

Regulatory expectations on intermediaries

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.

1. “Virtual asset” refers to any “virtual asset” as defined in section 53ZRA of the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO).↩
2. For the purpose of this article, “VA-related products” refers to investment 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.↩
3. See “Circular on intermediaries engaging in tokenised securities-related activities”, published by the SFC on 2 November 2023, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=23EC52.↩
4. See “Circular on tokenisation of SFC-authorised investment products”, published by the SFC on 2 November 2023, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=23EC53.↩
5. See “Circular on SFC-authorised funds with exposure to virtual assets”, published by the SFC on 22 December 2023, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=23EC65.↩
6. See “Joint circular on intermediaries’ virtual asset-related activities”, published by the SFC and HKMA on 22 December 2023, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=23EC67.↩