William Hallatt, Hannah Cassidy and Michael KS Tan, Herbert Smith Freehills, explore the Securities and Futures Commission’s new regulatory framework for virtual assets.
The Securities and Futures Commission (SFC) has published a statement (Statement), together with a press release, setting out its new regulatory framework for virtual assets (also known as cryptocurrencies, crypto-assets and digital tokens).
Ashley Alder, the Chief Executive Officer of the SFC, made clear in his speech during the Hong Kong FinTech Week that the SFC’s aim in setting up this framework is ‘to step up as much as we are able to protect investors who trade virtual assets’, in particular from the unique risks associated with a rapidly expanding industry.
The Statement was published in parallel with a circular on the expectations around the distribution of virtual asset funds and a circular on the content of the Statement.
What problem is the SFC trying to solve?
The explosion of crypto
Together with security regulators around the world, the SFC has taken note of growing public interest in virtual assets. The industry has grown exponentially. Over 2,000 different digital tokens are currently traded around the world with substantial trading volumes and an estimated total market capitalisation of over US$200 billion. In particular, there is a growing demand for funds which invest in virtual assets.
The primary concern with these developments relates to investor protection and the unique risks associated with virtual assets (see ‘Risks to investors’).
The existing regime
The SFC is principally mandated to regulate ‘securities’ and ‘futures contracts’. Where virtual assets fall under the definition of ‘securities’ or ‘futures contracts’, these products and related activities are likely to fall within the SFC’s jurisdiction. The problem is that many virtual assets do not fall within the meaning of either ‘securities’ or ‘futures contracts’, and in fact they are often purposely designed that way. This means that:
- these out of scope (OS) virtual assets will not fall within the SFC’s jurisdiction
- the operators of platforms which only provide trading services for OS virtual assets also do not fall within the SFC’s jurisdiction, and
- managing funds solely investing in OS virtual assets does not fall within the SFC’s remit (note however that if the firm is a
- licensed corporation, they are currently required to notify the SFC if they intend to provide trading and asset management services involving crypto-assets).
Currently, certain activities relating to OS virtual assets are already within the SFC’s jurisdiction and firms engaged in such activities are required to be licensed by, or registered with, the SFC. This includes:
- distribution of funds which invest in OS virtual assets (requires a type 1 licence), and
- managing fund of funds where the underlying fund invests in OS virtual assets (requires a type 9 licence).
The new regulatory framework pushes the SFC’s jurisdiction to its limits in order to expand the scope of regulation over virtual assets as much as possible.
Crypto fund managers and distributors of crypto funds
The SFC is seeking to impose further regulatory requirements on firms that it currently regulates (see ‘Who is in scope?’).
Licensing terms and conditions
The SFC will regulate the management activities by imposing a set of terms and conditions as licensing conditions. The terms and conditions will cover requirements around the type of investors and disclosure to investors, safeguarding of assets, portfolio valuation, risk management, auditors and liquid capital. In particular, only professional investors will be allowed to invest into a portfolio invested in virtual assets (subject to the de minimis threshold). Further details about the terms and conditions can be found in Appendix 1 to the SFC’s Statement.
The SFC will first seek to understand the firm’s business activities. If the firm appears to be capable of meeting the expected regulatory standards, the terms and conditions will be provided to the firm, and the SFC will discuss and vary them with the firm in light of its business model so as to ensure that the terms and conditions proposed by the SFC are reasonable and appropriate.
Failure to agree to comply with the proposed terms and conditions by an applicant or existing licensed corporation will respectively lead to the licensing application being rejected or the inability to manage any virtual asset portfolios.
Conceptual framework for crypto trading platforms
Conceptual framework and sandbox
The SFC has also set out a conceptual framework for the potential regulation of virtual asset trading platforms. The SFC plans to work with interested virtual asset trading platform operators who have demonstrated a commitment to adhering to the high expected standards by placing them in the SFC Regulatory Sandbox. Further details of the conceptual framework are set out in Appendix 2 to the Statement.
For an operator to join the sandbox, it would need to fall within the jurisdiction of the SFC, and therefore it should:
- operate an online trading platform in Hong Kong
- offer trading of at least one or more virtual assets which fall under the definition of ‘securities’ on its platform, and
- provide for trading, clearing and settlement services for virtual assets and have control over investors’ assets.
The SFC intends to discuss its expected regulatory standards with participants, observe the live operations of the trading platforms, and consider the effectiveness of the proposed regulatory requirements in addressing risks and providing adequate investor protection.
The aim of this information gathering exercise is to allow the SFC to determine whether or not it is able to effectively regulate such trading platform operators. In order not to confuse the public about the regulatory status of platform operators, the identity of the sandbox applicants in this stage and the discussions will be kept confidential.
Of course, it remains possible that the SFC will conclude that the risks involved cannot be properly dealt with under the standards it would expect and that investor protection still cannot be ensured.
Licensing and intensive review stage
If on the other hand the SFC decides that operators are suitable for regulation, this is likely to lead to the imposition of standards comparable to those applicable to existing licensed providers of automated trading services. A licence by the SFC would give a trading platform a clear competitive advantage over its unlicensed peers. It will act as an indicator to the market and investors that the operator is willing to adhere to a high level of standards and practices.
Where the SFC grants a licence to an operator, licensing conditions would be imposed and the operator would proceed to the next stage of the sandbox. This might involve more frequent reporting, monitoring and reviews under the SFC’s supervision so that the platform operators can implement robust internal controls and address the SFC’s concerns arising from the conduct of their business.
Exiting the sandbox
After a minimum 12-month period, the operator may apply to the SFC for removal or variation of some licensing conditions
and exit the sandbox.
Concluding thoughts – legitimisation through regulation
There will be mixed reactions to the steps taken by the SFC. As noted by Ashley Alder, there will be ‘many in the Fintech world [who] see regulation as an unnecessary or unwelcome brake on innovation’. This is largely reflective of the efforts by those in the crypto industry, and in particular virtual asset issuers, who have sought to ensure that virtual assets do not fall within the scope of securities and futures contracts.
However, a large part of that same industry has been waiting patiently for the SFC to take affirmative steps to bring order to this expanding industry through regulation. As recognised by Ashley Alder, ‘responsible players in this industry also recognise that clear and effective regulation will be essential for them to establish the trust and legitimacy they need to make their businesses credible’.
This will no doubt include a substantial number of those targeted by the new regulatory framework who will likely welcome the SFC’s efforts to legitimise crypto through regulation.
William Hallatt, Hannah Cassidy and Michael KS Tan
Herbert Smith Freehills
Copyright: Herbert Smith Freehills
More information is available on the SFC website: www.sfc.hk.