Webinar on STOs in Hong Kong

Background to securities token offerings

First, some background on securities tokens. So what is a securities token? Essentially, instead of being stored on a single company’s database a securities token is a digital or virtual asset (which I’m going to refer to as “tokens” for the purpose of this webinar) issued on distributed ledger technology (DLT) in the form of a security. In the United States for example, Tesla, Coinbase, Gamestop and Apple have issued tokenised shares which are fully-backed digital representations of traditional shares that trade on the NYSE or NASDAQ. Crypto exchanges FTX and Binance also enable users to trade tokenised shares. Securities tokens can also represent other traditional forms of investment products such as bonds, interests in a collective investment scheme (that is fund interests), loans and structured products. The other type of securities token is a token which is not intended to be a digital version of a traditional security, but is a token such as a “utility” or “network” token which regulators decide should be regulated as securities. An example of this was the US Munchee token, a utility token which of itself was not a security, but became a security because of the way it was marketed to lead investors to expect a profit from future trading of the tokens. It is in relation to this category of tokens that the regulatory position is unclear in many jurisdictions.

Impact of US SEC decision on DAO

In terms of background, STOs evolved from, and to some extent have come to replace, ICOs. The reasons for this lie in the approach of the US regulators, principally the SEC. In the US, the watershed moment in terms of the regulation of token offerings was the SEC’s determination that DAO tokens offered and sold by a “virtual” organisation called “The DAO”, were an “investment contract” under the US Howey test, and were therefore “securities”. Their classification as securities meant that the unregistered public offering of tokens breached US securities laws.

However, the DAO tokens were fairly obviously tokenised securities – that are securities in the form of tokens. The proceeds of the token sale were invested in various projects on the understanding that investors would receive a share of the profits from the investments. It was essentially a tokenised investment fund which, if publicly offered in Hong Kong, would also have breached Hong Kong’s Securities and Futures Ordinance (the SFO) – as an unauthorised public offer of interests in a collective investment scheme under section 103(1) of the SFO. Offering by unlicensed entities would potentially also breach the SFO’s licensing requirements.

Initial coin offerings

The DAO decision led to a proliferation of ICOs in a bid to avoid US regulation. Initial Coin Offerings – which took off in 2017 – are essentially a form of crowdfunding. The developer of a blockchain-based project would issue tokens to raise funds to finance the development or improvement of a blockchain-based project. On completion of the project, token holders gain access to a product or service available on the platform and typically, the tokens are used as the means of payment for the product or service provided. These are generally referred to as “utility tokens” and the intention was that they would fall outside the scope of regulation, as something akin to a pre-paid voucher.

Comparison of US & Hong Kong Regulation of STOs

US “securities” definition – the Howey test

The days of unregulated ICOs were however short-lived. In a string of enforcement decisions, the US courts found various ICOs to be unregistered securities offerings conducted in breach of US securities laws. The courts applied the Howey test, under which a token will be a security if it has four key characteristics.

1) First, there must be an investment of money. Tokens are typically paid for using other cryptocurrencies (most commonly Bitcoin (BTC) or Ethereum (ETH)) which are regarded as money for these purposes.

2) Secondly, there must be an expectation of profit from the investment. Statements in marketing materials suggesting that investors will likely profit from purchasing tokens will fulfil this requirement. It is not necessary for these statements to be explicit. References to the token becoming available for trading on a crypto trading exchange and/or to plans for token “burning” (i.e. to reduce the token supply) have been found to create an expectation of profit.

3) Thirdly, there must be an investment in a common enterprise – which will be the funding of the project.

4) The fourth and final element is that the profit must result from the effort of a promoter or third party beyond the investors’ control.

One of the most high profile SEC actions is its ongoing action against Ripple and two of its senior executives for allegedly conducting a US$1.3 billion unregistered securities offering of XRP tokens, currently the world’s eighth largest cryptocurrency by market cap. XRP tokens were offered to investors in the US and worldwide allegedly in breach of the US Securities Act of 1933. Ripple also distributed billions of XRP in exchange for non-cash consideration such as labour and market-making services.

The SEC alleges that XRP is an “investment contract” within the Howey Test and a security subject to the registration requirements of the Securities Act. According to the SEC, the “defendants understood and acknowledged in non-public communications that the principal reason for anyone to buy XRP was to speculate on it as an investment.” In particular, in publicly offering and selling XRP, Ripple allegedly promised to undertake significant entrepreneurial and managerial efforts, including to create a liquid market for XRP, which would in turn increase demand for XRP and therefore its price.

Ripple is disputing the allegation arguing that:

• XRP is a currency, similar to Bitcoin and Ether, which the SEC has said are not securities; and

• XRP has a fully functional ecosystem and a real use case as a bridge currency that does not rely on Ripple’s efforts for its functionality or price. According to Ripple, XRP differs from earlier ICO cases which did not develop ecosystems or an established utility for the digital assets which were sold to purchasers based on promises of profits and ongoing efforts.

SEC Statement on Framework for “Investment Contract” Analysis of Digital Asset (April 2019)

In April 2019, the SEC issued a Statement on “Framework for ‘Investment Contract’ Analysis of Digital Assets” providing guidance on when a token offering will be a securities offering. The framework applied the Howey Test which looks at the token’s terms and the surrounding circumstances including how it is offered, sold and re-sold.

With regard to the “reasonable expectation of profits derived from the efforts of others” prong of the Howey test, the guidance states that it raises two main questions.

The first question is whether purchasers rely on the efforts of others, in particular the efforts of an active participant (AP) such as a promoter or other third party. The second question is whether those efforts are “significant…, that is… essential managerial efforts which affect the failure or success of the enterprise”.

According to the Guidance, token purchasers are likely to rely on the efforts of others where the network or virtual asset is still in development or not fully functional at the time of the token offering. In this situation, purchasers would reasonably expect an active participant to further develop the functionality of the network or virtual asset.

Characteristics giving rise to a reasonable expectation of profits include firstly, where token holders have the right to share in the enterprise’s income or profit or to realise a gain from the token’s capital appreciation which results, at least in part, from the development or improvement of the platform. A feature making an expectation of profits particularly likely is the existence of a secondary market that enables token holders to realise a gain on selling their tokens.

Another factor which makes tokens more likely to be securities is where they are offered broadly to potential purchasers rather being offered to the expected users of the goods or services or those with a need for the network’s functionality.

If the tokens are currently, or will in future be, tradable on a secondary market (i.e. a crypto trading exchange) this will also make it more likely that they are securities, particularly where the active participant promises to support trading in the tokens.

Another major factor is whether the tokens are sold for use by the purchaser. Tokens are unlikely to be securities where the distributed ledger network is fully developed and operational and the tokens can be used immediately (e.g. as a means of payment) on the network.

When ICOs are STOs under US law

In February 2018, SEC Chairman Jay Clayton famously said “I believe every ICO I’ve seen is a security”, a statement recently endorsed by current SEC Chair, Gary Gensler on the basis that people “buying these tokens are anticipating profits”. Gensler has also gone further than his predecessor suggesting not only that platforms trading tokens can implicate securities laws, but also that DeFi platforms that allow people to lend tokens may implicate commodities and banking laws.

Going back to 2018, views such as those of Jay Clayton and a series of high profile enforcement actions against ICO issuers gave rise to STOs. Whereas ICOs tried to operate outside regulation, STOs sought to bring themselves within the scope of US regulation so that they could rely on various exemptions from the securities laws’ registration requirements. The exemptions relied on were those under Reg D (for offers only to “accredited investors” or not exceeding US$5 million), Reg A (for companies with 2 years’ financial statements raising no more than $50 million), Reg S (available only to firms outside the US) and the JOBS Act Crowdfunding Regulations (which allow firms to raise up to US$5 million but prevent resale for 12 months).

The tokenised securities market

Looking now at securities tokens which are traditional securities in digital form, the US is the leading jurisdiction for securities token issuance, followed by Switzerland. The global STO market has continued to expand in 2021 with the total market cap now valued at billions of US dollar. To date, STOs have been most frequently used for financial services, particulary bond issues. Another major trend has been tokenised real estate, which was the highest growth segment in 2020.

In 2020, there were 80 publicly announced STOs. US$4.8 billion was raised by 80 companies, the majority of which was raised by two STOs. The first one was Red Swan, a US commercial real estate firm which tokenised US$2.2 billion in high-end properties in partnership with Polymath. The second STO was conducted by the Thai Central Bank and sold US$1.6 billion of savings bonds using blockchain technology.

In 2020, the market capitalisation of security tokens reportedly rose over 500% from roughly US$60 million to US$370 million.

In 2019, the Bank of China issued US$2.8 billion in blockchain based bonds to small and micro businesses with their own blockchain platforms. HSBC has also explored the use of distributed ledger technology for the issue of digital bonds to improve efficiency and cut costs for issuers and investors. In September 2020, the first digital bond was issued on the Singapore Exchange working with HSBC and Temasek on behalf of Olam International.

The most popular platform for securities token offerings (STOs) is Ethereum, although there are alternative platforms. The second most popular platform is Tezos, followed by Elevated Returns which issued one of the first security tokens backed by real estate. One of the advantages of securities tokens is the ability to embed transfer restrictions in the tokens’ transfer rules so that they can never be transferred to an ineligible individual in the primary or secondary market. Digitisation also improves transferability while reducing settlement and reconciliation costs.

Tokenised shares in the US

Security token trading volume increased over 1,000% in 2020, although two securities tokens accounted for the bulk of this trading volume. The 2020 return on tZERO security token ($TZROP) increased 205.26% and the 2020 return of e-commerce company Overstock.com Inc’s security token ($OSTKO) was up 195.00%.

$OSTKO are digital preferred shares of Nasdaq-listed Overstock.com Inc. They carry equivalent voting rights and an equivalent liquidation preference to its common shares. They carry a preferential right to an annual cash dividend and trade only on the tZERO ATS marketplace owned by an Overstock subsidiary. In spring 2020 the company made history by offering a digital dividend – one $OSTKO for every 10 shares owned. The advantages of digital shares include faster and more efficient settlement and the ability to programme governance and regulation into the code.

For the past few years, the US has witnessed an increasing number of security tokens offered to professional investors in the US and overseas retail investors based on exemptions such as Reg A, Reg D and Reg S.

Exodus was the first blockchain company to issue a Reg A+ security token offering. Reg A+ allows issuers to raise funds from a crowd of retailers up to $75 million but requires them to obtain SEC approval to conduct a STO.

tZERO Group, Inc. (“tZERO”) is a majority-owned subsidiary of Overstock.com involved in the development and commercialisation of financial technology. It provides a service of digitising the securities of private companies for trading on its tZERO ATS marketplace. The tZERO offering relied on the Reg D exemption for offers to accredited investors and Reg S exemption for offers outside the US to non-US persons.

In October 2020, Curzio Research listed its STO tokens on a Seychelles-based exchange (MERJ exchange) becoming the first private US company to list tokenised securities on an international exchange open to US and overseas investors. Curzio relied on exemptions to offer the securities tokens to US accredited investors under Reg D and to non-US investors under Reg S. The company raised US$4 million from investors reportedly at a considerably lower cost than if it had pursued an IPO in the US.

It is also possible in the US to buy digital securities using digital cash such as stablecoins (e.g. USDC and DAI). Crypto platforms in the US require an alternative trading systems (ATS) licence to trade security tokens.

While security tokens are legal in the US, regulators have not yet put a clear regulatory framework in place or provided definitions.

Nevertheless, STOs which rely on exemptions from the US Securities Act’s registration requirements are seen in the US as a way of enabling companies to raise funds fairly quickly at a lower cost than a traditional IPO. Offers under the Reg D exemption to accredited investors allow issuers to raise an unlimited amount and can be conducted quickly – taking approximately one month. This can be combined with an offer to non-US persons outside the US under Reg S. There can apparently also be tax benefits for non-US residents of trading security tokens including not being subject to US capital gains tax.

In the US, Dapper Labs, Inc and its CEO are being sued for alleged violation of securities laws for the sale of non-fungible tokens (NFTs) on its platform. The plaintiffs allege that the NFTs are securities. Issuing NFTs in the form of security tokens in reliance on exemptions from the registration requirements of the securities legislation may be a means to avoiding litigation.

Tokenised shares in Europe

Switzerland is the most popular country for securities token offerings (STOs) in Europe accounting for around 30% of European STOs, followed by the UK with 23% and Germany with 19%.

Switzerland

Switzerland’s popularity for STOs is due to the country’s efforts to encourage cryptocurrency development and the adoption of regulation to facilitate this. In February 2021, parts of the DLT Act came into effect allowing uncertified securities to be issued and managed on DLT. Companies can now offer tokens representing their shares which are managed on the Ethereum blockchain. These are the first equity tokens issued on Ethereum.

There are also a number of regulated entities on which tokenized securities can be traded. The Swiss Stock Exchange, SIX, was the first major stock exchange to launch an exchange dedicated to digital assets. Launched in December 2021, the exchange provides regulated trading, settlement and custody for digital stocks and bonds.

Germany

The German Federal Financial Supervisory Authority (BaFin) has said that tokenised financial instruments such as tokenised shares, bonds and subordinated loans are securities under German securities law. They are therefore subject to Germany’s Securities Prospectus Act and Securities Trading Act rather than its Investment Act. Despite the work required in preparing a securities prospectus, an advantage is that once approved, the securities tokens can be offered throughout the EU under the passporting system.

Tokenised shares in Asia

Fusang Corp (FSC), announced on 19th January 2022 that it has received approval from the Labuan Financial Services Authority in Malaysia for an IPO of its equity tokens. The offering of FSC’s equity tokens, giving investors a direct stake in the company, will be the first of its kind in Asia. The FSC tokens are digital representations of its shares and are recorded on a blockchain rather than a traditional share register. It is proposed that the equity tokens will be listed on Fusang Exchange, Asia’s first regulated stock exchange for securities tokens owned by the company, by the first quarter of 2022.

Hong Kong regulation of STOs

SFO definition of securities

Turning now to the regulatory position in Hong Kong, the SFC has provided little useful guidance other than various statements to the effect that a token that has the features of a traditional security (that is a share, a debenture or an interest in a collective investment scheme) will (unsurprisingly) be regulated as a security.

The definition of “securities” in Schedule 1 to the SFO is wide and includes:

• Shares, debentures, bonds or notes of any body (incorporated or unincorporated), government or municipal government authority or any rights, options or interests therein;

• Interests in a collective investment scheme;

• Interests, rights or property (whether in the form of an instrument or not) that are commonly known as securities; and

• Structured products (which I’ll talk about in a moment).

In contrast to the US, there have been no Hong Kong court decisions on whether tokens are securities.

SFC’s action against Black Cell

The only SFC enforcement action to date involved the SFC halting Black Cell Technology’s ICO in Hong Kong in 2018. However, this was a fairly clear-cut case of an offering in breach of Hong Kong securities laws. The tokens were exchangeable for shares in the ICO issuer – making the offering tantamount to a share offering in Hong Kong in breach of section 103 SFO. The SFC’s press announcement however referred to the ICO potentially amounting to a collective investment scheme and also to the potential breach of SFO licensing requirements.

SFC statements re. ICOs

The SFC issued statements on ICOs in February 2018 stating that it had written to seven ICO issuers and seven crypto exchanges warning them of the regulatory consequences of offering or trading tokens that are securities under Hong Kong law. The entities contacted apparently either confirmed their activities complied with Hong Kong’s securities laws or ceased their activities in Hong Kong. No details of the characteristics of the tokens offered or traded were provided by the SFC.

Clearly, where a token is essentially a tokenised share (with rights such as rights to participate in the issuer’s profits or to a share of its assets on winding-up) or a tokenised debenture (with a right to repayment of the purchase money and possibly interest), it will be a security. A public offering of a securities token that is a share or debenture in Hong Kong will require compliance with the prospectus regime under the Companies (Winding Up and Miscellaneous Provisions) Ordinance and the restrictions on public offering without SFC authorisation under Section 103(1) of the SFO. However, C(WUMP)O’s prospectus regime applies only to offerings by a company of its shares and debentures. On the face of it, the prospectus regime would not apply to the digital shares or debentures of decentralised autonomous organisations which are often the issuers of tokens. In the US, some states, including Wyoming, have passed laws recognising DAOs as legal entities, in Wyoming’s case, as Limited Liability Corporations (LLCs). Section 103 of the SFO applies simply to securities, and so STOs will need SFC authorisation in the absence of an applicable exemption irrespective of the corporate status of the issuer. Intermediaries offering securities tokens will also be need to be licensed for the relevant regulated activities (Type 1 (dealing in securities) where the intermediary is involved in marketing or trading securities tokens, Type 4 where the intermediary advises on buying and selling tokens, and Type 9 where the intermediary is a fund manager investing in securities tokens).

Collective investment scheme definition vs Howey test

Whether a token offering would be considered by a Hong Kong court to be an offer of interests in a collective investment scheme (CIS) is unclear. The key elements of the definition of a CIS under Schedule 1 to the SFO are that:

i. Firstly, it must involve an arrangement in respect of property (which is broadly defined);

ii. Secondly, the participants in the CIS should 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);

iii. Thirdly, the property should be managed as a whole by or on behalf of the person operating the arrangements, and/or the participants’ contributions and the profits or income should be pooled; and

iv. Finally, the purpose of the arrangement should be to provide participants with profits, income or other returns from the acquisition or management of the property.

The definition bears similarities to the US Howey test. It differs in that the CIS definition requires that the purpose of the arrangement should be to provide a profit, income or “other return” to participants in the scheme. Howey on the other hand requires there to be an expectation (among purchasers) of profits.

Whether the Hong Kong courts would follow a similar line of reasoning to that applied by the US courts is not yet clear. When we have been asked to provide legal opinions on token offerings, we have thought long and hard about whether a token’s proposed listing on a crypto exchange and the potential for token holders to earn a return if the tokens appreciate in value would bring it within the definition of a CIS. Applying the reasoning used by the US courts, purchasers of tokens which have no immediate use (where the platform will be developed using the proceeds of the ICO) would appear to be buying the tokens as investments rather than their use case on the platform. Whether that is the aim of the token issuer is a different question. The decision to list tokens is not always that of the token issuer. A crypto exchange may decide to list a popular token without the consent or knowledge of the issuer. This raises another issue, which is that the categorisation of a token as a security can change over time. For example, Bitcoin was intended as a means of payment but has evolved into a store of value. Similarly the US SEC has said that tokens that started life as securities, such as Ethereum, ceased to be securities once the network on which they function is sufficiently decentralised such that purchasers no longer rely on the promoters’ efforts for the enterprise’s success.

STOs which offer digital shares or debentures will be regulated under the SFO meaning that they will need to be offered under an exemption from section 103. An offer to professional investors would achieve that. Any intermediary offering the STO or offering trading in the securities tokens would need to be licensed by the SFC for Type 1 (dealing in securities) and probably Type 7 (providing automated trading services).

There is no Hong Kong or UK case law which would assist in determining the questions surrounding whether an ICO token offering would constitute a collective investment scheme. Nor has the SFC provided any useful guidance on the factors it takes into account in assessing whether an ICO potentially breaches Hong Kong securities law. Questions addressed to the SFC on the various grey areas have been met with their standard advice to seek legal advice.

SFC Statement on Security Token Offerings (March 2019)

The SFC’s Statement on Security Token Offerings issued in March 2019 describes STOs as “structured to have features of traditional securities offerings” and securities tokens as “digital representations of ownership of assets (e.g. gold or real estate) or economic rights (e.g. a share of profits or revenue)” using blockchain technology.

Securities tokens clearly encompass digital versions of traditional securities such as shares, debentures and interests in investment funds.

However, the SFC does not elaborate on why digital representations of assets such as gold or real estate should fall within the definition of securities.

Gold is a commodity for the purposes of Hong Kong regulation, but commodities trading is not a regulated activity in Hong Kong. It is not clear therefore why dealings in a token representing gold would be regulated. Nor is trading in real estate a regulated activity under the SFO.

The SFC might be referring to a tokenised real estate or gold fund where money raised in a token offering is invested in gold or real estate with the expectation that token holders will receive a share of the future proceeds of sale of the gold or real estate when sold at a profit. In that case, the tokens would likely constitute securities as interests in a collective investment scheme. Alternatively, the SFC might be suggesting that tokens whose value or price is relative to the value or price of an underlying asset such as gold or real estate would be considered to be “regulated investment agreements” or “structured products”.

Structured products & Regulated investment agreements

Structured products are defined broadly in the SFO and include any product where all or part of the return or amount due, or both, or the settlement method, is determined by reference to any one or more of:

(i) changes in the price, value or level (or within a range) of securities, commodities, indices, property, interest rates, currency exchange rates or futures contracts, or any combination or basket of any of these; or

(ii) the occurrence or non-occurrence of any specific events other than an event relating only to the issuer and/or the guarantor of the product.

The SFC has not provided guidance on its regulation of stablecoins that are backed by physical assets (e.g. traditional fiat currencies or gold) or synthetic stablecoins which are not physically backed by the underlying asset.

However, the Financial Services and the Treasury Bureau’s (FSTB) Consultation Conclusions on the new licensing regime for centralised platforms that trade tokens that are not securities stated that cryptocurrencies that are backed by assets for the purpose of stabilising their value will be regulated under the new licensing regime being introduced under amendments to the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615) (AMLO). This would suggest that they are not then securities the trading of which would require the exchange to be licensed under the SFO.

A regulated investment agreement is an agreement intended to provide any party to the agreement with a profit, income or other return calculated by reference to changes in the value of any property. The most common example of a regulated investment agreement in Hong Kong are equity-linked deposits. The regulated investment agreement definition excludes collective investment schemes.

Unless an STO is essentially a tokenised fund offering and thus an offering of interests in a collective investment scheme, it is difficult to understand the SFC’s assertion that tokens representing digital ownership of assets, such as gold or real estate, are securities under the SFO.

Regarding the analysis of real estate funds, in the same way as traditional funds, these will be collective investment schemes which will need to be offered only to professional investors or in a non-public offer to less than 50 potential investors. If the manager is based in Hong Kong, it will need to be licensed for Type 9 and intermediaries marketing interests in the fund will need to be Type 1-licensed.

SFC regulation of fund managers managing funds investing in digital assets

As I mentioned earlier, the SFC’s statements regarding its regulation of activities involving digital tokens have focused on fund managers investing in digital tokens and platforms providing trading in them.

De minimis threshold

In November 2018, the SFC published a regulatory framework which extended its regulation of licensed fund managers which are already licensed for their fund management activities in relation to traditional securities so that the SFC would also regulate their fund management activities in virtual assets. The SFC will regulate a Type 9 licensed fund manager with respect to its management of virtual assets where:

• it has a stated investment objective of investing in virtual assets; or

• it invests more than 10% of its gross asset value (GAV) in virtual assets.

Licensing requirement for managers of funds investing in digital assets that are securities or futures contracts

However, a fund manager which only manages funds which invest only in virtual assets which are not securities or futures contracts does not require a Type 9 licence. This is because managing funds investing only in virtual assets that are not securities or futures contract is not a regulated activity. However, if the fund manager distributes the fund in Hong Kong, it will need to be licensed for Regulated Activity Type 1 (dealing in securities). A fund is a collective investment scheme irrespective of the type of property it invests in. Collective investment schemes come within the definition of “securities” in Schedule 1 to the SFO. Accordingly, any marketing or offering of interests in a collective investment scheme will be “dealing in securities” which requires a Type 1 licence under the SFO.

SFC notification requirement

A fund manager intending to invest in virtual assets is required to notify the SFC even if it intends to invest less than 10% of its GAV in virtual assets.

Licensing conditions

Regulation is imposed by the attachment of licensing conditions which are set out in the SFC’s Proforma Terms and Conditions for Licensed Corporations which Manage Portfolios that Invest in Virtual Assets.

Professional investor restriction

The licensing conditions include a restriction to investors who are “professional investors” as defined in the SFO (which include the categories of high net worth investors under the Securities and Futures (Professional Investor) Rules).

Custody requirements

A manager of a virtual asset fund is required to assess and select the most appropriate custodial arrangement – that is whether to hold the assets itself or with a third-party custodian or an exchange – taking into consideration the advantages and disadvantages of holding cryptocurrencies at different host locations by way of “hot” or “cold” wallets, considering the ease of accessibility to the virtual assets and the security of the custodial facility.

Where the licensed fund manager opts for self-custody, it has to document the reasons for self-custody and disclose the risks of self-custody to investors. Appropriate measures must be implemented to protect the fund’s assets and effectively segregate the virtual assets from the fund manager’s own assets in the event of its insolvency. The fund manager is also required to use best endeavours to acquire and maintain insurance cover over the virtual assets.

Valuation and liquidity

The licensing conditions require licensed fund managers to select valuation principles, methodologies, models and policies which are reasonably appropriate in the circumstances and in the best interests of investors.

Virtual asset fund managers must consider setting a cap on a fund’s investment in illiquid virtual assets and newly-launched ICO Tokens and their exposure to counterparties.

Audit requirement

The SFC requires the appointment of an independent auditor to audit the financial statements of managed funds.

Liquid capital

A licensed fund manager which holds virtual assets on behalf of the funds it manages has to maintain liquid capital equal to the higher of HK$3 million or the amount of its variable required liquid capital.

Venture Smart Asia was the first fund manager to obtain a Type 9 asset management licence to manage funds investing in virtual assets in April 2020. It is also licensed for Types 1 and 4.

SFC regulation of crypto exchanges under the SFO

At least one digital asset that is a “security”

According to the SFC’s November 2019 Position Paper on Virtual Asset Trading Platforms, it will only license centralised trading platforms that trade at least one virtual asset that is a security under the SFO. To date, the SFC has only licensed one virtual asset trading platform OSL Digital Securities Limited. According to a press release from OSL, the security token traded on its platform is the BCAP Token issued by Blockchain Capital TokenHub Pte. Ltd, which holds interests in Blockchain Capital III Digital Liquid Venture Fund LP. Through this structure, BCAP Tokens provide indirect exposure to the venture capital fund.

Virtual asset trading platforms are required to be licensed for Type 1 (dealing in securities) and Type 7 (providing automated trading services).

Licensing conditions for crypto exchanges

The licensing conditions that the SFC imposes on a licensed virtual asset trading platform restrict provision of trading services to professional investors.

Licensed platforms have to comply with the SFC’s “Terms and Conditions for Virtual Asset Trading Platform Operators” which require the virtual assets to be held by a Hong Kong subsidiary of the platform operator which holds a licence as a trust or company service provider under the AMLO. The platform operator must have an insurance policy covering the risks of custody of the virtual assets and have strict controls on the generation and storage of private keys.

Problems with the existing regulatory framework for crypto exchanges

Probably the most difficult condition for platform operators to meet is the requirement that virtual assets which are securities that are traded on the platform must:

1) be asset-backed;

2) be approved or registered with regulators in comparable jurisdictions (as determined by the SFC); and

3) have been issued more than 12 months previously.

The SFC has provided no guidance on which virtual assets will be regarded as “asset-backed”. Presumably this would include physically backed stable tokens such as Tether (although whether Tether is backed one-for-one by US Dollar has been disputed). Whether synthetic stablecoins would be considered asset-backed is unclear – my guess is that they wouldn’t be. The requirement for the virtual assets to have been issued more than 12 months prior to their listing on the trading platform rules out most ICO tokens. Further, the SFC has not published a list of jurisdictions it regards as comparable.

The difficulty for Hong Kong crypto exchanges in meeting the requirement for trading of securities tokens meeting these conditions is partly that there have not been any STOs in Hong Kong to date. As we saw earlier, STOs in the US have been of digital shares or bonds or ICO tokens offered in reliance on exemptions from the registration requirement.

In Hong Kong, the SFC has not spelt out that ICO tokens would be securities, nor the circumstances in which that would be the case. If they had, life would probably be easier since offerings could then be made to “professional investors” relying on the professionals exemptions from the C(WUMP)O prospectus regime and the SFC authorisation requirement under section 103 of the SFO.

I’ve heard unofficially that a law firm is working on an STO where the tokens are backed by bonds. Presumably this is a tokenisation of bond securitisation which provides for the interest and principal payments from the underlying bonds to flow through to investors in the STOs. Using DLT for securitisation promises to streamline processes and would presumably reduce costs, enhance security and increase the speed of transactions.

Regulatory implications of STOs being “securities” under the SFO

Intermediaries which market and distribute security tokens are required to satisfy the Code of Conduct including the obligation under paragraph 5.2 to ensure that customer recommendations and solicitations in relation to security tokens are reasonably suitable for customers based on the information about customers of which intermediaries should be aware through the exercise of due diligence.

Due diligence obligations

The SFC’s Statement on Security Token Offerings also noted that where licensed intermediaries distribute security tokens, they need to conduct due diligence to develop an in-depth understanding of the tokens. This should include due diligence on the background and financial soundness of the management of the token issuer and of the rights attaching to the assets backing the securities tokens. In particular, intermediaries are required to review all materials published in relation to the STO including the whitepaper and relevant marketing materials.

STOs as “complex products”

According to the SFC’s March 2019 Statement on Security Token Offerings, securities tokens are considered to be “complex products” under paragraph 5.5 of the Code of Conduct and under the Guidelines on Distribution and Advisory Platforms. Both set out additional KYC obligations for complex products. A licensed intermediary providing services to a client in complex products is required to ensure that the product is suitable for the client in the circumstances and to provide the client with information on the key nature, features and risks of the complex product.

The SFC’s Guidelines on Distribution and Advisory Platforms apply to licensed intermediaries providing online distribution and advisory platforms for investment products. Paragraph 6.3 requires intermediaries to ensure that transactions in complex products are suitable for particular clients. Paragraphs 6.7 and 6.8 contain requirements for the provision of information and warnings similar to the requirements of the Code of Conduct. Exemptions from all these requirements are available for clients who are institutional professional investors or corporate professional investors as defined in the Code of Conduct.

Provision of information to clients

The Statement on Security Token Offerings also requires licensed intermediaries to provide clients with information relating to STOs which must include warnings of the risks of investing in virtual assets. It notes in particular that intermediaries should consult with the SFC before engaging in activities relating to STOs.

Licensed platform operators are also required to provide a legal opinion confirming whether each virtual asset to be traded on their platform is a “security” under the SFO.

Shortcomings of SFC’s regulatory approach

A criticism of the SFC’s regulatory approach to tokens generally is that the Code of Conduct’s requirements aimed at ensuring investor protection, including the obligation to ensure the suitability of investment products for individual customers, is that these obligations apply only where a traditional intermediary is involved. The Code of Conduct does not apply to issuers of securities issuers. Traditional securities intermediaries such as brokers are not typically involved in token offerings. Issuers thus have no obligation to ensure the suitability of their tokens for prospective investors or to disclose the risks of investing in them.

As token issuers, their designers and developers are typically based offshore, the SFC has no regulatory jurisdiction over these foreign actors. Protection for Hong Kong investors against fraudulent or incompetent overseas issuers is very limited. The SFC’s Code of Conduct requirements would only ever apply if an SFC-licensed or registered intermediary were to market the tokens to Hong Kong investors which is never the case.

The SFO prohibits the marketing of security tokens to Hong Kong investors unless it is conducted by a person who is licensed for Type 1 regulated activity. If securities tokens are offered from outside Hong Kong, there will only be a breach of section 115 of the SFO if the offshore entity markets services to the Hong Kong public which would require it to be licensed in Hong Kong. If there is no active marketing of services to the Hong Kong public, there is no breach of the SFO.

Moreover, there is no protection for Hong Kong investors who acquire tokens on an offshore platform. Trading platforms operating in cyber space are not regulated by the SFC. The SFC only regulates centralised exchanges operating in Hong Kong – that is trading platforms that provide trading, clearing and settlement services for tokens. The SFC does not license platforms which trade tokens for clients and provide order routing to offshore exchanges, but do not themselves provide automated trading services. Nor does the SFC license exchanges which provide peer-to-peer trading in tokens between clients where the trade takes place off-exchange and the clients retain custody of their tokens.

Where an STO turns out to be a scam, investors have only a claim under contract or common law against the token issuer. Since STO white papers rarely contain the legal names and registered addresses of issuers, it will be difficult, if not impossible, for investors to recover damages.

Julia Leung’s Keynote Address to HK Fintech Week November 2021

The SFC’s Julia Leung made a keynote address to Hong Kong FinTech Week in November 2021 which noted that financial institutions are increasingly looking to offer virtual assets to professional investors and their private bank clients.

Can licensed firms provide trading services for clients?

She commented on the unevenness of the regulatory landscape – alluding to the fact that some licensed firms want to provide virtual asset trading services to clients by acting as an introducing agent or through an omnibus account opened with a virtual asset trading platform. The questions she said the SFC needs to address include whether these firms expose their clients to undue risks if the virtual asset trading platforms are unregulated or only regulated for limited purposes?

SFC regulatory concerns where licensed firms trade through omnibus accounts with crypto exchanges?

In the situation where a firm trades for its clients through an omnibus arrangement, the firm will onboard the clients directly. She raised questions as to whether some of the regulatory obligations typically imposed on licensed virtual asset trading platforms should be extended to licensed firms trading virtual assets on their clients’ behalf and whether firms should be required to conduct a knowledge assessment before providing virtual asset trading services to clients?

The SFC is apparently reviewing its regulatory regime for virtual assets to see if it remains fit for purpose.

The future of STOs in Hong Kong

STOs provide an innovative platform and ecosystem enabling issuers to raise funds and investors to invest into business projects. An STO may be more appealing than an IPO for small and medium-sized enterprises and seed to Series A rounds rather than unicorn startups and billion-dollar publicly traded companies. Although an STO reduces the costs associated with raising capital which is important for smaller businesses, securities token markets generally lack the liquidity for larger funding needs. This explains why some larger blockchain companies (e.g. Coinbase) have opted for an IPO instead of an STO.

STOs however offer a number of advantages over IPOs. Because of the characteristics of DLT and Blockchain technology, clearance and settlement do not require central third parties such as stock exchanges. Both are handled by the technology itself. As trading is not limited to established institutions, 24-hour trading is also possible. Compliance with anti-money laundering legislation (AML) will be another area that will need to be considered. While banks involved in an IPO must conduct KYC and AML checks on their clients, there is no comparable legal obligation on token issuers. However, operators of licensed crypto exchanges and licensed crypto fund managers and distributors are subject to AML obligations.

Despite the fact that the global market cap of security tokens trading on regulated secondary markets only reached US$700 million, and the daily trading volume averaged only around US$100,000 in April 2021, the soaring demand for tokenised traditional stocks such as Tesla (TSLA), Coinbase (COIN), Gamestop (GME), and Apple (AAPL) has demonstrated the potential for security token growth.

The future of STOs in Hong Kong will depend very much on the attitudes of Hong Kong’s regulators. More guidance on the characteristics of tokens which would bring them within the definition of securities would be welcome. ICOs have virtually ceased in the wake of repeated warnings from the SFC.