By HENRY YU & ASSOCIATES
On 28 January 2022, the Securities and Futures Commission (the “SFC”) and the Hong Kong Monetary Authority (the “HKMA”) published the “Joint circular on intermediaries’ virtual asset-related activities” (the “Joint Circular”), which would supersede the “Circular to intermediaries: distribution of virtual asset funds” dated 1 November 2018 (the “2018 Circular”). Noting the rapid evolution of the virtual asset (singularly “VA” and plurally “VAs”) landscape, the Joint Circular sets out the SFC and the HKMA’s updated regulatory framework on the distribution of VA-related products and the provision of VA dealing services and VA advisory services.
A. Distribution of VA-related products
In the Joint Circular, the SFC and the HKMA have reiterated their view that VA-related products are very likely to be considered “complex products”1 (the “Complex VA-Related Products”), the distribution of which would be subject to the followings:-
(a) Compliance with the existing requirements relating to the sale of complex products (the “Existing Complex Product Regime”), including various suitability tests and due diligence obligations;2 and
(b) Complex VA-Related Products shall only be offered to professional investors3 (the “Professional Investor-Only Restriction”);4 and
(c) Except for institutional professional investors5 and qualified corporate professional investors,6 intermediaries should conduct a virtual asset-knowledge test (the “VA Knowledge Test”) to assess whether the client possesses sufficient knowledge of investing in VAs or VA-related products7 prior to effecting a transaction in VA-related products on the client’s behalf (the “VA Knowledge Test Requirement”).8
Certain VA-related derivative products, which are either traded on regulated exchanges specified by the SFC or are permitted by the regulator for offering to retail investors in a designated jurisdiction, would be exempted from the Professional Investor-Only Restriction (the “ExemptedVA Derivative Products”). The SFC and the HKMA consider that this Exempted VA Derivative products are similar to those traded in the traditional regulated markets with established conventional rules, hence pricing transparency and potential market manipulation would less likely be an issue. Nevertheless, as Exempted VA Derivative Products are still considered Complex VA-Related Products, the requirements relating to derivative products9 under the Existing Complex Product Regime and the VA Knowledge Test Requirement would continue to apply.10
B. Provision of VA dealing services
The SFC and the HKMA have expressed that, at this point of time, they are only prepared to allow intermediaries licensed or registered for Type 1 regulated activity (dealing in securities) to provide VA dealing services.11 To provide VA dealing services, the Type 1 intermediaries shall partner only with VA trading platforms licensed by the SFC (currently, there is only one licensed VA trading platform in Hong Kong, namely OSL, being owned and operated by the BC Technology Group Limited (Stock Code: 863)). Furthermore, intermediaries may only offer such VA dealing services to their existing clients who are professional investors.12 Type 1-licensed intermediaries are expected to comply with all the regulatory requirements imposed by the SFC and the HKMA when providing VA dealing services, regardless of whether the VAs in question are security or non-security in nature.13 Such regulatory requirements would be imposed as licensing or registration conditions and include the following:
(a) Introducing agent arrangement:
(i) Any clients to be introduced by the intermediaries to the VA trading platforms shall be limited to professional investors only; and
(ii) intermediaries are not allowed to trade on behalf of clients or hold any client assets (whether fiat currencies or VAs)14 via the VA trading platforms; and
(b) Omnibus account arrangement:
Any intermediaries establishing omnibus accounts with the VA trading platforms shall only allow clients to deposit or withdraw fiat currencies from their accounts. No VA is allowed for deposit or withdrawal to avoid any risks of transfer of VAs.15
C. Provision of VA advisory services
The SFC and the HKMA are only prepared to allow intermediaries with Type 1 regulated activity (dealing in securities) or Type 4 regulated activity (advising on securities) to provide VA advistory services.16 Any VA advisory services to be provided by the intermediaries shall only be limited to existing clients who are professional investors.17 Type 1 and Type 4-licensed intermediaries are expected to comply with all the regulatory requirements imposed by the SFC and the HKMA when providing VA advisory services, regardless of whether the VAs in question are security or non-security in nature.18 In general, intermediaries that wish to offer VA advisory services shall comply with the same requirements as for the distribution of VA-related products, including the suitability tests under the Existing Complex Product Regime and the VA Knowledge Test Requirement.19
Our Observations
As the SFC has already granted the licences to a VA trading platform and certain VA asset management firms, the Joint Circular provides much-needed clarity to Hong Kong’s regulatory framework regarding the distribution of VA-related products and also the relevant dealing and advisory services in order to build up the VA ecosystem in Hong Kong. Importantly, the Joint Circular makes it clear that certain limited VA-related derivative products traded on regulated exchanges may be offered to retail investors, which may prove to be a significant step by opening a small door for VA-related products to enter into the mainstream economy and become part of retail investors’ investment portfolios. Furthermore, Type 1-licensed intermediaries would be permitted to provide VA dealing services by partnering with VA trading platforms licensed by the SFC. Although at present there is only one SFC-licensed VA trading platform, it is expected that more VA trading platform licences will be granted by the SFC in the near future.
Separately, the HKMA has issused its own circular (the “HKMA Circular”) on the same date of 28 January 2022,20 in which the HKMA has made it clear that it does not intend to prohibit the banks from investing in VAs, lending against VAs as collateral, or allowing their customers to use credit cards or other payment services to acquire VAs provided adequate risk-management controls are in place.21 Together, the Joint Circular and the HKMA Circular provide relatively clear guidance for licensed securities brokers, banks and investment managers to follow the prescribed regulatory requirements when engaging in the VA-related activities.
Although the Joint Circular does not address the issue of retail investment in VAs directly, it is expected that the new regulatory regime set out in the Position Paper dated November 2019 on the regulation of VA trading platforms (the “VASP Licensing Regime”) will take effect later this year, after which all crypto-exchanges that intend to market to the Hong Kong public would need to be licensed by the SFC regardless of whether the tokens in trade on the crypto-exchange are “securites” in nature or not. Given that the VASP Licensing Regime (under which a licensed VA trading platform may only offer its services to professional investors) covers only centralised VA trading platforms, it does not apply to over-the-counter (“OTC”) and peer-to-peer (“P2P”) trading platforms. It appears that, once the VASP Licensing Regime takes effect, the only available options for retail investors in Hong Kong for purchasing VA-related products would be limited to (i) purchasing Exempted VA Derivative Products via the Type 1 licensed intermediaries; (ii) purchasing non-security VAs via the local OTC/P2P desks; and/or (iii) trading on the overseas trading platforms. If you have any view or questions on the above or would like to further discuss the issues raised in this Client Alert or the Joint Circular generally, please do not hesitate to get in touch with our members at hyu@lylawoffice.com or at (+852) 2115-9525.
Disclaimer: The information provided in this article is not intended to be, nor does it constitute, legal advice and is not a substitute for obtaining proper legal advice in respect of any specific issue.
1 “Complex product” is defined in paragraph 6.1 of the Guidelines on Online Distribution and Advisory Platforms dated July 2019 (the “Guidelines”) as “an investment product whose, terms, features and risks are not reasonably likely to be understood by a retail investor because of its complex structure”. See Appendix 3 to the Joint Circular for a flowchart illustrating the factors for determining whether or not a VA-related product is a complex product.
2 See paragraph 5.5 of Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the “Code of Conduct”) and Chapter 6 of the Guidelines, as supplemented by the Frequently Asked Questions on Compliance with Suitability Obligations by Licensed or Registered Persons and the Frequently Asked Questions on Triggering of Suitability Obligations (the “Suitability FAQs”).
3 As defined in section 1 of Part 1 of Schedule 1 to the Securities and Futures Ordinance (Chapter 571 of the Laws of Hong Kong) (the “SFO”)
4 See paragraph 7.1 of the Joint Circular.
5 “Institutional professional investors” are defined under paragraph 15.2 of the Code of Conduct as persons falling under paragraphs (a) to (i) of the definition of “professional investor” in section 1 of Part 1 of Schedule 1 to the SFO. This includes recognised exchanges and clearing houses, licensed corporations and registered institutions (and their wholly-owned subsidiaries and holdings companies), authorised financial institutions (and their wholly-owned subsidiaries and
holdings companies), authorised insurers, authorised collective investment schemes, registered provident fund schemes, registered occupational retirement schemes, governments and central banks, as well as the overseas equivalents of such institutions and entities.
6 “Qualified corporate professional investors” refer to corporate professional investors which have passed the assessment requirements under paragraph 15.3A of the Code of Conduct and gone through the consent and annual confirmation procedures under paragraph 15.3B of the Code of Conduct.
7 The criteria for assessing whether a client can be regarded as having knowledge of virtual assets include (but are not limited to): (i) whether the client has undergone training or attended courses on VAs or VA-related products; (ii) whether the client has current or previous work experience related to VAs or VA-related products; or (iii) whether the client has prior trading experience (e.g. 5 or more transactions within prior 3 years) in any VA or VA-related product. See further Appendix 1 to the Joint Circular.
8 See paragraph 7.2 of the Joint Circular.
9 See paragraphs 5.1A and 5.3 of the Code of Conduct.
10 See paragraph 8 of the Joint Circular.
11 See footnote 19 of the Joint Circular. The Joint Circular does not provide a definition of “VA dealing services”. However, reference may be made to the definition of “dealing in securities” in Part 2 of Schedule 5 to the Securities and Futures Ordinance (Cap. 571) (the “SFO”), namely making or offering to make an agreement (or inducing another person to do the same) with a view to acquiring, disposing of, subscribing for or underwriting securities or for the purpose of securing a profit from the yield of the securities or by reference to fluctuations in their value.
12 See paragraph 17 of the Joint Circular.
13 See paragraph 18 of the Joint Circular.
14 See paragraph 21 of the Joint Circular.
15 See paragraphs 19 and 20 of the Joint Circular.
16 See footnote 26 of the Joint Circular.
17 See paragraph 24 of the Joint Circular.
18 Ibid.
19 See paragraphs 25 and 26 of the Joint Circular.
20 “Regulatory approaches to Authorized Institutions’ interface with Virtual Assets and Virtual Asset Service Providers”,HKMA, 28 January 2022.
21 See page 3 of the HKMA Circular.