1. Introduction
Tokenisation is one of the hottest topics in finance circles these days. This article introduces you to what tokenisation is, why it is important and explores some key legal and regulatory considerations, with a focus on Hong Kong and China Mainland.[1]
Last week, the Securities and Futures Commission of Hong Kong (“SFC”) published two highly anticipated circulars on tokenisation of SFC-authorised investment products and intermediaries engaging in tokenised securities-related activities. We will analyse these SFC circulars in future articles. For now, it suffices to say that the SFC’s latest regulatory guidance, along with other important initiatives taken by the Hong Kong Government, including the Hong Kong Monetary Authority (“HKMA”), signify:
- Hong Kong’s collaborative efforts to foster responsible innovation in the financial sector and to promote greater diversification of securities and other investment products (collectively, “investment products”); and
- increasing regulatory embracement of applying distributed ledger technology (“DLT”) and similar technology to traditional financial products. This is partly in response to market interest in expanding tokenised offerings to a wider range of investors, including retail investors.
As the first in a new KWM series on tokenisation across Asia, this article explores:
- the basics of tokenised investment products: what are they and how do they work;
- the SFC’s latest attitude towards tokenised investment products;
- key regulatory considerations relating to tokenised investment products in Hong Kong;
- regulatory attitude towards tokenisation in China Mainland; and
- regulatory and compliance considerations under PRC law relating to tokenised investment products that reference assets in China Mainland.
2. The basics of tokenisation
2.1 What is tokenisation and what are tokenised investment products?
Tokenisation can be applied to any tangible asset (eg real estate) or intangible asset (eg stocks, bonds or intellectual property rights in an artwork).
Tokenisation involves creating tokens on a blockchain which represent:
- ownership of all or a fraction of an asset (including an investment product); and/or
- a record of ownership in an investment product.
Tokenised investment products can be issued, recorded, managed or transferred digitally on a blockchain. Subject to relevant regulatory requirements, tokenised investment products may also be traded in secondary markets following their primary issuance.
Currently, there are no statutory definitions of “tokenisation” or “tokenised investment products” in Hong Kong. However, in the context of tokenised securities, the SFC has described tokenisation as generally involving the process of recording claims on assets that exist on a traditional ledger onto a programmable platform, which includes the use of DLT in the security lifecycle.
According to the SFC, tokenised investment products are fundamentally traditional investment products with a tokenisation “wrapper”. Therefore, the existing legal and regulatory requirements governing the underlying traditional investment products continue to apply to tokenised investment products. Similarly, depending on the economic benefits and rights attached to the tokens, fractional ownership of real-world assets such as artwork or real estate achieved through tokenisation may trigger regulatory requirements applicable to offerings of securities, interests in collective investment schemes (“CIS”) or structured products.
2.2 How are tokenised investment products different from traditional investment products, and what are the benefits of tokenisation?
We highlight below three main differences between tokenised investment products and traditional investment products and the benefits of the former:
(a) Flexibility in fractional ownership rights / interests
Tokenisation enables greater flexibility and creativity in achieving fractional ownership of real-world assets and related financing arrangements. This is particularly helpful for underlying assets which are relatively illiquid or require significant investment contributions (eg the purchase of real estate). Fractional ownership enables investors (especially retail investors) to access a broader range of assets at lower investment entry levels. With reduced minimum investment levels and a wider potential investor base, tokenisation could potentially enhance the transferability and liquidity of assets which would otherwise be illiquid or inaccessible by retail investors.
Not all tokens represent fractional ownership rights in an underlying asset. Instead, the token itself may constitute the investment product. Using the first offering of tokenised securities in Hong Kong (known as a security token offering or “STO”) as an example, the tokens in question were in the form of securities offered by a close-ended fund with a minimum investment of HKD1,000. The tokenised securities entitled holders to the annual distribution of rental income generated from the underlying real estate as well as future appreciation in the value of such real estate.[2]
(b) Immutable records on a blockchain, increased transparency and enhanced settlement processes
Ownership information regarding traditional financial products such as shares and bonds is typically recorded in a centralised register maintained by a third-party, often involving multi-tier custody arrangements.
In contrast, ownership information regarding tokenised investment products is immutably recorded on a blockchain. The use of blockchain technology can enable near-instantaneous settlements (also known as “atomic settlements”) and eliminate operational hurdles due to time zone differences or other legacy system inefficiencies.
Records on a blockchain may also go beyond mere ownership information and allow investors to access other real-time information, such as investment performance.
(c) Potential for 24/7 secondary trading
As tokenised investment products exist in an online digital environment, there is potential for tokenised investment products to be available for trading 24/7. By contrast, a traditional securities exchange is only open during regular business hours on weekdays.
The recently established regulatory regime in Hong Kong for virtual asset trading platforms (“VATPs”) is a crucial step in realising 24/7 trading of tokenised investment products on VATPs in the future. Having said this, the SFC is adopting a cautious approach to secondary trading of tokenised SFC-authorised investment products, noting that secondary trading requires careful consideration in order to provide a similar level of investor protection to those trading in non-tokenised products.
2.3 Who has a role to play in a tokenisation project?
Asset tokenisation is projected to grow into a USD16 trillion market by 2030.[3] We are actively discussing with market participants, including financial institutions, fund houses, asset managers and fintech companies regarding their STO and other tokenisation projects. The following roles/parties are typically involved in a tokenisation project:
In this article:“Hong Kong” or “Hong Kong SAR” means the “Hong Kong Special Administrative Region of the People’s Republic of China”; and “PRC” or “China Mainland” means the People’s Republic of China, excluding Hong Kong, Macao Special Administrative Region and Taiwan.
The Standard, Real estate token launched in city (11 September 2023), available at: https://www.thestandard.com.hk/section-news/section/2/255973/Real-estate-token-launched-in-city.
Press release by BCG and ADDX (12 September 2022), available at: https://www.addx.co/files/bcg_ADDX_report_Asset_tokenization_trillion_opportunity_by_2030_de2aaa41a4.pdf.
3. SFC’s attitude towards tokenised investment products and regulatory considerations
3.1 SFC’s attitude towards tokenised investment products
The SFC takes a technology-neutral approach to tokenised investment products, and it will continue to apply the “same business, same risks, same rules” principle. Accordingly, while the SFC does not intend to create a whole new regulatory regime for tokenised investment products, it will bring tokenisation features and related technologies into the existing regulatory regime under the Hong Kong Securities and Futures Ordinance (“SFO”).[4]
The SFC’s regulatory attitude is generally informed by its “see-through” approach to tokenisation, whereby it regards tokenised investment products as being fundamentally traditional investment products with a tokenisation “wrapper”. At the same time, the SFC recognises that tokenisation, despite being a “wrapper”, may introduce additional risks to an investment product which market participants (including issuers, advisers, dealers, custodians and portfolio managers) need to identify, disclose and manage. These risks include, among other things, technology, ownership, cybersecurity, AML, legal, regulatory, custody, business continuity and data privacy-related risks. The SFC’s recent circulars on tokenisation provide important guidance on how market participants should adequately address these risks.
We also expect to see further collaboration between token issuers and licensed VATPs in connection with the primary issuance and secondary trading of tokenised investment products. However, in view of the nascent state of the VATP regime in Hong Kong, the SFC stated that it will first focus on primary issuance of tokenised SFC-authorised investment products before addressing secondary trading-related issues.
3.2 Regulatory considerations on offering and providing intermediary services relating to tokenised investment products in Hong Kong
Hong Kong Government’s press release, Task Force on Promoting web3 Development established (30 June 2023), available at: https://www.info.gov.hk/gia/general/202306/30/P2023063000579.htm.
The following high-level summary covers just some of the key regulatory issues to consider when issuing tokenised investment products and providing related intermediary services in Hong Kong. It is not intended to be exhaustive or comprehensive. Depending on the location of the issuer, financial intermediaries, service providers and target investors, the laws and regulations of jurisdictions other than Hong Kong will also need to be carefully considered.
While the SFC generally welcomes the idea of tokenisation, the offering of tokenised investment products and provision of related intermediary services require careful consideration to ensure compliance with the applicable licensing and regulatory requirements in Hong Kong.
Tokenisation is still in its infancy and concrete legal and regulatory standards are evolving. Issuers, intermediaries and related service providers should engage with regulators at an early stage to discuss their tokenisation projects to align with prevailing regulatory policies, objectives and expectations. For example, prior consultation with the SFC is required for new SFC authorised investment products that have tokenisation features. Prior SFC consultation is also required for the tokenisation of existing SFC-authorised investment products. Similarly, intermediaries which are interested in engaging in activities involving digital securities (including tokenised securities) should notify and discuss their business plans with the SFC in advance.
Some of the key legal and regulatory considerations in a tokenisation project include:[5]
SFC’s speech, Enabling Innovation in the Asset Management Industry Keynote speech at Bloomberg Buy-Side Forum Hong Kong 2023 (26 September 2023), available at: https://www.sfc.hk/-/media/EN/files/COM/Speech/EDIPs-speech-at-Bloomberg-Buyside-Forum-2023final20230926.pdf?rev=5256c2c1e1ee430596182f173f9039c3&hash=EB796616E0BBCEE252742A354D1A3921.
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Key consideration
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Key question to ask
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Further commentary
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Classification of the tokenised investment product
As noted above, the SFC has stated that secondary trading of tokenised SFC-authorised investment products would warrant more caution and careful consideration in order to provide a substantially similar level of investor protection to those investing in non-tokenised products. See OCED Blockchain Policy Series, The Tokenisation of Assets and Potential Implications for Financial Markets (2020), available at: https://www.oecd.org/finance/The-Tokenisation-of-Assets-and-Potential-Implications-for-Financial-Markets.pdf. |
Setting aside the tokenisation wrapper, what is the regulatory classification of the underlying investment product? As noted above, the SFC has stated that secondary trading of tokenised SFC-authorised investment products would warrant more caution and careful consideration in order to provide a substantially similar level of investor protection to those investing in non-tokenised products. See OCED Blockchain Policy Series, The Tokenisation of Assets and Potential Implications for Financial Markets (2020), available at: https://www.oecd.org/finance/The-Tokenisation-of-Assets-and-Potential-Implications-for-Financial-Markets.pdf. |
This is one of the most important threshold questions to ask, and it is key to determining target investors for the tokenised investment product. For example, if the tokenised investment product has the features of a traditional security (eg a right to a share of profits or a right to receive repayment of a debt), the product is regulated as a security under the SFO, which has two key implications: (a) SFC product authorisation regime - offering securities, interests in a CIS, or structured products to the public is prohibited, unless an exemption applies or the offering is authorised by the SFC. This generally means that any advertisement, invitation or document that contains an invitation to the public in respect of the tokenised investment product must be authorised by the SFC. (b) SFC licensing regime – subject to certain exemptions, SFC licensing requirements apply to regulated activities such as dealing in or advising on securities. Consistent with the SFC’s “see-through” approach to tokenisation, the substance is more important than the labels used to describe the tokenised investment product. Therefore, a detailed legal analysis of the substantive nature of the tokenised investment product is essential in a tokenisation project. As noted above, the SFC has stated that secondary trading of tokenised SFC-authorised investment products would warrant more caution and careful consideration in order to provide a substantially similar level of investor protection to those investing in non-tokenised products. See OCED Blockchain Policy Series, The Tokenisation of Assets and Potential Implications for Financial Markets (2020), available at: https://www.oecd.org/finance/The-Tokenisation-of-Assets-and-Potential-Implications-for-Financial-Markets.pdf. |
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Liquidity of the tokenised investment product
As noted above, the SFC has stated that secondary trading of tokenised SFC-authorised investment products would warrant more caution and careful consideration in order to provide a substantially similar level of investor protection to those investing in non-tokenised products. See OCED Blockchain Policy Series, The Tokenisation of Assets and Potential Implications for Financial Markets (2020), available at: https://www.oecd.org/finance/The-Tokenisation-of-Assets-and-Potential-Implications-for-Financial-Markets.pdf. |
How will the tokenised investment product be traded and will there be any market makers to provide liquidity support? As noted above, the SFC has stated that secondary trading of tokenised SFC-authorised investment products would warrant more caution and careful consideration in order to provide a substantially similar level of investor protection to those investing in non-tokenised products. See OCED Blockchain Policy Series, The Tokenisation of Assets and Potential Implications for Financial Markets (2020), available at: https://www.oecd.org/finance/The-Tokenisation-of-Assets-and-Potential-Implications-for-Financial-Markets.pdf. |
Eventually, some tokenised investment products will be listed on licensed VATPs and available for secondary trading.[6] Although tokenisation can enhance the liquidity of otherwise illiquid or near-illiquid assets, sufficient demand, robust price-discovery mechanisms and regular trading are essential for such benefits to materialise.[7] Issuers that would like to list their tokenised investment products are encouraged to speak with licensed VATPs to find out their listing criteria and whether the VATPs can support 24/7 trading and have sound risk management frameworks and business continuity plans. As noted above, the SFC has stated that secondary trading of tokenised SFC-authorised investment products would warrant more caution and careful consideration in order to provide a substantially similar level of investor protection to those investing in non-tokenised products. See OCED Blockchain Policy Series, The Tokenisation of Assets and Potential Implications for Financial Markets (2020), available at: https://www.oecd.org/finance/The-Tokenisation-of-Assets-and-Potential-Implications-for-Financial-Markets.pdf. |
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Disclosure of risks associated with the tokenised investment product
As noted above, the SFC has stated that secondary trading of tokenised SFC-authorised investment products would warrant more caution and careful consideration in order to provide a substantially similar level of investor protection to those investing in non-tokenised products. See OCED Blockchain Policy Series, The Tokenisation of Assets and Potential Implications for Financial Markets (2020), available at: https://www.oecd.org/finance/The-Tokenisation-of-Assets-and-Potential-Implications-for-Financial-Markets.pdf. |
Do investors (especially retail investors) fully understand the risks associated with the tokenised investment product, including the additional risks relating to the use of blockchain technology? Do investors understand the difference (in terms of pricing, liquidity and security etc) between trading tokenised investment products on a VATP and trading traditional investment products on a traditional securities exchange? As noted above, the SFC has stated that secondary trading of tokenised SFC-authorised investment products would warrant more caution and careful consideration in order to provide a substantially similar level of investor protection to those investing in non-tokenised products. See OCED Blockchain Policy Series, The Tokenisation of Assets and Potential Implications for Financial Markets (2020), available at: https://www.oecd.org/finance/The-Tokenisation-of-Assets-and-Potential-Implications-for-Financial-Markets.pdf. |
Consistent with the SFC’s “see-through” approach to tokenisation, the documentation requirements for tokenised investment products are quite similar to those that apply to traditional regulated financial products. However, there is a need to fully disclose additional risks associated with tokenisation and blockchain technology, which involves using plain language to accurately describe the nature, ownership and operation of tokenised investment products as well as how they will be traded on any VATPs. The SFC makes clear that its priority is to uphold market integrity and promote sound risk management. This translates into making adequate risk disclosures and ensuring investors understand what they are signing up for when they invest in and trade tokenised investment products on VATPs. It also means effectively managing investment, ownership, liquidity, leverage, counterparty, custody, technology, cybersecurity, AML and other risks associated with tokenised investment products. The nature of risk disclosures and risk management measures depend, among other things, on:
As noted above, the SFC has stated that secondary trading of tokenised SFC-authorised investment products would warrant more caution and careful consideration in order to provide a substantially similar level of investor protection to those investing in non-tokenised products. See OCED Blockchain Policy Series, The Tokenisation of Assets and Potential Implications for Financial Markets (2020), available at: https://www.oecd.org/finance/The-Tokenisation-of-Assets-and-Potential-Implications-for-Financial-Markets.pdf. |
4. Regulatory attitude towards tokenisation in China Mainland
Over the past decade, the PRC Government has increasingly tightened its stance on virtual currencies.[8] On 15 September 2021, the People’s Bank of China (“PBOC”), alongside nine other ministries and judicial institutions in China Mainland, jointly issued the Notice on Further Preventing and Dealing with the Risks of Virtual Currency Trading Speculation, which explicitly states that non-government issued virtual currencies are prohibited from being circulated as fiat money in China Mainland.[9] All services related to such virtual currencies are also considered illegal financial activities.
Although strict bans have been imposed on virtual currencies in China Mainland, tokenised assets have not been expressly categorised as “virtual currencies”. Tokenised assets, despite using blockchain technology, are merely digital representations of underlying traditional assets. Accordingly, the process of tokenisation should not, in and of itself, cause an otherwise lawful traditional asset or financial product to explicitly fall within the scope of the regulatory ban on virtual currencies in China Mainland. As such, it is still feasible to explore the issuance of tokenised investment products with underlying assets in China Mainland.
5. Tokenised investment products with underlying assets in China Mainland – some regulatory considerations under PRC law
Traditionally, cross-border equity or debt financing structures are common ways for investors to gain exposure to, or finance, businesses or assets (including financial assets such as receivables) in China Mainland.
Due to foreign exchange controls in China Mainland, some cross-border equity and debt financing structures are subject to PRC legal and regulatory requirements that need to be carefully analysed. Since tokenisation is a “wrapper” that does not change the fundamental nature of an investment product, the mere fact that a cross-border equity or debt financing structure involves tokenised securities instead of traditional securities should not, in and of itself, affect the applicability of these PRC legal and regulatory requirements.
We will now take a brief look at some common cross-border debt and equity financing structures and the applicable PRC requirements.
5.1 Cross-border equity financing structures that involve the issuance of overseas-listed equity securities
In February 2023, the China Securities Regulatory Commission (“CSRC”) issued the Trial Administrative Measures for Overseas Issuance and Listing of Securities by Domestic Enterprises (“Overseas Listing Measures”), which require a PRC company to make a filing with the CSRC when it issues equity securities that are listed on an overseas exchange. In this context, equity securities include convertible bonds.
Significantly, overseas-listed equity securities issued by a non-PRC incorporated company are deemed to be issued by a PRC company (known as an “indirect” overseas listing) where any one of the conditions is satisfied (“Deeming Conditions”):
- more than 50% of the non-PRC issuer’s consolidated revenues, profits, total assets or net assets are attributable to its PRC subsidiaries;
- the non-PRC issuer’s main business activities are conducted in China Mainland;
- the non-PRC issuer’s main place of business is in China Mainland; or
- the majority of the non-PRC issuer’s senior management personnel are Chinese citizens or are domiciled in China Mainland.
In determining whether any of the Deeming Conditions are satisfied, the CSRC applies a substance over form approach that is designed to prevent attempts to circumvent the Deeming Conditions.
Accordingly, a company incorporated in Hong Kong or another non-PRC jurisdiction that satisfies any of the Deeming Conditions must comply with the CSRC filing requirement when issuing overseas-listed equity securities. Whether the overseas-listed equity securities are tokenised should not, in and of itself, affect the applicability of the CSRC filing requirement or foreign exchange regulatory requirements.
5.2 Cross-border debt financing structures
When a PRC company borrows money from a non-PRC company, this gives rise to a “foreign debt” which is subject to PRC regulations. At a very high-level, there are restrictions imposed by the PBOC and State Administration on Foreign Exchange (“SAFE”) regarding how much foreign debt a PRC company can borrow. In addition, foreign debts with a maturity of more than one year (known as “medium-to-long-term foreign debt”) must generally be approved by the National Development and Reform Commission (“NDRC”). The NDRC approval requirement also applies to “indirect” medium-to-long-term foreign debts where the borrower is a non-PRC company that:
- has its main business activities in the PRC; or
- is controlled by a PRC company.
A common cross-border debt financing structure involves a PRC company borrowing foreign debt from a non-PRC company. The money borrowed by the PRC company can be used to acquire or finance assets or businesses in China Mainland. The non-PRC company may in turn obtain financing by issuing debt securities to investors in the international capital markets. Whether the foreign debt borrowed by the PRC company or the debt securities issued by the non-PRC company are tokenised should not, in and of itself, affect the applicability of PRC regulations on foreign debts discussed above.
6. Thinking of tokenising your next product offering or providing services related to tokenised investment products? Come speak to us
KWM’s bilingual financial regulatory, financial markets, structured products and international funds teams have extensive experience in advising financial institutions, fund houses and fintech companies on a broad range of matters related to tokenisation, virtual assets, emerging fintech and financial regulation.
We are familiar with the unique and nuanced commercial and legal issues faced by financial institutions, asset managers and fintech companies in the fast-evolving regulatory landscape in Hong Kong, China Mainland, Europe and the United States. We can provide a range of support for your tokenisation project, including initial structuring strategy, advice on licensing and product authorisation requirements, fund formation as well as the preparation and negotiation of product offering and transaction documents.
Come speak to us - we would be pleased to share our further insights with you.
The PRC government has issued a number of policy statements regarding Bitcoin and other virtual currencies since 2013. See Notice of the People's Bank of China, the Ministry of Industry and Information Technology, the China Banking Regulatory Commission, the China Securities Regulatory Commission, and the China Insurance Regulatory Commission on the Prevention of Bitcoin-related Risks (3 December 2013), available at: https://www.gov.cn/gzdt/2013-12/05/content_2542751.htm; Announcement of the People's Bank of China, the Cyberspace Administration of China, the Ministry of Industry and Information Technology, the State Administration for Industry and Commerce, the China Banking Regulatory Commission, the China Securities Regulatory Commission, and the China Insurance Regulatory Commission on the Prevention of Risks Associated with Initial Coin Offerings (4 September 2017), available at: https://www.gov.cn/xinwen/2017-09/04/content_5222657.htm; Risk Warning on Preventing Illegal Fundraising under the Guise of “Virtual Currency” and “Blockchain" (27 August 2018), available at: https://www.gov.cn/fuwu/2018-08/27/content_5316810.htm; Opinions of the Supreme People's Court and the National Development and Reform Commission on Providing Judicial Services and Safeguards for Accelerating the Improvement of the Socialist Market Economic System in the New Era (22 July 2020), available at: https://www.court.gov.cn/zixun-xiangqing-242911.html; and Notice on Further Preventing and Addressing Risks of Virtual Currency Trading Speculation (15 September 2021), available at: https://www.gov.cn/zhengce/zhengceku/2021-10/08/content_5641404.htm.
See Notice on Further Preventing and Dealing with the Risks of Virtual Currency Trading Speculation (15 September 2021), available at: https://www.gov.cn/zhengce/zhengceku/2021-10/08/content_5641404.htm.
This publication is for general information purposes only and should not be construed as legal advice.
