Recently, the Hong Kong* Monetary Authority (HKMA) issued an important circular setting out the supervisory standards expected of authorized institutions (AIs) in relation to their tokenised product-related activities. The HKMA circular applies to tokenised products that are not regulated under the Securities and Futures Ordinance (Cap. 571) (SFO). Examples of non-SFO-regulated tokenised products include currency-linked and/or interest rate-linked tokenised structured deposits/investment products issued by AIs. According to the HKMA, AIs should also comply with the standards set out in the HKMA circular in respect of their tokenised deposits.
SFO-regulated tokenised products are not subject to the HKMA circular because Hong Kong’s Securities and Futures Commission (SFC) has issued separate guidance regarding SFO-regulated intermediaries that engage in tokenised securities-related activities and the tokenisation of SFC-authorised investment products.
Similar to the SFC, the HKMA generally takes the view that many tokenised products are basically traditional products with a tokenisation “wrapper”. Therefore, the HKMA’s existing supervisory requirements and investor protection measures that apply to non-SFO-regulated investment products (Existing HKMA Requirements – see links to these requirements below) also apply to their tokenised versions.
However, both the SFC and HKMA also recognise that tokenisation, despite being a “wrapper”, introduces a range of additional risks that AIs and other regulated financial institutions must identify, disclose and manage (in accordance with the circular) when they issue, sell and distribute tokenised products. Additional risks associated with tokenisation include, among other things, technology, cybersecurity, ownership, legal, regulatory, custody, systems interoperability and business continuity related risks. Importantly, an AI must discuss with the HKMA before engaging in tokenised product-related activities.
This article provides an overview of the HKMA circular and recaps the Existing HKMA Requirements, which are also relevant to AIs that issue, distribute or sell non-SFO-regulated tokenised products.
1. The HKMA circular applies only to non-SFO-regulated tokenised products
The HKMA circular does not apply to SFO-regulated tokenised products because these products are subject to separate guidance issued by the SFC regarding SFO-regulated intermediaries that engage in tokenised securities-related activities and the tokenisation of SFC-authorised investment products. The HKMA’s and SFC’s circulars regarding regulated financial institutions that engage in tokenised product-related activities are broadly consistent. Please see our earlier article on the SFC’s circulars.
The HKMA circular sets out the supervisory standards expected of AIs in the sale and distribution of “tokenised products” to their customers. For the purposes of the HKMA circular and this article, the term “tokenised products” refers to products that are: (1) digital representations of real-world assets using distributed ledger or similar technology (DLT); and (2) not regulated under the SFO.
Examples of non-SFO-regulated tokenised products include:
- Tokenised currency-linked and/or interest rate-linked deposits/investment products issued by AIs - Currency-linked and/or interest rate-linked deposits/investment products issued by AIs are not regulated under the SFO because section 103(ea) of the SFO exempts currency-linked instruments, interest rate-linked instruments as well as currency and interest rate-linked instruments issued by AIs from the SFC authorisation requirement.[1]
- Tokenised spot precious metal products other than paper gold schemes[2]
- Tokenised bank deposits:
- In respect of placing of tokenised deposits by customers, AIs should also comply with the standards set out in the HKMA circular. Tokenised deposits are tokenised versions of traditional bank deposits.
- The HKMA considers central bank digital currencies (such as the e-HKD and e-CNY), tokenised deposits and stablecoins as three potential payment tools in Hong Kong’s emerging virtual asset ecosystem. From the perspective of an AI, accepting tokenised deposits may be more cost-effective than issuing stablecoins since the latter must be fully backed by high-quality and liquid reserve assets at all times.
The HKMA circular does not apply to stablecoins because stablecoins will be subject to a separate licensing and regulatory regime to be overseen by the HKMA. Please refer to our earlier article on Hong Kong’s proposed stablecoin licensing and regulatory regime.
2. The HKMA’s views on tokenisation
The HKMA supports AIs’ tokenisation initiatives. The HKMA circular is issued to support continued innovation and realisation of the benefits associated with tokenisation, while ensuring appropriate safeguards are in place from a consumer and investor protection perspective. It offers regulatory clarity to facilitate AIs’ tokenised product-related initiatives.
We observe aligned regulatory views and approaches on tokenised products by both the HKMA and the SFC:
- The regulators generally view tokenised products as basically traditional products with a tokenisation “wrapper”. Therefore, the Existing HKMA Requirements that apply to non-SFO-regulated investment products also apply to their tokenised versions. We provide a high-level overview of the Existing HKMA Requirements further below in this article.
- The regulators also recognise that, despite being a “wrapper”, tokenisation introduces a range of additional technology, cybersecurity, ownership, legal, regulatory, custody, systems interoperability and business continuity related risks. The HKMA circular provides guidance to AIs on how they should identify, disclose and manage tokenisation-related risks associated with tokenised products, focussing in particular on their due diligence, disclosure and risk management obligations.
The HKMA circular also notes that, in some circumstances, the nature, features and risks of a tokenised product can be altered by how the product is structured and arranged in the tokenisation process. For example, the tokenisation of fractionalised interests in a real-world asset may constitute a collective investment scheme[3] which gives rise to additional legal and regulatory compliance considerations.
3. Relevance of the HKMA circular to AIs that issue tokenised products
Although the HKMA circular focusses on the supervisory standards expected of AIs when they sell and distribute tokenised products, many of these standards are also relevant to AIs when they issue tokenised products:
- Product due diligence and custody arrangements - if an AI issues or is substantially involved in the issuance of a tokenised product, it should take into account the due diligence guidelines set out in the circular. AI issuers should consider the most appropriate custodial arrangements for their tokenised products taking into account product features and risks, including the additional risks associated with the use of public permissionless DLT networks. Please see our earlier article on the HKMA’s digital asset custody guidelines for AIs.
- Product risk disclosures - the risk disclosure requirements set out in the HKMA circular and the Existing HKMA Requirements applicable to non-SFO-regulated products are also relevant to AIs that issue tokenised products. Although technically the focus of the HKMA circular and the Existing HKMA Requirements is generally on the selling, marketing and/or distribution of non-SFO-regulated products (as opposed to the issuance of such products), as a matter of prudence and market practice, many AI issuers comply with the disclosure standards under various codes, guidelines and circulars (including the Existing HKMA Requirements) in relation to non-SFO-regulated products, regardless of whether such disclosure standards are technically targeted at intermediaries as opposed to issuers.
As a general market observation, product distributors in Hong Kong typically expect a product issuer to provide all product offering-related documentation to facilitate the distributors’ sale of investment products to end customers, rather than having the distributors generate their own additional product offering or selling documentation to meet applicable disclosure requirements.
AIs intending to issue tokenised products should be prepared to generate the full suite of product offering and marketing materials to ensure that information disclosures relating to their products are complete, accurate and fair, and are presented in a clear, concise and effective manner that can be readily understood by the investing public.
4. Due diligence obligations
The HKMA circular requires AIs to: (1) act with due skill, care and diligence; (2) conduct adequate due diligence; and (3) fully understand the nature, features and risks of tokenised products (including those relating to the underlying product and those relating to the tokenisation aspects).
AIs must comply with these due diligence related obligations both: (1) before offering tokenised products to customers; and (2) thereafter on a continuous basis at appropriate intervals.
This diagram summarises some key areas that AIs should focus on when conducting due diligence on the tokenisation aspects of tokenised products:
The terms “currency-linked instrument”, “interest rate-linked instrument” and “currency and interest rate-linked instrument” are defined in the SFO and essentially capture an instrument that is a “structured product” only because some or all of the return or amount due (or both the return and the amount due) or the method of settlement is determined by reference to changes in the value or level of currency exchange rate(s) and/or interest rate(s) (as applicable).
The term “structured product”, in turn, is defined in the SFO as: “an instrument under which some or all of the return or amount due (or both the return and the amount due) or the method of settlement is determined by reference to one or more of:
- changes in the price, value or level (or a range within the price, value or level) of any type or combination of types of securities, commodity, index, property, interest rate, currency, exchange rate or futures contract;
- changes in the price, value or level (or a range within the price, value or level) of any basket of more than one type, or any combination of types, of securities, commodity, index, property, interest rate, currency exchange rate or futures contract; or
- the occurrence or non-occurrence of any specified event or events (excluding an event or events relating only to the issuer or guarantor of the instrument or to both the issuer and the guarantor) . . . .”
Paper gold schemes (PGS) are deemed to be collective investment schemes under the Securities and Futures (Collective Investment Schemes) Notice (Cap. 571M). For these purposes, a PGS is an arrangement for the purchase of gold coins or gold bullion that is made available in the course of business and has the purpose or effect, or pretended purpose or effect, of enabling participating persons:
(a) to acquire the ownership of the coins or bullion for valuable consideration;
(b) to defer taking possession of the coins or bullion; and
(c) to transfer or retransfer the ownership of the coins or bullion to a person who is a party to, or is referred to in, the arrangement.
The term "collective investment scheme" is broadly defined in the SFO and captures a wide range of arrangements that essentially involve pooling contributions from different investors into a single investment fund.
Generally, a CIS has four relevant elements:
(1) it must involve an arrangement in respect of property (which can be any property, real estate, whether located in Hong Kong or overseas);
(2) participants do not have day-to-day control over the management of the property even if they have the right to be consulted or to give directions about the management of the property;
(3) the property is managed as a whole by or on behalf of the person operating the arrangements, and/or the contributions of the participants and the profits or income from which payments are made to them are pooled; and
(4) the purpose of the arrangement is for participants to participate in or receive profits, income or other returns from the acquisition or management of the property.
5. Disclosure obligations
The general information disclosure standards described in the HKMA circular are broadly consistent with the Existing HKMA Requirements applicable to non-SFO-regulated products, which are summarised further below in this article. The HKMA circular reminds AIs that these general disclosure standards apply to information contained in advertising messages and marketing materials, whether online (e.g., through social media platforms) or in physical form.
When offering a tokenised product, in addition to making disclosures about the underlying traditional product or asset(s) (which are to be made in accordance with the Existing HKMA Requirements), AIs should disclose material information about the tokenisation arrangement itself. For the reasons given above, these disclosure requirements are also relevant to AIs that issue tokenised products. This diagram provides examples of tokenisation-related risks that an AI should consider making in relation to a tokenised product:
6. Risk management obligations
According to the HKMA circular, AIs should adopt proper policies, procedures, systems and controls to identify and mitigate the risks arising from their tokenised product-related activities. AIs should have appropriate risk management frameworks for selling activities in respect of tokenised products, which should include policies and procedures for internal controls, complaint handling, compliance, internal audit and business contingency planning.
AIs should also allocate adequate resources to ensure that their management and relevant staff have the necessary expertise to perform their duties when engaging in activities related to tokenised products. For example, staff should be able to explain tokenised products to customers and manage the risks arising from them.
Before engaging in tokenised product-related activities, AIs should put in place adequate policies, procedures, systems and controls to ensure that all applicable requirements (including those set out in the HKMA circular and the Existing HKMA Requirements) are complied with, and should implement appropriate additional internal controls to address the specific risks and unique nature of tokenised products.
Importantly, an AI must discuss with the HKMA before engaging in tokenised product-related activities.
7. Overview of the Existing HKMA Requirements applicable to non-SFO-regulated products
Over the years, the HKMA has provided extensive guidance to AIs in relation to the issuance, offering, distribution and selling of non-SFO-regulated products. Since the HKMA generally takes the view that many tokenised products are basically traditional products with a tokenisation wrapper, the Existing HKMA Requirements that apply to non-SFO-regulated products also apply to their tokenised versions.
At a very high-level, the Existing HKMA Requirements reflect the following overarching information disclosure principles, although the topics covered in the Existing HKMA Requirements extend far beyond disclosure obligations:
- AIs must act in the best interests of their customers and must make adequate disclosures about a non-SFO-regulated product (including key terms, features and risks) to enable the customer to make an informed investment decision.
- Information disclosed to customers should be accurate and fair, should not be false or misleading, and should not be presented in a deceptive or unfair manner.
- Information disclosures should be presented in a clear, concise and user-friendly manner that is easily accessible and understandable by customers. Thus, AIs should use plain language and should avoid highly technical terms or jargon.
In addition to these overarching disclosure principles, the Existing HKMA Requirements contain detailed rules and standards covering a wide range of matters, as summarised in this diagram. A detailed overview of the Existing HKMA Requirements is beyond the scope of the article.
Where the tokenised product is in the form of a deposit, additional disclosure and compliance requirements apply under the Deposit Protection Scheme Ordinance (Cap. 581) and the rules issued thereunder, such as the Deposit Protection Scheme (Representation on Scheme Membership and Protection of Financial Products under Scheme) Rules (Cap. 581A). A detailed overview of deposit-related disclosure and compliance requirements is beyond the scope of this article.
Links to key Existing HKMA Requirements applicable to non-SFO-regulated products
- Circular on selling of investment products issued by the HKMA on 13 July 2009, available here
- Report on issues concerning the distribution of structured products connected to Lehman Group companies published by the HKMA on 31 December 2008 and updated on 1 August 2011, available here
- Circular on selling of investment products issued by the HKMA on 5 January 2012, available here
- Circular on issues and good practices in relation to the sale of investment products issued by the HKMA on 30 July 2014, available here
- Circular on selling of investment products issued by the HKMA on 6 January 2015, available here
- Circular on requirements applicable to online and offline distribution of non-SFO-regulated structured investment products issued by the HKMA on 30 October 2018, available here
- Circular on investor protection measures in respect of investment, insurance and mandatory provident fund products issued by the HKMA on 25 September 2019, available here
- Circular on frequently asked questions on investor protection measures issued by the HKMA on 23 December 2020, available here
8. Where can I learn more about tokenised products, the HKMA circular, the Existing HKMA Requirements and related issues? Come speak to us
KWM’s bilingual financial regulatory, financial markets, structured products and international funds teams have extensive experience in advising banks, other financial institutions, fund houses and fintech companies on a broad range of matters related to tokenisation, digital 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, Australia, 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.
This article is provided for general information purposes only and does not constitute legal advice.
*For purposes of this article, “Hong Kong” means “Hong Kong Special Administrative Region of the People's Republic of China”, and “China”, “China Mainland” or “PRC” shall mean the People’s Republic of China excluding Hong Kong, Macau Special Administrative Region and Taiwan.
Reference
[1] The terms “currency-linked instrument”, “interest rate-linked instrument” and “currency and interest rate-linked instrument” are defined in the SFO and essentially capture an instrument that is a “structured product” only because some or all of the return or amount due (or both the return and the amount due) or the method of settlement is determined by reference to changes in the value or level of currency exchange rate(s) and/or interest rate(s) (as applicable).
The term “structured product”, in turn, is defined in the SFO as: “an instrument under which some or all of the return or amount due (or both the return and the amount due) or the method of settlement is determined by reference to one or more of:
- changes in the price, value or level (or a range within the price, value or level) of any type or combination of types of securities, commodity, index, property, interest rate, currency, exchange rate or futures contract;
- changes in the price, value or level (or a range within the price, value or level) of any basket of more than one type, or any combination of types, of securities, commodity, index, property, interest rate, currency exchange rate or futures contract; or
- the occurrence or non-occurrence of any specified event or events (excluding an event or events relating only to the issuer or guarantor of the instrument or to both the issuer and the guarantor) . . . .”
[2] Paper gold schemes (PGS) are deemed to be collective investment schemes under the Securities and Futures (Collective Investment Schemes) Notice (Cap. 571M). For these purposes, a PGS is an arrangement for the purchase of gold coins or gold bullion that is made available in the course of business and has the purpose or effect, or pretended purpose or effect, of enabling participating persons:
- to acquire the ownership of the coins or bullion for valuable consideration;
- to defer taking possession of the coins or bullion; and
- to transfer or retransfer the ownership of the coins or bullion to a person who is a party to, or is referred to in, the arrangement.
[3] The term "collective investment scheme" is broadly defined in the SFO and captures a wide range of arrangements that essentially involve pooling contributions from different investors into a single investment fund.
Generally, a CIS has four relevant elements:
- it must involve an arrangement in respect of property (which can be any property, real estate, whether located in Hong Kong or overseas);
- participants do not have day-to-day control over the management of the property even if they have the right to be consulted or to give directions about the management of the property;
- the property is managed as a whole by or on behalf of the person operating the arrangements, and/or the contributions of the participants and the profits or income from which payments are made to them are pooled; and
- the purpose of the arrangement is for participants to participate in or receive profits, income or other returns from the acquisition or management of the property.
