Regulators Update Their Joint Circular on VA Activities for Licensed Intermediaries - Retail Clients Welcome !

On the eve of CNY last year, the SFC and HKMA published their Joint Circular in relation to Type 1, Type 4 and Type 9 regulated activities carried out by licensed intermediaries insofar as those activities related to Virtual Assets (VA). My article summarising this circular can be found here:

https://www.dhirubhai.net/pulse/sfcs-hkmas-updated-guidelines-va-activities-related-gaven-cheong/?trackingId=r5b3awnGRJSwhuFcFqnN2Q%3D%3D

The one feature that overwhelmingly characterised the VA regime in 2022 was the restriction that the regulators had placed on the provision of these services - Intermediaries were allowed only to serve Professional Investors (PIs).

Almost two years later, the regulators have refined and updated their positions, but importantly have opened the doors to retail access in relation to the provision of dealing, distribution, advisory and management services for VA. Citing developments such as the proliferation of VA products, their expansion into mainstream finance, and relaxation of restrictions to allow the retail public to access VA exchange services in Hong Kong, this change, although not entirely unexpected, is still a fundamental shift towards liberalisation of the VA market.

For the full text of the Updated JC, see here: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/intermediaries/supervision/doc?refNo=23EC44

A more detailed piece will follow but for now, some of the key takeaways from this updated joint circular (Updated JC) are worth noting.

General

As a general point, the SFC expects all licensed intermediaries ("Intermediaries") to notify the SFC in advance before:

• engaging in any activities involving VA, tokenised securities or VA-related products; or
• expanding VA services to retail clients.

In terms of implementation, the regulators have provided a 3 month transition period for existing Intermediaries who are servicing non-qualified corporate PIs and individual PIs to update their systems and controls to align with the new Appendix 6 T&Cs as introduced by the Updated JC.

Type 1 - Distribution of VA Products

No material change here in relation to the SFC's position. VA-related products fall into 2 broad categories: (1) non-derivative and (2) derivative products.

(1) Non-derivative VA products (eg, spot BTC) are very likely to be considered complex products which means they can only be distributed to PIs.

(2) Derivative VA products are further divided into 2 sub-categories:

(a) Unlisted VA derivative products, or those listed on non-specified exchanges (that is, exchanges NOT specified in Schedule 3 of the Securities and Futures Financial Resources) Rules (exchanges that are specified in Schedule 3 being "Schedule 3 Exchanges"); and

(b) Listed products VA products traded on Schedule 3 Exchanges AND that are authorised for retail offering by a regulator in a designated jurisdiction (see Appendix 2) or, obviously, by the SFC in Hong Kong.

The SFC has made it clear that derivative VA products under 2(a) above are also complex products that can only be distributed to PIs (no distribution to retail investors allowed).

As for derivative VA products under 2(b) above, these may be distributed to retail investors.

Additional Distribution Requirements

• In all cases of (1) and 2(a) and (b) above, and except for institutional or qualified corporate PIs, the Type 1 Intermediary must impose a virtual-assets knowledge test on its clients and provide adequate training (where they assess the client does not have adequate knowledge), and ensure clients have sufficient net worth to bear the loss from VA trading. In respect of the VA knowledge test, the SFC has removed the exemption from having to conduct this test solely because a client has executed 5 or more transactions in VA or VA-related products within the past 3 years. Instead, the regulator has opted for a wider test focussing on areas such as training, work experience and trading experience (see Appendix 1 to the UPdated JC).
• In addition, for category 1 products, these are also subject to the complex products requirements (ensure suitability, minimum information and warning statements and due diligence of product and issuer).
• For 2(a) products, these are subject to all requirements for category 1 products, but must also comply with the derivative product requirements (5.1A and 5.3 of the Code of Conduct).
• Finally for 2(b) products, these are subject to the derivative products requirements but there is no need for the complex product requirements (suitability, warning statements etc) where there has been no solicitation or recommendation (unless they are not of the same type as a complex exchange-traded derivative as set out in the SFC's website: https://www.sfc.hk/en/Rules-and-standards/Suitability-requirement/Non-complex-and-complex-products).
• Interestingly, at para 10 of the Updated JC, the SFC referred to the need for authorisation of certain "investments" if they were being offered to the Hong Kong public under Pt IV of the SFO. Pt IV, however, only relates to the offering of "securities", "structured products" or "collective investment schemes" - so unless a VA falls into these categories (eg, if they are security tokens of interests in tokenised funds), it is unlikely they would be caught under Pt IV.

Type 1 - VA Dealing

The big change here is that the SFC will now permit VA Dealing services to be provided to "retail" investors (that is, non-PIs): (i) in partnership with the SFC-licensed VA trading platforms (“VATPs”) (they may partner with multiple VATPs), which are also licensed for trading by retail investors, and (ii) subject to the VA knowledge test, suitability, limit to exposure and other requirements. In particular, VA Dealing may only be conducted through an omnibus account maintained with a VATP that can serve retail investors. In particular, the Type 1 Intermediary must ensure it is only dealing in the types of VA for which the partner VATP is itself approved to offer to retail customers.

Previously, clients were not allowed to deposit or withdraw amounts in VA but only fiat currencies. This restriction has now been lifted, but such withdrawal /deposit must be through segregated accounts established either with the partner VATP, or an authorised bank (that meets the HKMA standards for VA custody).

The SFC reiterated that only entities licensed for Type 1 (Dealing in Securities) regulated activity ("RA") are permitted to provide VA Dealing services. In addition, the Intermediary is only allowed to provide VA Dealing services to persons who remain at all times its clients in respect of its Type 1 business. In my earlier article, I noted that this would appear to prohibit Type 9 VA Managers from providing VA Dealing services (even though in the absence of any VA, a Type 9 (Asset Management) RA licence also permits the holder to carry out Type 1 (Dealing in Securities) RA as an incidental activity. (A Type 9 Manager exercising an incidental Type 1 function is not "licensed or registered" for Type 1 activity, but is instead regarded as not carrying out Type 1 dealing when performing that act solely for the purpose of its Type 9 activity).

The SFC has now clarified (see para 17 of the Updated JC) that even if dealing services do not amount to "dealing in securities", such services may still have an impact on an Intermediary's fitness and properness to conduct regulated activities, and that "trading activities" involving VA form part of the dealing services provided by an Intermediary. As such, the expectation is that such trading activities must comply with all regulatory requirements of the SFC/HKMA - including that they can only be provided by an entity licensed for Type 1 (Dealing in Securities) RA. I think this leaves little doubt that a Type 9 VA Manager looking to provide VA Dealing services as part of its management mandate would need to separately engage an entity with a Type 1 VA Dealing licence (unless that manager also has a separate Type 1 VA Dealing licence).

Type 1 VA Dealing - Other notable takeaways

Type 1 Intermediaries providing VA Dealing services must comply with the Appendix 6 T&Cs, which impose comprehensive requirements in relation to financial soundness ; operations; prevention of market manipulation; dealing with clients; custody ; client moneys; record keeping; audit; AML and counter financing of terrorism; conflicts of interest; and ongoing reporting obligations (to the SFC or HKMA). Some notable changes to these T&Cs include the following:

• Intermediaries should not make arrangements with its clients to use client VA held with them to generate returns - this would rule out DeFi-related activities such as staking, lending, liquidity mining.
• Intermediaries are not required to ensure suitability for orders in VA placed by a client directly (a) on a VATP, or (b) with the Intermediary for onward transmission to a VATP for execution, if it has not made any solicitation or recommendation to the client in respect of that order.
• Where a recommendation/solicitation is being made to a retail client, the Intermediary must ensure that the VA is of high liquidity, is a large-cap VA, and generally complies with the requirements imposed on VA that are accessible by retail investors under the VATP licensing regime (ie, included in 2 independent indices etc).
• Intermediaries should take active steps to detect and prevent persons who are attempting to circumvent their home jurisdiction's ban on trading VA (for example, by using a VPN) from accessing their services.
• Intermediaries can now act as introducing agents for retail as well as PI clients. However, the restrictions in relation to relaying orders on behalf of their clients, or holding client assets/VA remain.
• Expectations around the scope of information rights and disclosures to be made to retail clients have been enhanced, including in relation to voting rights and how they will be handled by the VATP; fees and their structure; and risk disclosures such as the extreme volatility and unpredictability of VA prices, website names through which client transactions are executed/settled and list of VA available for trading.
• Finally, Intermediaries dealing in tokenised securities will need to comply with existing requirements in relation to dealing in securities generally.

Type 4 - VA Advisory

In a similar vein, the previous restriction on Type 4 VA Advisory entities being able to provide VA Advisory services to PIs only has now been lifted such that they can also serve retail clients.

However, in providing services to retail clients, Intermediaries are subject to the following additional conditions:

• They must assess a client's knowledge of virtual assets (including relevant risks) and if the client does not possess sufficient knowledge, they must provide adequate training.
• They must also assess a client's risk tolerance level and apply appropriate risk profiling to the client.
• Where a recommendation/solicitation is being made to a retail client, the Intermediary must ensure that the VA is of high liquidity, is a large-cap VA, and generally complies with the requirements imposed on VA that are accessible by retail investors under the VATP licensing regime (ie, included in 2 independent indices etc).

Similar to Type 1 VA Dealing services, the SFC has reiterated its position that VA Advisory services should only be provided by an entity possessing a Type 4 (Advising on Securities) licence (and to persons who are customers of its Type 1 or Type 4 business). As such, and as noted in our previous article, this would presumably preclude a Type 9 VA Manager from providing VA Advisory services as part of its management mandate.

Type 9 - VA Management

VA Fund Management

An important clarification has been made to an issue that plagued the industry since the SFC first announced the Type 9 VA Management regime back in November 2018. In short, the SFC's circular at the time appeared to suggest that only Type9 Managers who were proposing to manage a portfolio of VA in excess of 10% of their AUM across all portfolios managed by them would need to apply for a licensing uplift (and to then have the Type 9 VA T&Cs imposed on them).

https://www.sfc.hk/en/News-and-announcements/Policy-statements-and-announcements/Statement-on-regulatory-framework-for-virtual-asset-portfolios-managers

That announcement, however, seemed to contradict the actual wording of the T&Cs in 2019, which provided that the T&Cs applied to any portfolio where the proportion of VA exceeded 10% of that portfolio.

https://ddei3-0-ctp.asiainfo-sec.com:443/wis/clicktime/v1/query?url=https%3a%2f%2fwww.sfc.hk%2fweb%2ffiles%2fIS%2fpublications%2fVA%5fPortfolio%5fManagers%5fTerms%5fand%5fConditions%5f%28EN%29.pdf&umid=4B8E50A7-0602-9006-9341-ABDC6DE0BB6B&auth=1b7026dd0d0ddf2d048eb69ec2055ced11f64474-41058976286307fa5924c27cea9d72bdace7e608

This left many managers with a dilemma in situations where they were proposing to manage a fund that had 100% of its portfolio in VA, but where that fund represented less than 10% of their total AUM across all portfolios and accounts. For the most part, those managers took the view that while they didn't need to apply for an uplift of their Type 9 (Asset Management) RA licence, the fund they were managing still needed to comply with the Type 9 VA T&Cs - which was not an ideal outcome and made the regime difficult to navigate.

Under the Updated JC, it appears clear now that the de minimis threshold of 10% is applied at the portfolio level, such that if a Type 9 Manager manages a fund which intends to invest 10% or more of the gross asset value of its portfolio in VA, the manager is subject to the additional requirements under Type 9 VA T&Cs, and these will be imposed on them as licensing conditions (so there must be an application for an uplift beforehand).

In determining the 10% threshold, however, tokenised securities are considered as "securities" and not VA.

Other notable changes in relation to Type 9 VA Management include:

• Intermediaries must now obtain insurance in respect of the fund's VA (previously they only had to use reasonable endeavours to obtain insurance); and
• It being contemplated now that an Intermediary may manage and/or distribute a retail fund (subject to authorisation under Pt IV of the SFO and the prospectus rules under the C(WUMP)O).

Type 9 - Discretionary VA Account Management

Discretionary VA Account Management services may now be provided to retail clients, subject to the same restrictions as for VA Advisory retail clients, namely:

• They must assess a client's knowledge of virtual assets (including relevant risks) and if the client does not possess sufficient knowledge, they must provide adequate training;
• They must only trade (presumably through an entity with a Type 1 VA Dealing licence or unless they have a separate Type 1 licence) VA that are highly liquid, large cap, and generally comply with the requirements imposed on VA that are accessible by retail investors under the VATP licensing regime (ie, included in 2 independent indices etc);
• They must conduct a suitability assessment on a holistic basis and based on the client's personal circumstances and net worth; and
• They must enter into a Discretionary Client Agreement with appropriate warning statements and risk disclosures.

Conclusion

The Updated JC is certainly a welcome step in opening up VA Distribution, VA Dealing, VA Advisory and VA Management services to retail clients. This is good news for industry participants, and is also in line with what is happening with other parts of the ecosystem (for example, the introduction of the VATP Licensing regime and allowing retail customers to access exchange services). Nevertheless, the measures taken to liberalise the scope of services are considered and incremental, rather than wholesale in their changes. Distribution activities, for example, are still pretty much restricted to PIs except for a small selection of exchange traded VA derivative products.

In relation to VA Dealing and VA Advisory, allowing retail clients to withdraw and deposit VA as well as fiat currencies through VATP and/or authorised banks is certainly a positive development. Additionally, the requirements for servicing retail clients such as information rights/disclosures, suitability and knowledge tests and education, and restriction to only large cap and liquid VA, are all sensible protective measures.

As for VA Management, while the rules around the de minimis threshold have now been clarified (such that most Type 9 RA managers looking to manage VA funds will likely have to apply for a licence uplift), the requirement that any VA Dealing by the Fund will have to be done through a Type 1 VA Dealing Intermediary would appear to be quite restrictive on VA Fund Management. For example, the attendant restrictions around Type 1 VA Dealing Intermediaries being able only to transact on SFC Licensed VATPs, not being able to generate returns through DeFi type activities, and the requirements to custody assets on a licensed VATP platform or bank, would seem to rule out many "on-chain", DeFi, or high frequency/systematic strategies. On the plus side, opening up Discretionary Account Management services to retail clients would certainly be a boon for managers.

It will be interesting to see how this "seismic shift" in allowing retail access to VA related services will impact Intermediaries in the coming days. Opening up an entirely new sector and revenues streams can only be a positive development for the industry as a whole. On balance, the safeguards the regulators have built around this nascent market are, in my view, measured and sensible.