The SFC issued a statement to clarify its regulatory approach in relation to non-fungible tokens and remind investors of related risks.

By Simon Hawkins, Farhana Sharmeen, Adrian Fong, Gen Huong Tan and Shirley Wong

On 6 June 2022, the Hong Kong Securities and Futures Commission (SFC) issued a statement drawing attention to the risks associated with investing in non-fungible tokens (NFTs) and summarising the legal and regulatory requirements applicable to NFTs.

This follows recent guidance from Hong Kong’s banking, securities, and insurance regulators to financial institutions looking to undertake virtual asset activities (see Latham’s Client Alert Hong Kong’s New Crypto Regulatory Framework to Facilitate Greater Institutional Participation). Together, the statement and guidance demonstrate that the regulators are continuing to look closely at the digital asset space.

NFTs are digital assets based on a blockchain that can be used to represent an underlying digital item or asset. They differ from other blockchain-based digital assets such as cryptocurrency, which is fungible in nature and can be used for payment purposes. Instead, NFTs that are fully functional upon issuance are usually created to be unique, digital collectible items (though the potential use cases for NFTs extend far beyond this model).

The SFC observed that the majority of NFTs appear to be genuine digital representations of collectibles, and such NFTs do not fall within the SFC’s regulatory remit. However, the SFC noted that some NFTs cross the boundary between a digital collectible and a financial asset (e.g., fractionalised or fungible NFTs).

If NFTs are structured with features similar to regulated financial products like securities or interests in collective investment schemes (i.e., an arrangement in property with delegated management and where contributions and profits are pooled), then such NFTs may fall within the ambit of the Hong Kong Securities and Futures Ordinance (SFO) as well as the SFC’s regulatory purview.

In particular, persons dealing in such NFTs may be conducting a regulated activity under the SFO for which they would need to be licensed by the SFC (unless a statutory licensing exemption applies). Product authorisation requirements may also be triggered if these NFTs are offered to the Hong Kong public, along with related prospectus and disclosure requirements.

Against the backdrop of crypto markets experiencing a significant period of correction, the SFC reminded investors that NFTs are exposed to heightened risks including illiquid secondary markets, volatility, opaque pricing, hacking, and fraud — and that they should not invest in NFTs if they cannot understand such risks or bear potential losses.

The SFC is not the only regulator in the region to turn its attention to NFTs. The SFC’s statement follows similar statements and guidance issued by other regulators in Asia. For example, in Singapore, in a Parliamentary Reply dated 15 February 2022, the Senior Minister and Minister in charge of the Monetary Authority of Singapore (MAS) noted that if an NFT had the characteristics of a capital markets product (such as a collective investment scheme) under the Securities and Futures Act, then it would fall within the MAS’ regulatory remit and would be subject to existing prospectus, licensing, and business conduct requirements. The MAS also reminded consumers that investments in digital tokens, including NFTs, are not suitable for retail investors.

Meanwhile, the National Internet Finance Association of China, the China Banking Association, and the Securities Association of China issued a joint statement (available in Chinese only) on 13 April 2022 prohibiting, amongst other actions, any securitisation of NFTs, and NFTs linked to underlying securities, bonds, or other financial assets.

In light of the SFC’s statement and similar statements in other jurisdictions, companies issuing, marketing, or dealing in NFTs (including NFT issuers, marketplaces, custodians, and blockchain gaming operators) should assess how their NFTs are characterised. In particular, such companies should assess whether their NFTs have characteristics of securities or other financial instruments.

If the NFT arrangement has special features (e.g., fractionalisation, revenue-bearing, redemption rights, or liquidity pool features) that may increase the risk of triggering financial services laws and regulations, the firm should ensure that its activities and the offering are structured in a way that is compliant with the Hong Kong and other relevant legal and regulatory framework.