Earlier this month, the Hong Kong Securities and Futures Commission (SFC) published two highly-anticipated circulars providing guidance to intermediaries engaging in tokenised securities-related activities (Tokenised Securities Circular), and on the tokenisation of SFC-authorised investment products (Investment Products Circular) (together, Circulars).
These Circulars, along with other initiatives taken by the Hong Kong government (including the new Virtual Asset Trading Platform licensing regime which became effective on 1 June 2023) signifies Hong Kong’s efforts to embrace financial innovation using distributed ledger technology (DLT) and to foster a responsible regulatory environment for the sector.
The focus on tokenisation corresponds with the growing global interest in tokenising traditional financial instruments and expanding these products to retail. Over the past year, powerful financial institutions such as JP Morgan, Citi and BlackRock have voiced their ambition in this space commencing work on various tokenisation projects.
The key points in these Circulars are below.
See-through Principle
Deviating from its 2019 Statement which regarded all security tokens as "complex products" requiring enhanced investor protections, SFC now explicitly adopts a "see-through" approach to tokenised investment products. SFC said in their Tokenised Securities Circular:
...the nature of Tokenised Securities are fundamentally traditional securities with a tokenisation wrapper, the existing legal and regulatory requirements governing the traditional securities markets continue to apply to Tokenised Securities.
This reflects a significant change of position for SFC. It means that the distribution and marketing of Tokenised Securities will no longer be strictly limited to professional investors (so called PI-only restriction), as required in the 2019 Statement.
SFC instructs intermediaries to adopt the see-through approach and:
... determine whether a Tokenised Security is complex or not by assessing the underlying traditional security...
However, the offerings of Tokenised Securities to the Hong Kong public will continue to be subject to SFC's public offering regimes, which prescribes prospectus and other documentary and procedural requirements.
SFC has also noted that existing conduct requirements for securities-related activities will apply to the distribution of or advising on Tokenised Securities, management of funds investing in Tokenised Securities and secondary market trading of Tokenised Securities on licensed Virtual Asset Trading Platforms.
SFC's guidance for Tokenised Securities
In the Tokenised Securities Circular, SFC has set out considerations for intermediaries choosing to engage in Tokenised Securities-related activities. Some of them are:
Managing new risks: intermediaries should manage new risks created by tokenisation in relation to ownership (e.g. how ownership interests are transferred and recorded) and technology (e.g. forking, network outages and cybersecurity risks, depending on the type of DLT network used);
Issuance of Tokenised Securities: where intermediaries issue Tokenised Securities which they also intend to deal in or advise on (e.g. fund managers of tokenised funds), they remain responsible for the overall operation of the tokenisation arrangement, even if they have entered into outsourcing arrangements with third parties.
Dealing in, advising on, or managing portfolios investing in Tokenised Securities: intermediaries should conduct due diligence on the issuers and their third party vendors / service providers, as well as the features and risks arising from the tokenisation arrangement. They should be satisfied that adequate controls are in place to before engaging in any of these activities; and
Disclosure: intermediaries should make adequate disclosures to clients of material information (including risks) specific to Tokenised Securities.
SFC considers that some securities that utilise DLT are not traditional financial instruments "wrapped" in a token - rather, they are complex products called Digital Securities, on the basis that they are likely to be bespoke in nature, terms and feature. Digital Securities should generally not be offered to retail investors.
SFC's guidance for other tokenised investment products
The Investment Products Circular separately sets out SFC’s considerations for tokenisation of other investment products (i.e. SFC-authorised investment products) for offering to the Hong Kong public. It is worth noting that SFC requirements for Tokenised Securities will also apply to the tokenisation of SFC-authorised investment products.
Applying the same “see through” approach, SFC will allow primary dealing of tokenised SFC-authorised investment products provided that the underlying product meets certain product authorisation requirements, for example:
Having in place a sound tokenisation arrangement;
Making clear and comprehensive disclosure in offering documents of a tokenised SFC-authorised investment product;
Only regulated intermediaries (e.g. licensed corporations or registered institutions) can distribute tokenised SFC-authorised investment products.
Staff competence; and
Prior consultation with SFC will be required for tokenisation of existing SFC-authorised investments and the introduction of new investment products with tokenisation features.
Meanwhile, driven by investor protection concerns, SFC has adopted a more prudent stance regarding the secondary trading of SFC-authorised investment products. SFC believes further consideration is required in order to provide investor protection on a substantially similar level to those provided for non-tokenised products. SFC flagged a few considerations including maintenance of proper and instant token ownership record, readiness of trading infrastructure and market participants to support liquidity, and fair pricing of tokenised products.
What's next?
The Circulars provide welcome guidance to intermediaries in relation to tokenisation of traditional financial instruments. It is clear that SFC will expect intermediaries to closely engage with them prior to embarking on any activities in relation to tokenised products. Apparently undeterred by the recent JPEX scandal, the Hong Kong government is pressing ahead with a regulated approach to protect consumers, foster a better innovation environment for crypto business, and to regain its status as Asia's crypto hub.
By Steven Pettigrove, Michael Bacina and Jake Huang