As the first cryptocurrency fund licensed by the Securities and Futures Commission is launched in Hong Kong, Richard Keady, Partner, and Henry Li, Associate, Dentons Hong Kong, give an overview of the regulatory regime applicable to such funds.
Technology is changing the landscape of the Hong Kong financial services industry. On 20 April 2020, Venture Smart Asia launched its cryptocurrency fund in Hong Kong that purchases, holds and tracks the price of Bitcoin. This is the first time a pure cryptocurrency fund has been licensed to trade virtual assets in Hong Kong since the Securities and Futures Commission (SFC) introduced its regulatory framework for management and distribution of virtual assets on 1 November 2018.
The fund launch is certainly a welcome development in the Hong Kong financial services industry and is expected to spur interest from industry players to join the market. Those who wish to follow in the footsteps of Venture Smart Asia will have to meet the SFC’s licensing conditions, which are designed to mitigate the inherent risks associated with investing in virtual assets at both the fund management and distribution levels.
The requirements for fund managers
Generally speaking, the SFC’s current approach is that all licensed portfolio managers investing or intending to invest in virtual assets (subject to a de minimis threshold) should be required to observe essentially the same existing requirements that are applicable to licensed institutions dealing in ‘securities’ or ‘futures contracts’ as defined under the Securities and Futures Ordinance (Cap 571) (SFO) (such as the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission and the Fund Manager Code of Conduct), subject to elaborations and amendments catering for the virtual asset portfolio managers’ particular business models.
The exact principles and requirements with which the manager of a virtual asset portfolio may need to comply are set out in the Proforma Terms and Conditions for Licensed Corporations which Manage Portfolios that Invest in Virtual Assets (the Proforma T&Cs) published by the SFC on 4 October 2019. These terms and conditions, if accepted by a virtual asset portfolio manager, would be imposed by way of a licensing condition, as in the case of Venture Smart Asia.
Below is a summary in broad terms of some of the key conditions.
Type of investors
Only professional investors (as defined in Schedule 1 to the SFO) should be allowed to invest in any virtual assets funds. As such, if a fund is distributed through distributors, the fund manager is expected to implement measures to ensure that it will only be distributed to professional investors.
Disclosure to investors
Licensed virtual asset portfolio managers are required to make adequate disclosure of information (as well as any material changes to that information) on the funds that is necessary for fund investors to make an informed decision about their investment. This includes information about the distributors appointed for distribution of the virtual assets funds, as well as the associated risks with investment in the virtual assets.
Safeguarding of assets
Licensed virtual asset portfolio managers are under a duty to ensure that any fund assets entrusted to them are properly accounted for and adequately safeguarded. When choosing which custodial arrangement (or combination of custodial arrangements) to adopt for holding the fund’s virtual assets (such as independent custodian or self-custody, host locations, use of ‘hot’ or ‘cold’ wallets), the Proforma T&Cs mandate the virtual asset portfolio managers to assess each arrangement with reference to the accessibility of the assets and security of the custodial facility, and exercise due skill, care and diligence in the selection, appointment and ongoing monitoring of custodians.
Fund portfolio valuation
All fund assets managed by a virtual asset portfolio manager shall be valued on a regular basis. In doing so, a virtual asset portfolio manager should select valuation principles, methodologies, models and policies which are reasonably appropriate and in the best interests of the investors of the portfolios under its management.
Effective risk management measures should be implemented and maintained to manage and monitor risks to which each fund is or may be exposed, which may be related to market conditions, liquidity of the assets of the funds, creditworthiness of the fund’s counterparty and cybersecurity. The Proforma T&Cs provide that appropriate position limits should be set in respect of each product and market the portfolios invest in, and each counterparty to which the portfolios have exposure, including the trading platforms and custodians. Other suggested practices include setting a cap on the portfolios’ investment in illiquid or hard-to-value virtual assets, conducting periodic stress testing to determine the effect of abnormal and significant changes in market conditions on these portfolios, implementing procedures to assess reliability of the fund’s counterparties, and setting operating controls to protect the confidentiality and integrity of information used in the operation of the fund.
Auditors and audited accounts
It is a requirement that an independent auditor should be appointed to perform an audit of the financial statements of the funds under management. The virtual asset portfolio manager will need to understand the steps taken by which the auditor proves the existence and ownership and ascertains the reasonableness of the valuation of the virtual assets.
A licensed virtual asset portfolio manager should at all times maintain a liquid capital of not less than HK$3 million or its variable required liquid capital (whichever is higher), if it holds virtual assets on behalf of the funds it manages.
The requirements for distributors
As for distributors of virtual assets funds, apart from complying with their existing requirements for Type 1 regulated activities (dealing in securities), they are expected to exercise due diligence when making a recommendation and solicitation to a client, to ensure that the recommendation or solicitation is suitable and reasonable having regard to the available information about the client. When distributing virtual assets funds which are not authorised by the SFC (subject to a de minimis threshold), the distributors should conduct proper due diligence on the fund; only target clients who are professional investors; provide sufficient information for the clients to make informed investment decisions; and ensure that such clients would not invest an unreasonable amount in the funds in light of their net worth.
The compliance challenge
The SFC has made it clear that contravention of these conditions is likely to be considered as misconduct under the SFO, which will reflect adversely on the fitness and properness of a virtual asset portfolio manager/distributor to remain licensed and may result in disciplinary action by the SFC. As such, a licensed firm should regularly review the status of its regulatory compliance and the adequacy of its internal controls. Ultimately, for virtual assets to be widely accepted, there needs to be proper oversight and risk management.
Richard Keady, Partner, and Henry Li, Associate
Dentons Hong Kong