Hong Kong Crypto Law – November 2018

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Virtual Asset Fund Distributors

Firms which distribute funds that invest (wholly or partially) in virtual assets in Hong Kong are required to be registered for Type 1 regulated activity (dealing in securities) irrespective of whether or not the virtual assets are securities or futures contracts. Type 9 licensed asset managers which also distribute funds under their management which invest in virtual assets can rely on the incidental exemption from the Type 1 licensing requirement.

The SFC’s “Circular to intermediaries on the distribution of virtual asset funds” (the Circular) reminds licensed corporations which distribute virtual asset funds that they are required to comply with the SFC’s Code of Conduct for Persons Licensed by or Registered with the SFC, including the requirement to ensure the reasonable suitability of any recommendation or solicitation made to a client under paragraph 5.2 of that Code (as supplemented by the SFC’s Frequently Asked Questions on Compliance with the Suitability Obligations by Licensed or Registered Persons [5] and the Frequently Asked Questions on Triggering of Suitability Obligations). [6]

The Circular also sets out additional requirements which apply to distributors of virtual asset funds which:

  1. are not authorised by the SFC for retail distribution under section 104 Hong Kong Securities and Futures Ordinance (SFO); and
  2. have a stated investment objective of investing in virtual assets or intend to invest or have invested more than 10% of their GAV in virtual assets (i.e. funds which the licensed corporation knows, or should reasonably have known, to be investing more than 10% of their GAV in virtual assets at the time it distributes the fund, unless it has been advised that the fund manager intends to reduce the fund’s investment in virtual assets to below 10% of the fund’s GAV in the near future). The investment in virtual assets may be direct or indirect (i.e. through fund of funds and funds which invest in derivatives, for example, total return swaps, with virtual assets as the underlying).

Additional Requirements

The additional requirements that apply to licensed corporations distributing these funds are as follows:

1. Selling restrictions

  • Only professional investors as defined under the Securities and Futures Ordinance (SFO) should be targeted.
  • Except in the case of institutional professional investors, licensed corporations should assess whether clients have knowledge of investing in virtual assets or related products before effecting the transaction on their behalf. They may only effect a transaction for a client without such knowledge, if this would be in the best interest of the client. For the purposes of the knowledge assessment, a licensed corporation may take into account a client’s prior investment experience in private equity or venture capital or whether they have provided capital for a start-up business in the previous two years.

2. Concentration assessments

  • A particularly difficult obligation on licensed corporations is a requirement that they must consider the aggregate amount to be invested by a client in virtual asset funds to be reasonable given the client’s net worth.

3. Due diligence on virtual asset funds not authorised by the SFC

Licensed corporations will need to conduct extensive due diligence on non-SFC authorised funds, their fund managers and parties providing trading and custodian services to the funds. Where licensed corporations distribute third party funds, their compliance with these obligations will depend on the willingness of the various parties to disclose the required information. The assessments licensed corporations will be required to make are difficult given the lack of developed standards in the industry. The due diligence is required to include (without limitation) an examination of the fund’s constitutive documents and completion of a due diligence questionnaire, in addition to making enquiries of the fund manager to obtain an in-depth understanding of the following:

In relation to the fund manager

  1. General
    • its background, relevant experience and, where applicable, the track record of its senior management, including its chief investment, operation, risk and technology officers;
    • its regulatory status, e.g., whether the fund manager is subject to any regulatory oversight and its robustness; and
    • its compliance history, e.g., whether any disciplinary or regulatory actions have been taken against it by any regulatory authorities.
  2. Operations/ Internal controls and systems for example:
    • whether there is proper segregation of key functions, such as portfolio management, risk management, valuation and custody of assets and, if not, whether there are any adequate compensating controls to prevent abuse;
    • the persons who can transfer assets from the fund or custodians and what safeguards are in place;
    • the persons responsible for, and the procedures for, reconciling transactions and positions, including the frequency of reconciliations; and
    • the methodology and the persons responsible for determining the pricing and assessment of the reasonableness of the determined price of each virtual asset.
  3. IT system
    • its IT infrastructure (e.g. in terms of security and access management).
  4. Risk management
    • its risk management procedures, including concentration limits, counterparty risk management procedures, stop-loss arrangements and stress testing;
    • its liquidity risk management policy; and
    • disaster recovery plan.

In relation to the fund

  1. The fund’s targeted investors;
  2. List of instruments the fund intends to trade or invest in and any limitations on the size of its holding of ICO tokens, pre-ICO Tokens or other illiquid or hard-to-value instruments;
  3. Its valuation policy (especially for ICO Tokens, pre-ICO Tokens or other illiquid or hard-to-value instruments);
  4. The custody arrangement for the fund assets, including the policy on the allocation of assets to be kept at different host locations, such as exchanges, custodians, hot storage, cold storage;
  5. Its use of leverage and derivatives;
  6. The fund’s targeted risk and return per annum;
  7. Key risks (as described in “Information for clients” below); and
  8. The fund’s auditors and audited financial statements, including whether the fund has received a qualified audit opinion in the past, and whether the audited statements are up-to-date.

In relation to the fund’s counterparties

  1. Legal and regulatory status (whether they are regulated by any authorities to, among other things, undertake custody business or trade in virtual assets);
  2. Their experience and track record in dealing with virtual assets;
  3. The robustness of their IT systems (including cybersecurity risk management measures) and contingency plans; and
  4. Their financial soundness and insurance coverage, e.g., insurance to cover losses of customer assets.

4. Provision of information to clients

Licensed corporations will need to provide prominent warning statements covering, among others:

  1. The continuing evolution of virtual assets and how this may be affected by global regulatory developments;
  2. Price volatility;
  3. Potential price manipulation on exchanges or trading platforms;
  4. Lack of secondary markets for certain virtual assets;
  5. That most exchanges, trading platforms and custodians of virtual assets are currently unregulated;
  6. Counterparty risk when effecting transactions with issuers, private buyers/sellers or through exchanges or trading platforms;
  7. The Risk of loss of virtual assets, especially if held in “hot wallets” [7]; and
  8. Cybersecurity and technology-related risks.

For licensed fund managers which manage funds investing in virtual assets and distribute those funds, the new requirements should not prove problematic, particularly where they provide custody for the virtual assets. The requirements are likely to be much more problematic for Type 1-licensed fund distributors where the extent of due diligence they will be required to perform on third party funds, their fund managers and custody arrangements may not be practical.

[5] SFC. Frequently Asked Questions on Compliance with Suitability Obligations by Licensed or Registered Persons. 23 December 2016 at https://www.sfc.hk/web/EN/faqs/intermediaries/supervision/suitability-obligations-of-investment-advisers/compliance-with-suitability-obligations.html

[6] SFC. Frequently Asked Questions on Triggering of Suitability Obligations. 23 December 2016 at https://www.sfc.hk/web/EN/faqs/intermediaries/supervision/triggering-of-suitability-obligations/triggering-of-suitability-obligations.html

[7] A “hot wallet” refers to a wallet used for holding virtual assets in an online environment which provides an interface with the internet, which is more susceptible to cyber-attacks.