November 2023
Earlier this month, the Hong Kong Securities and Futures Commission (SFC) issued two circulars on tokenization-related activities: on intermediaries engaging in tokenized securities-related activities and the tokenization of SFC-authorized investment products. Announced during Hong Kong FinTech Week, these circulars provide regulatory clarity and give guidance to SFC-licensed intermediaries on new risks arising from the use of tokenization technology. They also set the expectations for investor protections.
Key Takeaways:
● The HK SFC is supportive of intermediaries tokenizing securities and offering them to retail investors, provided the risks are managed. The circular on intermediaries aims to provide regulatory certainty to support continued innovation and investor protection.
● SFC is supportive of tokenization of SFC-authorized retail investment products (i.e. retail funds and structured products) for primary dealing via subscription and redemption, but will reserve its position on secondary trading of these products for the time being.
Circular on intermediaries engaging in tokenized securities-related activities
Classification and Compliance Requirements
The SFC classifies “Tokenized Securities” as a subset of “digital securities”, which are defined as securities that utilize DLT or similar technology. Because they are traditional securities with a tokenization wrapper, existing traditional securities markets regulations will apply, including distribution, dealing, advising and fund management activities.
As tokenized securities introduce new technology (i.e. forking, blockchain network outages, cybersecurity risks) and ownership risks (how Tokenized Securities ownership interest is transferred and recorded), the SFC mandates that intermediaries should manage these risks in compliance with existing regulatory requirements. The circular highlights that issuing bearer form (i.e. self-custodial) permissionless tokens on public-permissionless DLT networks may result in heightened cybersecurity risks, with higher exposures to ML and KYC issues relative to tokenized securities in registered form.
Operational and Disclosure Requirements
Intermediaries substantially involved in the issuance of tokenized securities are responsible for the overall operation of the tokenization arrangement, with consideration for the ownership and technology risks as outlined above. Intermediaries that deal in, advise on, or manage portfolios investing in tokenized securities should conduct due diligence on issuers and third-party
providers.
Adequate disclosures should be provided to clients, including on-chain or off-chain settlement finality, any transfer limitations, smart contract audits, administrative controls, and custodial arrangements, as applicable.
Retail Access and Compensation Arrangement
Digital securities that are not tokenized securities are likely complex products and cannot be offered to retail investors. They may include tokenization of fractionalized interests in real world or digital assets (e.g. artwork or land), or a profit sharing arrangement different from traditional securities. Tokenized securities, on the other hand, do not require a PI-only (professional investors only) restriction.
Virtual Asset Trading Platforms (VATPs) licensed by the SFC must implement a compensation arrangement to cover the potential loss of security tokens, subject to SFC approval.
Circular on tokenization of SFC-authorized investment products
“Product Providers” of SFC-authorized, tokenized investment products are responsible for the management and operational soundness of the arrangement, and for recordkeeping. Product Providers “should not use public-permissionless blockchain networks without additional and proper controls”, which could be done by using a permissioned token. They should have at least one competent staff to manage the ownership and technology risks.
Offering documents should provide disclosures on settlement finality, ownership presentation, and risks. The distributors of these investment products should be regulated intermediaries, including SFC-licensed corporations or registered institutions.
Prior consultation with the SFC is required for both new and existing investment products. For details on Hong Kong’s latest virtual asset guidelines, please refer to CCI’s Insight Report here.
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