This article was written by Urszula McCormack and Jack Nelson.
Ask anyone in the industry what the greatest pain point is for virtual assets, and they will say it is the absence or uncertainty of regulation.
On 1 November 2018, the Securities and Futures Commission (“SFC”) announced a roadmap with concrete measures for creating a virtual asset regulatory framework. This swiftly follows other major announcements over the last two weeks, including from the Financial Action Task Force (“FATF”), a taskforce of regulators from the United Kingdom (“Taskforce”) and the Fintech Association of Hong Kong (“Fintech Association”).
The new SFC framework paves the way for a far more robust virtual asset industry and will undoubtedly create an opportunity to create safe markets, including for the emerging class of “security tokens” and “STOs”.
This alert describes the material features of the new framework, plus a primer on a few other important points.
But first – what has not happened
Let’s start with what the SFC announcement is not, because we have already seen a number of incorrect press reports.
- It is not a ban on virtual asset trading.
- It is not a ban on token sales/ICOs.
- It does not regulate previously unregulated assets or activities. This is critical for those already operating lawfully and who do not wish to participate in this new framework.
- It does not expand the SFC’s existing remit over securities, futures and certain other financial products and services.
This may well change in future given the other international developments that we describe below. However, the current state of play is effectively only expanded.
So what has happened?
It has been an incredible fortnight for blockchain.
First, two important international announcements were made in late October.
- FATF Recommendations updated - On 19 October 2018, FATF, the global standard-setter on anti-money laundering/counter-terrorist financing (“AML/CTF”) announced that “[a]ll jurisdictions should urgently take legal and practical steps to prevent the misuse of virtual assets.”
- More concretely, the FATF Recommendations were updated to include a recommendation for member states (including Hong Kong, which is currently under evaluation by FATF), to regulate “virtual asset service providers for AML/CTF purposes” and establish a licensing or registration regime for them.
- UK Taskforce report - 10 days later, the Taskforce released a joint report into virtual assets (“Virtual Asset Report”), and will shortly begin a series of consultations on what a regulated virtual asset market might look like.
Shortly after these announcements, three further major blockchain developments occurred in Hong Kong:
- HKEx Stock Connect blockchain project – On 30 October 2018, the Stock Exchange of Hong Kong and Digital Asset announced a project to collaborate on a blockchain-based post-trade allocation and processing platform for Northbound trading under the Hong Kong-Mainland China “Stock Connect” scheme.
- Updated industry best practices – On 31 October 2018, the Fintech Association launched an updated set of Best Practices for Token Sales, expanding upon the 2017 version and building upon the ground-breaking Global Digital Finance codes that are currently being finalised.
- SFC announcement – The next day, the SFC weighed in, announcing its “new regulatory approach for virtual assets” (“New Regulatory Approach”).
The following paragraphs describe the New Regulatory Approach in further detail. First, we provide a (very) brief virtual asset primer, before diving into the New Regulatory Approach and providing our thoughts on the road ahead.
A. Virtual asset primer
A virtual asset is an intangible asset that is issued using distributed ledger technology (commonly referred to as “blockchain”). It typically entitles the virtual asset holder to a bundle of rights (and possibly liabilities) set out in smart contracts and other relevant documentation, such as an offering document or a whitepaper (or both).
The Virtual Asset Report places virtual assets into one of three categories:
However, as our graphic illustrates, these three categories are by no means mutually exclusive – indeed, some virtual assets have characteristics of all three.
We also stress that these are conceptual categories only – they are not legal categories as such, making an analysis of each asset critical to understanding its regulatory status.
This means that the regulations that apply to a particular virtual asset can only be determined on a case-by-case basis. At present, this is because virtual assets are not specifically regulated in most jurisdictions (with the notable exception of Japan).
The lack of specific regulation does not mean that regulators have been ignoring the industry: here in Hong Kong we have seen the SFC intervene to help shut down a virtual asset sale.
Further, there are a wide variety of other laws, from data protection to consumer protection, that are directly relevant to the virtual asset industry.
But there is increasing recognition by regulators that the current financial services regimes are not coping with the sheer weight of retail and institutional interest in virtual assets - and the speed with which the industry moves.
B. New Regulatory Approach
The New Regulatory Approach is not new law per se. This would require a significant legislative process to expand the powers of the SFC beyond its current remit under the Securities and Futures Ordinance (Cap. 571), which does not extend to all virtual assets.
Rather, the New Regulatory Approach clarifies the application of some existing rules to virtual assets portfolios, and opens the door to virtual asset exchanges entering the SFC’s regulatory sandbox.
The New Regulatory Approach is set out in two key documents:
- Statement on regulatory framework for virtual asset portfolio managers, fund distributors and trading platform operators (“Statement”);
- Circular to intermediaries on distribution of virtual asset funds (“Circular”).
The Statement is further accompanied by two appendices:
- Regulatory standards for licensed corporations managing virtual asset portfolios (“Regulatory Standards”);
- Conceptual framework for the potential regulation of virtual asset trading platform operators (“Conceptual Framework”).
The Statement sets out the New Regulatory Approach generally and highlights some of the risks surrounding virtual assets. The other three documents, however, are more targeted. We describe each below.
The Circular and the Regulatory Standards
These two documents make the key point that even if a particular virtual asset is not a “security” or “futures contract” under the Securities and Futures Ordinance (Cap. 571 of the Laws of Hong Kong) (“SFO”), managing or dealing in these “non-SF virtual assets” can still amount to a regulated activity.
We summarise the key impacts as follows:
|Distributing a fund in Hong Kong that partially or wholly includes virtual assets
||Yes, Type 1 (dealing in securities) plus additional requirements if the fund is not authorised by the SFC and 10% or more of the gross asset value of the fund is invested in virtual assets
|Managing a fund comprising only non-SF virtual assets
||No, no licence required. However, if the manager is already a licensed intermediary, they will be subject to additional requirements as a licensing condition and any distribution will require a Type 1 licence
||Regulatory Standards and Circular
|Managing a fund of funds, where any of the underlying funds includes non-SF virtual assets
||Yes, Type 9 (asset management) plus additional requirements as a licensing condition unless exclusively managing funds that invest in virtual asset funds
The Regulatory Standards also make it clear that the SFC expects to be kept fully informed by licensed intermediaries regarding their current or planned virtual asset management activities – and that a failure to do so may result in regulatory action. As always, we recommend early engagement to head off these issues.
The Conceptual Framework
This document sets out the circumstances in which a virtual asset exchange – which the SFC calls a “virtual asset trading platform operator” (“Platform Operator”) – could potentially:
- be admitted to the SFC’s regulatory sandbox; and
- become licensed by the SFC for Type 1 (dealing in securities) and Type 7 (providing automated trading services) regulated activities.
The catch is that it will be up to the Platform Operator to bring themselves within the SFC’s jurisdiction by offering for trading at least one virtual asset that constitutes a “security” under the SFO. As the SFC phrases it:
"This is an opt-in approach designed to set those Platform Operators who are committed to adhering to the SFC’s high standards apart from those who are unwilling or unable to meet the conduct standards set by the SFC."
The two-stage process also allows the SFC the opportunity to first observe a Platform Operator in the sandbox, before granting them any licences. But any licences granted to a Platform Operator will be subject to various licensing conditions, including the core principles set out below:
These core principles will be in addition to terms and conditions that the SFC is currently developing, that will cover a broad spectrum of additional compliance topics:
C. The road ahead
Clearly, it has been a busy few weeks for the regulators. What these developments show is the increasing recognition that virtual assets will, eventually, be integrated into the global financial system. With this will come the legitimacy that some in the virtual asset industry have long craved. But it will also bring with it the full range (and weight) of financial services regulation.
Heading into 2019 we should start to see the first responses to consultations processes flagged in the Virtual Asset Report. Here in Hong Kong, we will begin to see the New Regulatory Approach in action - with a few Platform Operators in the SFC’s sandbox, and a few licensed intermediaries managing virtual asset portfolios under SFC supervision.
And the ripple effect from FATF’s virtual asset announcement will continue. We expect to see other major financial centres make moves toward regulation, by either expanding their current regime or, as Hong Kong has done, bringing virtual assets within the existing regulatory remit.
Accordingly, the regulatory landscape for virtual assets will look very different this time next year. What is most clear, however, is that any notion of virtual assets being “jurisdiction-less” or the “Wild West” is long gone.
The ongoing role of industry best practice
While regulation continues to expand, best practices and industry collaboration will continue to play a very important role in shaping this nascent market.
On that note, we have been delighted to be involved in creating the Fintech Association Best Practices for Token Sales and ASIFMA’s Best Practices for Digital Asset Exchanges, as well as participating in initiatives by Global Digital Finance.
These cover important areas such as:
- token sales/ICOs;
- admission to trading;
- market integrity; and
- anti-money laundering and counter-terrorist financing controls.
Opportunities for the industry
Regulation is a good thing. It strengthens market confidence by creating an appropriate baseline standard and levels of supervision commensurate with consumer expectations. This is not 2007 and the dawn of blockchain anymore, where virtual assets were limited to a reasonably small community of risk-tolerant participants.
Significant institutional growth and market expansion, particularly with the development of more credible custodial solutions and trading facilities (but also widespread abuse and risk in certain segments), require a regulatory response. That response must strike a balance in nurturing innovation, but also protecting the general public.
We believe that the key opportunities that the SFC announcement will bring are as follows:
- STOs and other instruments - Creating a pathway for blockchain-based securities and other financial investment products.
- Funds – Enhancing the opportunities for funds involving virtual assets to be offered to the Hong Kong market.
- Custody solutions – Advanced custody software, hardware and escrow providers will benefit from regulation that requires sophisticated solutions.
We are already working with a number of clients on the New Regulatory Approach, as well as on the launch of numerous cryptographic tokens and building institutional-grade virtual asset trading facilities.
Please speak to us if you would like to discuss the New Regulatory Approach, or any other aspect of virtual assets, further.
We would be delighted to help.
The information in this alert is by no means exhaustive. It is not legal advice. Please contact us if you need any advice. You can also learn more about virtual assets, blockchain, smart contracts and other related topics in our Digital 101 database, part of the KWM Digital Intelligence Hub.