Hong Kong lays out comprehensive guidance on crypto and tokenised securities-related activities by intermediaries, along with guidance on tokenisation of investment products

Since the new licensing regime for virtual asset trading platforms (VATPs) came into effect on 1 June 2023, allowing retail access to VATP services, the Securities and Futures Commission (SFC) has made further strides in expanding retail access in the virtual asset (VA) ecosystem.

The SFC and the Hong Kong Monetary Authority (HKMA) have issued the following new and updated guidance on VA and tokenised securities related activities by intermediaries (ie, licensed corporations and registered institutions) as well as on tokenisation of SFC-authorised investment products for public offering:

1. (Updated) SFC-HKMA joint circular on intermediaries’ virtual asset-related activities (with appendices) of 20 October 2023 (Updated Joint Circular) – This permits retail access to VA-related services through intermediaries, which was previously largely limited to professional investors (PIs). It updates the guidance on distribution of VA-related products and provision of VA dealing, advisory and asset management services, superseding the previous version (with appendices) issued in January 2022 (see our March 2022 briefing).
2. (New) SFC circular on intermediaries engaging in tokenised securities-related activities (with appendix) of 2 November 2023 (Tokenised Securities Circular) – This circular provides guidance and clarifies regulatory expectations on intermediaries engaging in tokenised securities-related activities. It permits retail access to the distribution and marketing of Tokenised Securities and supersedes the SFC’s previous statement on security token offerings dated 29 March 2019.
3. (New) SFC circular on tokenisation of SFC-authorised investment products of 2 November 2023 (Tokenised Investment Products Circular) – This circular sets out the requirements and additional safeguards for primary dealing of tokenised SFC-authorised investment products.

Other initiatives are being progressed, including:

• Plans to expand the regulatory remit to cover the buying and selling of VAs beyond trades taking place on VATPs;
• Upcoming joint consultation by the Financial Services and Treasury Bureau and the HKMA on the legislative proposal for implementing a regulatory regime for stablecoin issuers; and
• Ongoing industry consultation on the HKMA’s proposed guidance on banks’ provision of digital asset custodial services, to ensure client assets are adequately safeguarded and that the risks involved are properly managed.

In the meantime, we highlight the key takeaways from the three circulars, with further details appended.

1. Updated Joint Circular

The Updated Joint Circular provides revised guidance on investor protection issues arising from:

• distribution of VA-related products;
• provision of VA dealing services;
• provision of VA advisory services; and
• provision of asset management services in respect of VAs.

Intermediaries which are already providing VA dealing services to non-qualified corporate PIs and individual PIs will have a three-month transition period (ie, until 20 January 2024) to revise their systems and controls before the implementation of the updated requirements. Intermediaries may continue to provide VA-related services to their existing clients who have been assessed to possess VA knowledge based on the results of the VA knowledge tests conducted before the issue of the Updated Joint Circular.

Intermediaries which do not currently engage in VA-related activities or which plan to extend their VA dealing services to non-qualified corporate PIs, individual PIs, or retail investors should ensure that they comply with the updated requirements before introducing such services.

Key takeaways

• Permitting retail access to VA-related services – The provision of VA-related services will no longer be limited to PIs. Intermediaries may provide such services to retail investors, provided that they comply with the requirements in the Updated Joint Circular, including the revised licensing or registration conditions and the revised terms and conditions.
• Requirements on VA recommendations and discretionary trading for retail clients – Intermediaries are required to ensure that the VAs solicited, recommended or traded on a discretionary basis for retail clients are (i) of high liquidity (ie, the VAs should, at a minimum, be eligible large-cap VAs); and (ii) made available by SFC-licensed VATPs for retail trading.
• Allowing deposit and withdraw of VAs by clients – Intermediaries providing VA dealing services may permit clients to directly deposit or withdraw VAs from segregated accounts maintained with (i) SFC-licensed VATPs or (ii) authorised institutions as defined under the Banking Ordinance (or subsidiaries of locally incorporated authorised institutions) which meet the expected standards of VA custody issued by the HKMA from time to time. The HKMA is currently consulting the industry on proposed guidance relating to digital asset custodial services. Intermediaries should also comply with Chapter 12 of the SFC’s Guideline on Anti-Money Laundering and Counter-Financing of Terrorism (For Licensed Corporations and SFC-licensed Virtual Asset Service Providers) (AML Guidelines) when handling VA deposits and withdrawals.
• New risk tolerance assessment – Except for institutional and qualified corporate PIs, intermediaries are now required to assess each client’s risk tolerance level, risk profile, and whether it is suitable for the client to participate in the trading of VAs, before providing VA dealing or advisory services.
• Alignment of the VA definition – The definition of VA in the Updated Joint Circular has been aligned with that under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO). This provides clarity on the scope of VA-related products to which the Updated Joint Circular will apply.

Further details of the key revisions in the Updated Joint Circular are provided here.

2. Tokenised Securities Circular

The SFC is supportive of the efforts made by intermediaries in conducting pilots for the tokenisation of traditional securities, and considers it timely to provide further guidance on tokenised securities-related activities. This circular clarifies regulatory expectations and provides guidance to intermediaries in addressing and managing the new risks arising from the tokenisation technology.

Key takeaways

• Prior guidance superseded – This Tokenised Securities Circular supersedes the SFC’s previous statement on security token offerings dated 29 March 2019.
• Tokenised Securities – These are traditional financial instruments (such as bonds or funds) that are “securities” as defined under the Securities and Futures Ordinance (SFO) which utilise distributed ledger technology (DLT) or similar technology in their security lifecycle.
• Existing requirements to continue to apply – Given that Tokenised Securities are fundamentally traditional securities with a tokenisation wrapper, the existing legal and regulatory requirements governing the traditional securities markets will continue to apply, including those relating to the public offering of securities and the conduct of intermediaries engaging in securities-related activities.
• Retail access to distribution and marketing of Tokenised Securities permitted – The PI-only restriction will no longer apply to the distribution and marketing of Tokenised Securities.
• Complex product categorisation – Tokenised Securities will no longer be regarded as complex products and be subject to additional investor protection measures by default. Intermediaries should adopt a see-through approach in assessing whether a Tokenised Security is a complex product, with reference to the SFC’s existing guidance for traditional securities.
• Issuance of Tokenised Securities – Intermediaries should consider the list of non-exhaustive factors in Part A of the appendix to the Tokenised Securities Circular) when assessing the risks relating to the technical and other aspects of Tokenised Securities and considering the most appropriate custodial arrangement to manage ownership and technology risks. Additional considerations in Part B of the appendix apply to the custodial arrangement for bearer form Tokenised Securities which use permissionless tokens on public-permissionless networks.
• Dealing in, advising on, or managing portfolios investing in Tokenised Securities – Prior to engaging in such activities, intermediaries should conduct due diligence on the issuers and their third-party vendors or service providers involved in the tokenisation arrangement and be satisfied with the controls implemented by such parties (see Parts A and B of the appendix).
• Information for clients – Intermediaries should make adequate disclosure of relevant material information specific to Tokenised Securities and provide clients with material information on the tokenisation arrangement.

Further details on the key requirements and regulatory clarifications under the Tokenised Securities Circular are provided here.

3. Tokenised Investment Products Circular

This circular sets out the requirements and the additional safeguards under which the SFC would consider allowing tokenisation of SFC-authorised investment products for offering to the Hong Kong public (primary dealing).

Since secondary trading of tokenised SFC-authorised investment products warrants more caution and careful consideration, the SFC will keep this under review for the time being.

Key takeaways

• Existing requirements – Product providers of tokenised SFC-authorised investment products (Product Providers) should ensure that the underlying products meet the applicable requirements in the relevant rules and regulations and product codes, including eligibility of Product Providers, product structure, investment and operational requirements, disclosure and ongoing compliance obligations. Additional requirements (as set out below), as well as the requirements under the Tokenised Securities Circular must also be met.
• Responsibility for tokenisation arrangement – Product Providers should remain and be ultimately responsible for the management and operational soundness of the tokenisation arrangement adopted and record keeping of ownership, regardless of any outsourcing arrangement, taking into account the list of non-exhaustive factors in Part A of the appendix to the Tokenised Securities Circular, where applicable. Product Providers should also have appropriate measures in place to manage and mitigate cybersecurity risks, data privacy risks, and system outages, and maintain a comprehensive and robust business continuity plan. Upon the SFC’s request, Product Providers should obtain satisfactory legal opinion to support its application, and should demonstrate to the SFC’s satisfaction (or obtain third party verification on) the management and soundness of the tokenisation arrangement, record keeping of ownership and integrity of smart contracts. In addition, Product Providers should have at least one competent staff with relevant experience and expertise to operate and/or supervise the tokenisation arrangement.
• Distributors limited to regulated intermediaries – Distributors of tokenised SFC-authorised investment products should be regulated intermediaries such as SFC-licensed corporations or registered institutions.
• Disclosure – Offering documents of a tokenised SFC-authorised investment product should set out clearly the tokenisation arrangement, the ownership representation of the tokens, and the associated risks with the tokenisation arrangement.
• Public-permissionless blockchain networks – Product Providers should not use such networks without additional and proper controls.
• Prior consultation or approval – Prior consultation with the SFC is required for new investment products that have tokenisation features for which the SFC’s authorisation is sought, as well as the tokenisation of existing SFC-authorised investment products.

Further details on the key requirements under the Tokenised Investment Products Circular are provided here.

How we can help

For intermediaries which plan to extend their businesses to VA-related activities, or intermediaries which already carry on VA-related activities and wish to extend this to retail investors with the deadline of 20 January 2024 in mind, we can assist in the following ways:

• facilitate partnerships with SFC-licensed VATPs;
• advise on your compliance with the relevant VA related requirements, including the revised requirements under the Updated Joint Circular, AML Guidelines and the SFC’s expected standards of conduct and guidance on tokenised securities;
• design, review, and update your internal systems and controls to align them with the requirements under the Updated Joint Circular;
• assist with the advance notification to the SFC and/or HKMA of your intention to engage in activities involving VAs and/or tokenised securities;
• advise on the issuance of tokenised securities taking into account the SFC’s list of non-exhaustive factors;
• review the offering documents and disclosure materials to clients; and
• issue legal opinions to support applications made by Product Providers for the tokenisation of SFC-authorised investment products.

If you have any questions or are interested to know more about how we can assist, please reach out to any of our key contacts below.