Requirements For SFC Authorised Funds With Exposure To Virtual Assets

Demand for funds with exposure to virtual assets has been increasing in Hong Kong and as a result, the Securities and Futures Commission (SFC) has introduced new regimes that provide for the offering of certain virtual asset products to the Hong Kong public, provided the appropriate investor protection safeguards can be met.

In October 2022, the SFC started to accept applications for ETFs that have exposure to virtual assets primarily through futures contracts, and in June 2023, the SFC’s licencing regime for virtual asset trading platforms (VATPs) became effective, enabling Hong Kong investors to directly invest in large cap spot virtual assets, subject to certain eligibility requirements.

At the end of last year, on December 22, 2023, the SFC issued a new circular (SFC Circular) which significantly relaxed the previous approach to virtual asset ETFs and other funds with exposure to virtual assets. The key effect of the SFC Circular is to expand the scope of virtual asset ETFs that are eligible for authorisation by the SFC. Previously, only virtual asset ETFs, the underlying assets of which were Bitcoin futures and Ether futures traded on the Chicago Mercantile Exchange (CME), could be authorised.

In this article, we look at the requirements applicable to a fund that wishes to be authorised to (i) invest directly in the same spot virtual asset tokens which are already accessible to the Hong Kong public for trading on SFC licenced VATPs (referred to as direct exposure), and/or (ii) acquire indirect investment exposure to such virtual assets through, for example, futures traded on a regulated futures exchange or other exchange traded products (referred to as indirect exposure).

General Requirements

As a general matter, a fund applying to be approved as an SFC-authorised fund permitted to invest in virtual assets must meet the applicable requirements in both the (i) Overarching Principles Section of the SFC Handbook for Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted Structured Investment Products and (ii) Code on Unit Trusts and Mutual Funds (CUTMF).

Additional requirements as set out in the SFC Circular, together with certain relevant requirements set out in the joint circular (Joint Circular) issued by the SFC and the HKMA also on December 22, 2023, must also be satisfied.

Investment Strategy

An SFC-authorised virtual asset fund (SFC AVAF) should only invest, whether directly or indirectly, in virtual asset tokens that are accessible to the Hong Kong public for trading on SFC licenced VATPs, and an SFC AVAF must not have any leveraged exposure to virtual assets at the fund level.

The SFC Circular does allow an SFC AVAF to have exposure to virtual asset futures, but such futures must be traded on a conventional regulated futures exchange, and the management company of such SFC AVAF must demonstrate that the relevant virtual assets futures have adequate liquidity with manageable roll costs. If an SFC AVAF adopts a primarily futures-based investment strategy, it is expected to adopt an active investment strategy that allows flexibility in portfolio composition, rolling strategy, and the handling of any market disruption events.

Indirect exposure to eligible virtual assets via other exchange traded products is subject to applicable requirements in the CUTMF, and any other requirements which may be imposed by the SFC.

Transactions And Acquisitions Of Spot Virtual Assets

Transactions and acquisitions of spot virtual assets by an SFC AVAF should be conducted through SFC licenced VATPs, authorised financial institutions (AIs) such as banks or the subsidiaries of locally incorporated authorised financial institutions (Local AI Subs), in accordance with any applicable requirements of the HKMA.

For in-cash subscriptions and redemptions, SFC authorised spot virtual asset ETFs should acquire and dispose of spot virtual assets through SFC licenced VATPs, either on or off platform. For in-kind subscriptions, participating dealers should transfer spot virtual assets to SFC authorised spot virtual asset ETFs’ custody accounts held with an SFC licenced VATP, AI, or Local AI Sub. When handling in-kind redemptions, the process is reversed.

Both in-cash and in-kind subscriptions and redemptions are permitted for SFC authorised spot virtual asset ETFs. For ETFs that invest in spot virtual assets, their participating dealers should be SFC licenced corporations or registered institutions, and subject to such additional terms and conditions as may be imposed by the SFC.

Custody

The trustee or custodian of an SFC AVAF should only delegate its virtual asset custody function to an SFC licenced VATP, AI, or Local AI Sub, which meets the expected standards for virtual asset custody issued by the HKMA from time to time. 

The trustee or custodian (and any delegate responsible for taking custody of virtual asset holdings of an SFC AVAF) should ensure that (i) there is segregation between those virtual asset holdings and its own assets, as well as any assets it holds for other clients; (ii) it stores most of the virtual asset holdings in a cold wallet and minimises the amount of virtual assets held in a hot wallet; and (iii) seeds and private keys are securely stored in Hong Kong (this would include being tightly restricted to authorised personnel, sufficiently resistant to speculation or collusion, and properly backed up to mitigate any single point of failure).

Management Companies And Service Providers

The management company of an SFC AVAF should have a good track record of regulatory compliance and at least one competent staff member with relevant experience in the management of virtual assets or related products. The SFC’s licencing department may also impose additional terms on such management companies. Management companies should confirm that all necessary service providers (such as fund administrators, participating dealers, and market makers) are professionally competent and able to support the SFC AVAF.

Valuation Of Spot Virtual Assets

When valuing spot virtual assets, the management company of an SFC AVAF should adopt an indexing approach based on virtual asset trade volume across major virtual asset trading platforms (ie a benchmark index published by a reputable provider that reflects a significant share of trading activities in the underlying spot virtual asset).

Disclosure And Investor Protection

The offering documents (including the product key facts statement (KFS)) of an SFC AVAF should disclose the investment objectives and limits and key risks related to the fund’s virtual asset exposures. Those risks may include (i) price risk, custody risk, cybersecurity risk, and fork risk, for investments in spot virtual assets; and (ii) potentially large roll costs and operational risks for investments in virtual asset futures.

Distribution

Amongst other matters, the Joint Circular makes it clear that virtual asset related products will likely be considered complex products, and that intermediaries distributing virtual asset related products considered to be complex products will generally be required to comply with the SFC’s requirements on the sale of complex products.

Most notably, there will be a need to ensure the suitability of virtual asset related products, regardless of whether the intermediary has solicited or recommended that its client invests in the product. The Joint Circular also imposes two additional investor protection measures on the distribution of virtual asset related products to address specific risks related to those products:

1. Restrictions on sale: Subject to certain exceptions (discussed below), the Joint Circular provides that virtual asset related complex products should only be offered to professional investors (PIs).
2. Virtual asset knowledge test: Intermediaries must assess whether clients (other than institutional PIs and qualified corporate PIs) have knowledge of investing in virtual assets or virtual asset related products prior to effecting a transaction in virtual asset related products on their behalf. Where a client does not have such knowledge, the intermediary may only proceed with a transaction if it has provided sufficient training to the client on the nature and risks of virtual assets, and the client has sufficient net worth to bear potential losses from trading virtual asset related products.

However, the restrictions on sale in point 1 above will not apply to an SFC AVAF, subject to intermediaries complying with the following:

• For an SFC AVAF listed and traded on the Hong Kong Stock Exchange (SEHK), client orders can be executed on exchange without the need to comply with the suitability requirement or minimum information and warning statements requirements, providing that there has been no solicitation or recommendation by the intermediary.
• For an SFC AVAF that is not listed, or for a listed SFC AVAF where trading occurs off exchange, intermediaries should comply with the suitability requirements, and the minimum information and warning statement requirements set out in the Joint Circular, as well as undertaking the virtual asset knowledge test set out above on the clients concerned.

The Joint Circular also reminds intermediaries that where an SFC AVAF is also a virtual asset derivative fund, an intermediary also needs to comply with the requirements for derivative products set out in the Joint Circular.

Lastly, to assist intermediaries in determining whether an investment product with exposure to virtual assets is complex (and the corresponding selling requirements that may apply to the product), the Joint Circular includes a flowchart which sets out the relevant factors and the corresponding selling requirements.

Gavin Cumming
Mr. Cumming joined the firm in 2005 and has day-to-day responsibility for the firm’s non-contentious financial services practice. He is recognized by AsiaLaw Leading Lawyers as a leading lawyer in financial services regulation. Mr. Cumming has broad and deep experience in corporate, commercial and tax matters with a particular focus on strategic and operational initiatives of asset managers, investment banks, private banks and other wealth managers, insurance companies, broker-dealers and market infrastructure operators. He has a wealth of experience in electronic trading and clearing systems, the formation of private funds, including hedge funds and private equity funds, capital raising for funds, the authorization of public funds for sale to the retail public, private equity portfolio transactions, change of control transactions involving regulated financial institutions, and ongoing compliance issues for regulated financial institutions.