The virtual assets landscape is already ripe with acronyms (BTC, ICOs, STOs, to name a few), but Hong Kong’s securities regulator is keen for virtual assets investors to get familiar with a couple more: SFC and T&Cs.
The Securities and Futures Commission (SFC) has just published its proforma terms and conditions (T&Cs) which are imposed on regulated fund managers who invest in virtual assets. While these T&Cs are by no means unexpected – they were signposted 11 months ago in a Regulatory Framework Statement – there are some points on the T&Cs which are worth mentioning:
1. Evolving definition of “Virtual Assets”
The SFC, like many regulators, is yet to settle on a single definition of virtual assets, and has opted for a more expansive definition than the one included in its Regulatory Framework Statement last year. The SFC has started using the same taxonomy and terminology as the European and UK regulators, which refer to security tokens, payment tokens and utility tokens. We explain more here.
Below is the current definition of “Virtual Assets” under the T&Cs:
“Digital representations of value which may be in the form of digital tokens (such as digital currencies, utility tokens or security or asset-backed tokens), any other virtual commodities, crypto assets or other assets of essentially the same nature, irrespective of whether they amount to ‘securities’ or ‘futures contracts’ as defined under the Securities and Futures Ordinance”.
2. An expanded regulatory perimeter, but a permeable one
The SFC freely admits that its approach brings virtual assets into its regulatory net, even though “managing funds solely investing in virtual assets which do not constitute ‘securities’ or ‘futures contracts’ does not amount to a ‘regulated activity’”. The approach is one we have seen elsewhere – where legislation / regulation has not yet evolved to capture virtual assets themselves, regulators can still focus their gaze on the “touchpoints” where virtual assets meet the regulated financial services industry, for instance custody and fund management services.
Despite the broadened scope, the SFC has taken a pragmatic approach by only applying the T&Cs to managers who manage a fund which either has a stated objective to invest in Virtual Assets, or has an intention to invest 10 per cent or more of its gross asset value (GAV) in Virtual Assets. Recognising that the high volatility of (certain) virtual assets could cause difficulties if the 10 per cent threshold was a hard investment limit, the SFC allows value of virtual assets holdings to “temporarily” increase beyond 10 per cent of GAV, subject to conditions.
3. SFC’s answer to “cryptocustody”
Virtual assets stand apart from physical assets in many ways, but they do bear one important similarity: the “holder” of the asset is presumed to be the owner, and there is often no registration system available to verify ownership. Virtual assets are perceived as attractive targets for theft, hacks and fraud, and there is a real and rising demand for keeping virtual assets secured.
Recognising this need for proper “cryptocustody”, the SFC acknowledges different types of custodial arrangements for holding virtual assets (including self-custody, hot storage and cold storage), and through the T&Cs, it puts the onus on fund managers to assess in detail the different arrangements, and select “the most appropriate” arrangement. Factors to be considered (and documented in detail) include: (1) hard/software infrastructure; (2) controls over private key generation, storage and usage; (3) how custodians ensure storage devices remain future-proofed; and (4) the process for handling blockchain forks.
4. Tailored T&Cs for discretionary accounts
With investor protection at the heart of its supervisory priorities, the SFC has steered away from a one-size-fits-all approach in drafting the T&Cs. Appendix 1 of the T&Cs lists out the requirements that only apply to, and those that do not apply to virtual asset discretionary account managers.
Among the additional requirements, the SFC expects virtual asset fund managers to apply high “suitability” standards when managing discretionary accounts. In particular, the manager should consider the client’s personal circumstances of which it is or should be aware, and ensure that the aggregate amount to be invested by the client in virtual assets is reasonable considering the client's net worth.
The T&Cs can be accessed here, and do not hesitate to reach out to your Freshfields team with any questions.