The Hong Kong Securities and Futures Commission (HK SFC) published a circular that sets forth the requirements for authorizing the public offerings of investment funds that have an exposure to virtual assets of over 10% of net asset value (NAV).
Background
In October 2022, the Hong Kong SFC began accepting applications for exchange-traded funds (ETF) that obtain exposure to virtual assets (“VA”) via futures contracts. The June 2023 licensing regime of virtual asset trading platforms (VATPs) additionally enabled Hong Kong investors to directly access large-cap spot VA. This circular outlines the requirements for SFC-authorized funds to gain both direct and/or indirect exposure to virtual assets. Additional requirements may also be applicable according to the Joint Circular on intermediaries’ VA-related activities. As a reminder, CCI has provided a summary of two HK SFC circulars on tokenization-related activities issued in November 2023, regarding intermediaries and SFC-authorized investment products..
Requirements for SFC-authorized VA Funds
In addition to the applicable existing requirements, the circular establishes additional requirements, which are summarized below:
Management
Companies managing SFC-authorized VA funds should have a good track record of regulatory compliance and at least one staff member with relevant experience in the management of VA products.
VA Eligibility
SFC-authorized VA funds should only invest in VA tokens that are accessible to the Hong Kong public on SFC-licensed VATPs.
Investment Strategy
Only VA futures that are traded on conventional regulated futures exchanges are allowed. The management company has to demonstrate that 1) the VA futures have sufficient liquidity, and ii) the roll costs are manageable and how they will be managed.
SFC-authorized VA funds should not have leveraged exposure to these assets at the fund level. Active management is expected for funds that adopt a futures-based investment strategy.
Transactions and Direct Acquisitions of Spot VA
SFC-authorized spot VA ETFs are expected to acquire and dispose of spot VA through SFC-licensed VATPs. Participating dealers for in-kind subscriptions are expected to transfer spot VA to SFC-authorized spot VA ETF custody accounts at SFC-licensed VATPs or at authorized institutions, and vice-versa for in-kind redemptions. Both in-kind and in-cash subscriptions and redemptions are allowed for VA ETFs.
Participating dealers for ETFs investing in spot VA should be SFC-licensed or registered and subject to conditions imposed by the Licensing Department where applicable.
Custody
The trustee/custodian of an SFC-authorized VA fund should only delegate its VA custody from time to time, to a SFC-licensed VATP or an authorized financial institution that meets the VA custody standards.
The trustee/custodian should a) ensure asset segregation, b) store most of the VA holdings in a cold wallet–hot wallet storage should be minimized, except to meet subscription and redemption demands, c) ensure the secure storage of the seeds and private keys in Hong Kong, with restricted access only to authorized personnel. These seeds and private keys should be sufficiently resistant to speculation and collusion, and be properly backed up to avoid single points of failure.
Valuation
The management companies of SFC-authorized VA funds should adopt an indexing approach to determine the valuation of spot VA, based on trading volume across major platforms. This may include a benchmark index published by a reputable provider that reflects a significant share of trading activities of the underlying VA.
Disclosure and Investor Education
The offering documents should disclose investment limits and key risks related to the funds’ VA exposures. The product key facts statement (KFS) should contain disclosures including price risk, custody risk, cybersecurity risk, and fork risks, as well as roll costs and operational risks for investments in VA futures.
Application and Prior Consultation
Prior consultation is required for funds with, or intending to have over 10% NAV exposure to VA that wish to be authorized by the HK SFC.
CCI’s Take
In addition to existing crypto futures ETFs, which became available roughly a year ago in Dec 2022 on the Hong Kong Stock Exchange, this announcement is obviously very timely, as the anticipation of spot Bitcoin ETFs have been growing for the past few months, given the tremendous amount of institutional interests globally. As a digital asset hub, Hong Kong has been very welcoming to the crypto industry and would potentially be one of the first to approve a spot crypto ETF by a developed financial market. These products will be available to retail investors, subject to suitability, minimum information and virtual asset knowledge test, as applicable.
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