A new guidance creates a regulatory framework for tokenisation of retail investment products and provision of services for tokenised financial instruments.
On 2 November 2023, the Securities and Futures Commission (SFC) issued two widely anticipated circulars on tokenisation during the 2023 Hong Kong FinTech Week.
One circular provides conduct-related guidance to intermediaries engaging in tokenised securities-related activities (Activities Circular). The other circular addresses the tokenisation of SFC-authorised investment products (Products Circular), such as retail investment funds.
Before the circulars were released, the SFC’s chief executive spoke of the regulator’s evolutionary rather than revolutionary approach to addressing digital asset-related activities. The circulars indeed reflect this gradual, incremental approach rather than a big-bang moment of regulatory change, and we expect market participants to welcome the SFC’s new guidance as some of them consider exploring tokenised products and services.
Tokenisation refers to the process of digitally representing an asset (or ownership of that asset) using distributed ledger technology (DLT) through the use of digital tokens. Popular examples of tokenised assets include tokenised financial instruments like bonds and funds and also other real-world assets like real property and artwork.
The SFC notes the potential benefits of tokenisation, including increasing efficiency, enhancing transparency, reducing settlement time, and lowering costs for traditional finance, but also recognises that the use of DLT can create additional risks. With the growing interest among intermediaries in tokenisation, the SFC has decided to provide additional guidance to the market.
The circulars follow the SFC and the Hong Kong Monetary Authority’s joint circular (Joint Circular) issued on 20 October 2023 providing updated guidance to intermediaries conducting virtual asset (VA) activities (see Latham’s Blog Post). The Joint Circular primarily applies to VAs that do not constitute securities or futures contracts. The Activities Circular and the Products Circular supplement the Joint Circular by providing guidance for tokens that constitute “securities” under the Hong Kong securities regime.
This blog post summarises the regulatory framework for tokenisation that the SFC has set out in the Activities Circular and the Products Circular.
With some intermediaries already conducting tokenisation-related activities (e.g., advising on tokenised securities, distributing and managing tokenised funds, and trading tokenised products), the SFC believes more guidance and regulatory clarity on tokenised securities-related activities is appropriate.
As a starting point, the SFC differentiates between:
- Tokenised securities: traditional financial instruments (e.g., bonds or funds) that are characterised as “securities” under Hong Kong securities law and which utilise DLT.
- Digital securities: a larger category of “securities” which utilise DLTs that may or may not be traditional financial instruments. Digital Securities that do not qualify under the narrower subset of Tokenised Securities are securities with no links to extrinsic rights or underlying assets and that have no controls to mitigate the risks that ownership rights may not be accurately recorded. An example that the SFC gave is fractionalised interests in real-world or digital assets such as artwork or land in a manner different from a traditional fund structure.
Since Tokenised Securities are fundamentally traditional securities with a tokenisation wrapper, the existing securities and prospectus regime will continue to apply. However, with new and heightened ownership and technology risks around Tokenised Securities because of the use of DLT networks, the SFC will require intermediaries to consider the following when engaging in Tokenised Securities-related activities:
- General principles: Intermediaries engaging in Tokenised Securities-related activities are expected to have the necessary manpower and expertise, as well as act with due skill, care and diligence, to understand the Tokenised Securities.
- Issuance of Tokenised Securities: Intermediaries issuing Tokenised Securities remain responsible for the arrangement, regardless of outsourcing to third party service providers. They should take into account risks such as the experience and track record of the service provider, understand the technical aspects of the Tokenised Securities (e.g., relevant smart contracts deployed, relevant DLT network selected, legal and regulatory status associated with the Tokenised Securities such as settlement finality and enforceability of rights pertaining to the Tokenised Securities) and consider appropriate custodial arrangements.
- Dealing in, advising on, or managing portfolios investing in Tokenised Securities: Intermediaries should conduct due diligence on the issuers and their service providers and be satisfied that the ownership and technology risks of the Tokenised Securities are effectively managed.
- Information for clients: Intermediaries should adequately disclose to investors relevant material information specific to Tokenised Securities, including method of settlement finality and the limitations/restrictions imposed on transfers of the Tokenised Securities.
- Complex product categorisation: Since Tokenised Securities are fundamentally traditional securities, a see-through approach can be adopted to look at the profile of the underlying asset in determining whether a Tokenised Security is a “complex product” for suitability purposes. This is a welcome shift in position from the SFC’s previous approach of treating all security tokens as “complex products” even if the underlying asset was a traditional financial instrument that would not be characterised as a “complex product”.
- Professional investor-only restriction: Previously, the SFC restricted the distribution of security tokens to professional investors only (i.e., non-retail investors). Given the nature of Tokenised Securities, the SFC believes imposing a mandatory professional investor-only restriction is no longer necessary. However, all securities offered to the Hong Kong public (including to retail investors) will need to continue to comply with the prospectus and securities regime.
- Fund managers managing portfolios which may invest in Tokenised Securities: Fund managers overseeing portfolios investing in Tokenised Securities meeting the “de minimis threshold” (i.e., the stated investment objective of a fund is to invest in non-security VAs or the intention of a fund is to invest 10% or more of its gross asset value in non-security VAs) will not be subject to additional terms and conditions, unless the portfolios also invest in non-security VAs meeting the “de minimis threshold”.
- Virtual asset trading platform operators (VATPs) licensed by the SFC and the applicable insurance/compensation arrangement: VATPs are required to implement a compensation arrangement approved by the SFC to cover the potential loss of security tokens. However, the SFC may exclude certain Tokenised Securities from the required coverage on a case-by-case basis if it can be demonstrated that the loss to clients can be effectively mitigated (e.g., through transfer restrictions or whitelisting).
Digital Securities-Related Activities
Intermediaries cannot offer Digital Securities to retail investors in breach of the securities and prospectus requirements. If such securities are distributed on an online platform, the platform must be properly designed and have appropriate access rights and controls to ensure compliance with selling restrictions. Since Digital Securities (which are not Tokenised Securities) have heightened risks and legal uncertainties, they are likely to be regarded as “complex products” in connection with suitability requirements.
To protect clients’ interests, intermediaries dealing in Digital Securities are reminded to implement appropriate additional internal controls to address the specific risks and unique nature of the Digital Security.
In Hong Kong, investment products offered to the Hong Kong public (including to retail investors) must be authorised by the SFC and are subject to stringent investor protection and disclosure requirements. Managers have shown interest in tokenising retail investment products by creating blockchain-based tokens that represent ownership in the investment product. Such tokens can theoretically be offered directly to end-investors, distributed by SFC-licensed intermediaries, or traded between blockchain participants.
The SFC currently believes that it is appropriate to allow primary dealing of tokenised SFC-authorised investment products (e.g., subscriptions and redemptions, and intermediaries can distribute such tokenised products to end-investors). However, it will need more time to consider permitting secondary trading of tokenised SFC-authorised investment products (e.g., permitting trading of such tokenised products on SFC-licensed trading platforms) because of concern over issues such as liquidity and fair pricing.
Investment product providers looking to engage in primary dealing of tokenised SFC-authorised investment products (Product Providers) will need to comply with the following requirements:
- Tokenisation arrangement: Product Providers are ultimately responsible for the management and operational soundness of the tokenisation arrangement, regardless of any outsourcing to third parties. They should ensure that proper records of token holders’ ownership interests in the product are maintained and the tokenisation arrangement is operationally compatible with service providers involved. They should also maintain appropriate policies to mitigate technology risks and not use public-permissionless blockchain networks without additional and proper controls. The SFC may require Product Providers to demonstrate the soundness of the arrangements, and obtain audits and legal opinions.
- Disclosure: The offering documents should disclose details about the tokenisation arrangement, including around how settlement occurs, the ownership rights represented by the token, and the risks involved.
- Intermediaries: Distributors of tokenised SFC-authorised investment products should be licensed by the SFC and comply with existing requirements (including around investor protection). They also would need to comply with the conduct requirements under the Activities Circular, described above.
- Staff competence: Product Providers should have at least one competent staff with relevant experience and expertise to operate and/or supervise the tokenisation arrangement and to manage the new risks relating to ownership and technology appropriately.
- Prior consultation or approval: Prior consultation with the SFC (and/or approval) is required before introducing tokenised products (whether for new products or to uplift existing products).
The SFC may provide further guidance or impose additional requirements for tokenised SFC-authorised investment products, if appropriate.
The Hong Kong government has set out its aim to develop the digital asset and Web3 sector in Hong Kong, including through promoting real economy-related applications and innovations by tokenisation of real-world and traditional financial assets. The SFC’s Activities Circular and Products Circular will facilitate this effort by creating a framework for intermediaries to engage in tokenisation-related activities.
In terms of regulatory approach, the SFC has continued to apply its principle of “same business, same risks, same rules”. The Activities Circular and Products Circular demonstrate the SFC’s incremental expansion of the regulatory regime to allow intermediaries to conduct more digital asset activities while imposing similar standards to the securities regime.
With this updated guidance, intermediaries looking to engage in tokenisation activities have a clear pathway to begin to assess potential business plans and use cases. In planning which products may be suitable for tokenisation, the SFC is clearly focused on ensuring the risks around settlement finality, enforceability of ownership, technology, and custody are appropriately understood, managed, and disclosed. Intermediaries will need to have a solid grasp of these matters before they can begin to conduct such activities.
Intermediaries interested in engaging in any activities involving any Digital Securities (including Tokenised Securities) or tokenised SFC-authorised investment products should notify and discuss their business plans with the SFC.