Opening the door for retail Investors: SFC-authorized virtual asset funds

On 22 December 2023, the Hong Kong Securities and Futures Commission (SFC) issued a circular on SFC-authorized funds with exposure to virtual assets (the Circular).¹ The Circular was issued in response to recent market trends and supersedes the Virtual Asset Future Exchange Traded Funds circular issued on 31 October 2022. The Circular shows the authorities’ readiness to adjust their regulatory approach in light of market developments and their willingness to authorize for public offering in Hong Kong investment funds with exposure of more than 10 percent of their net asset value to virtual assets²(VA).

Updated policy

The SFC is now open to applications for authorization of funds that either:

(i) Directly invest in the same spot VA tokens accessible to the Hong Kong public for trading on SFC-licensed virtual asset trading platforms (VATPs) (i.e. direct exposure); and/or

(ii) Gain indirect exposure to such VA (e.g., through futures traded on regulated futures exchanges and other exchange-traded products).

These SFC authorized funds are collectively referred to as "VA Funds". The main updated requirements when authorizing VA Funds are summarized below:

Management companies

A VA Fund's management company should have a good track record of regulatory compliance and employ at least one skilled individual with experience in managing VA or related products. It must comply with the terms and conditions for licensed corporations or registered institutions managing portfolios investing in VAs. The previous requirement for the management company to show a minimum of three years' experience in managing exchange traded funds (ETFs) has been removed.

Eligible underlying VA

SFC-authorized VA Funds should only invest (either directly or indirectly) in VA tokens that are accessible to Hong Kong public for trading on SFC-licensed VATPs.

Investment strategy

VA Funds can invest directly or indirectly in eligible VA tokens, subject to the following requirements:

·     VA Funds should not have leveraged exposure to VA at the fund level.

·     In relation to investment in VA futures, only those traded on traditional regulated futures exchanges are permitted. The restriction that investments must be Bitcoin and Ether futures traded on the Chicago Mercantile Exchange has been removed.

·     Indirect exposure to eligible VA through other exchange-traded products must comply with the UT Code³ and other SFC requirements.

SFC-authorized VA Funds primarily using a futures-based investment strategy are expected to employ an active investment approach. This allows for flexible portfolio composition (e.g. diversifying futures positions with various expiry dates), rolling strategy, and management of potential market disruptions. The previous limitation that a VA Futures ETF’s net derivative exposure should not exceed 100 percent of the ETF’s total net asset value has been removed.

Transactions and direct acquisitions of spot VA

SFC-authorized VA Funds should perform spot VA transactions and acquisitions via SFC-licensed VATPs or authorized financial institutions (AIs) (or subsidiaries of locally incorporated AIs) in compliance with the Hong Kong Monetary Authority’s (HKMA) requirements. Specifically:

·     Spot VA ETFs should use SFC-licensed VATPs for cash-based subscriptions and redemptions.

·     For in-kind subscriptions, participating dealers should transfer spot VA, whether held locally or overseas, to the custody accounts of SFC-authorized spot VA ETFs with SFC-licensed VATPs or AIs. The process is reversed for in-kind redemptions.

Both in-kind and cash-based subscriptions and redemptions are permitted for SFC-authorized spot VA ETFs.

Participating dealers for ETFs investing in spot VA should be:

(i) SFC-licensed corporations or registered institutions; and

(ii) Comply with additional terms and conditions set by the SFC, if applicable.

Custody

SFC-authorized VA Fund trustees/custodians can only delegate VA custody to SFC-licensed VATPs or AIs meeting HKMA standards. They must segregate VA holdings from their own and other clients' assets, store most holdings in a cold wallet, and ensure secure storage, restricted access, and backup of seeds and private keys in Hong Kong. The amount and duration of VA holdings stored in the hot wallet should be minimized as much as possible, save for meeting the needs of subscriptions and redemptions.

Valuation

Management companies of SFC-authorized VA Funds should use an indexing approach for spot VA valuation, based on VA trade volume across major trading platforms. This means using a benchmark index from a reputable provider that reflects a significant portion of the underlying spot VA trading activities.

Service providers

Management companies must ensure that all required service providers, including fund administrators, participating dealers, market makers, and index providers, are competent, available, and prepared to support the SFC-authorized VA Funds.

Disclosure

SFC-authorized VA Funds' offering documents and key facts statements (KFS) should disclose investment limits and key risks tied to VA exposures. The KFS should contain upfront disclosure of the investment objectives and key risks associated with the funds’ VA exposures, such as, including price, custody, cybersecurity, and fork risks for spot VA, and roll costs and operational risks for VA futures.

Significance

The SFC's continuous monitoring of the VA market and regulatory landscape reflects its determination to lead secure and forward-thinking cryptocurrency investment market advancements in Asia and establish Hong Kong as a pacesetter in the global regulatory landscape for cryptocurrency. It reinforces the risk-based regulatory approach while catering to the growing demand for regulated cryptocurrency asset exposure amongst investors.

Footnotes

1) Circular on SFC-authorized funds with exposure to virtual assets | Securities & Futures Commission of Hong Kong.

2) “Virtual asset” as defined in section 53ZRA of the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO).

3) The UT Code being the Code on Unit Trusts and Mutual Funds in the SFC Handbook for Unit Trusts and Mutual Funds.