Hong Kong Virtual Asset Fund Managers – Current State of Play

April 19, 2023

Introduction

The current regulatory requirements in Hong Kong with regards to managing funds that invest in "virtual assets" ("VA") can be summarized as follows – if an asset manager has a licence from the Hong Kong Securities and Futures Commission (“SFC”) to conduct Type 9 regulated activity (asset management) (“Type 9 Licence”) and that licensed manager intends to (a) manage funds (or portions of funds) that invest in VA and such investment is a stated investment objective; or (b) invest 10 percent or more of the gross asset value of its portfolio in VAs ("Criteria"), it would be required to apply to the SFC to “upgrade” its Type 9 Licence. At the time of writing, we understand that around 10 SFC asset managers have successfully "upgraded" their Type 9 Licence ("VA Fund Managers") – Dechert Hong Kong's market-leading team has involved in four of those VA Fund Managers with their upgrade applications.

“VA” are defined as digital representations of value, which take the form of digital tokens (e.g., digital currencies, utility tokens or asset-backed tokens); any other virtual commodities; and crypto assets or other assets of essentially the same nature, irrespective of whether they may be deemed “securities” or “futures contracts” as defined in the Securities and Futures Ordinance (Chapter 571 of the Laws of Hong Kong) (“SFO”).

As part of the application to “upgrade” its Type 9 Licence, a licensed manager would be required to enter into standard form terms and licencing conditions issued by the SFC, the “Proforma Terms and Conditions for Licensed Corporations, which Manage Portfolios that Invest in Virtual Assets”¹ (“VA Fund Manager T&Cs”), with minor variations depending on the business model. The VA Fund Manager T&Cs are imposed on all upgraded VA fund managers and are substantially similar to the SFC’s Fund Managers Code of Conduct ("FMCC"), but adapted specifically for VA Fund Managers and business operations applicable to VA Fund Managers.

If a fund manager with a Type 9 Licence manages funds (or portions of funds) that invest in VA that do not meet either Criteria, the manager would not be required to "upgrade" its licence ("De Minimis Exemption"), but would nevertheless be required to notify the SFC of its intention to manage such VA funds and that it falls within the De Minimis Exemption.

VA Fund Managers responsible, or to which responsibility has been delegated, for the overall operation of a fund but who do not conduct discretionary account management are only subject to certain of the VA Fund Manager T&Cs.

VA Fund Managers that (i) conduct discretionary account management (in the form of an investment mandate or a pre-defined model investment portfolio) and (ii) receive management fees and/or performance fees as remuneration for managing the discretionary accounts ("VA Discretionary Account Managers") are subject to additional requirements that are set out in Appendix 1 of the VA Fund Manager T&Cs.

VA Fund Manager T&Cs – Summary of Key Terms

Summarized below some of the key responsibilities of VA Fund Managers under the VA Fund Manager T&Cs.

A VA Fund Manager should:
General Principles	Comply with general principles similar to the SFC's Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission.
Organization and Management Structure	Maintain an effective organization and management structure to: (a) handle conflicts of interest; and (b) ensure sufficient human and technical resources, manage risk and maintain compliance policies. Maintain a minimum liquid capital of the greater of: (a) HK$3 million (approximately US$382,000) or (b) the variable required liquid capital (5 percent of adjusted liabilities as calculated in accordance with the Securities and Futures (Financial Resources) Rules). Appoint an independent compliance officer and draft detailed compliance procedures. Comply with requirements relating to segregation of duties and senior management responsibilities.
VA Fund Management	Carry out investment transactions within each fund’s mandate and execute fund orders on the best available terms. Only participate in underwriting activities on behalf of a fund if specifically permitted in the fund’s mandate, and credit all commissions and fees received under such contract to the fund’s account. When participating in an initial offering, ensure that the allocation received in the offering provides for a fair allocation among the funds that it manages and that preferential allocations are prohibited. Comply with requirements relating to: order allocation; connected person transactions; house accounts; disclosure of leverage; and liquidity management.
Custody	Segregate fund assets from the VA Fund Manager’s proprietary assets. Select and adopt the most appropriate custodial arrangement, taking into account the characteristics of different arrangements. Appoint independent custodians and take steps to ensure that the custodians are capable of performing their functions. Where self-custody is adopted, ensure the following: the reasons for adopting self-custody are properly documented; appropriate safeguards are implemented; records are properly maintained; the licensed corporation’s own assets can be effectively segregated from VAs in the event of insolvency of the licensed corporation; adequate insurance is maintained to cover the crypto assets; and proper disclosure is made to investors regarding the risks associated with such arrangements.
Operations	Appoint an independent auditor to perform audits of financial statements, taking into account (among other matters) the auditor's experience and capability to check the existence and ownership, and ascertain the reasonableness of the valuation, of the relevant VAs. Exercise due care in selecting valuation principles, methodologies, models and policies, which are reasonably appropriate in the circumstances and in the best interests of the investors, and make proper disclosures to such investors. Comply with requirements relating to: recordkeeping; disclosure and management of side pockets; net asset value calculation; and pricing and reconciliations.
Dealing with the Fund and Fund Investors	Provide investors with adequate information and updates regarding any material changes to enable them to make an informed decision about their investments (including the trading platforms and custodians used by the fund, and key risks associated with the fund’s investment in VAs). Maintain proper procedures to ensure confidentiality of information and handling of complaints.
Marketing Activities	Offer VA funds only to "Professional Investors"2 as defined under the SFO. Ensure representations made to investors and all marketing materials are accurate and not misleading.
Marketing Activities Fees and Expenses	Disclose the basis and amount of their fees and charges (which should be fair and reasonable). Receive soft dollars and cash rebates only under prescribed circumstances.
Reporting to the SFC	Report to the SFC as soon as practicable any actual or suspected noncompliance with the VA Fund Manager T&Cs or any other applicable legal and regulatory requirements. Notify the SFC of any significant change in its business activities at least seven business days before the change takes place. Provide such other information as may be requested by the SFC promptly and in an open and cooperative manner. Ensure that all information provided to the SFC is accurate and not misleading.

Additional Requirements Applicable to Virtual Asset Discretionary Account Managers

VA Fund Managers that are also VA Discretionary Account Managers are subject to certain provisions of the VA Fund Manager T&Cs relevant to discretionary account management, as well as additional requirements set out in Appendix 1 of the VA Fund Manager T&Cs.

Appendix 1 also sets out the following additional requirements applicable to VA Discretionary Account Managers: (i) minimum content requirements of discretionary client agreements; and (ii) the additional requirements that are summarized below.

A VA Fund Manager should:
Target Clients	Prior to providing discretionary account management to clients, assess whether those clients have: knowledge regarding investment in VAs; prior investment experience in private equity or venture capital; or provided capital for a start-up business.
Suitability	Conduct due diligence to ensure the mandate or pre-defined model investment portfolio is suitable for each client. Review the mandate or pre-defined model investment portfolio on a regular basis and recommend revisions where suitable for client’s current circumstances. Document the relevant assessment and provide the assessment rationale to the client in writing.
Client Agreements	Set out in discretionary client agreements the precise terms and conditions under which discretion will be exercised. Meet the minimum content requirement of discretionary client agreements, as set out in Appendix 1 of the VA Fund Manager.
Performance Review and Valuation Reports	Review the performance of discretionary accounts against agreed benchmarks at least twice a year, unless otherwise agreed with the client. Provide valuation reports to clients within 10 business days after the monthly accounting period, unless otherwise agreed with the client.

Contravention of the VA Fund Manager T&Cs is likely to reflect adversely on the fitness and properness of a VA Fund Manager or VA Discretionary Account Manager, and may result in disciplinary action by the SFC. The SFC has said it will adopt a pragmatic approach when implementing the VA Fund Manager T&Cs, taking into account all relevant circumstances, including the size of the VA Fund Manager or VA Discretionary Account Manager, as the case may be, as well as any compensatory measures implemented by their senior management.

Upgrade Application Process

A fund manager who is applying for a Type 9 Licence or an existing Type 9 Licence fund manager who wishes to upgrade its existing licence ("Upgrade Applicant") is required to inform the SFC if it plans to manage one or more funds that invest in VAs, subject to the De Minimis Exemption. Once it receives this information, the SFC will first seek to understand the Upgrade Applicant's business activities. If the Upgrade Applicant appears to be capable of meeting the expected regulatory standards, the proposed VA Fund Manager T&Cs will be provided to the Upgrade Applicant (where applicable) and the SFC will discuss them with the Upgrade Applicant and vary them in light of its particular business model so as to ensure that they are reasonable and appropriate.

In practice, an Upgrade Applicant will be required to complete a questionnaire that covers, among others, the considerations (set out below). This should enable the SFC to determine whether the Upgrade Applicant is able to comply with the VA Fund Manager T&Cs. Then there will likely be several rounds of questions and queries from the SFC on the responses in the questionnaire, often resulting in a call or meeting with the SFC. A successful Upgrade Applicant will then be required to agree and comply with the VA Fund Manager T&Cs, which will be imposed as a licensing condition.

From our experience and understanding from the market, this application process can take any time from six months to over a year, depending on various factors including the Upgrade Applicant's responsiveness, the complexity of the application and the proposed key terms of the funds, the ability to demonstrate the Upgrade Applicant's willingness and capability to comply with the VA Fund Manager T&Cs, amongst other things.

Key Upgrade Application Considerations

We have set out below some key considerations for an Upgrade Applicant when submitting its application. These are in addition to those set out in the VA Fund Manager T&Cs:

Management Experience: Generally, similar to a traditional SFC licence application, one or more key personnel (ideally the existing or the proposed responsible officer of the Upgrade Applicant) should have three or more years of work experience in the relevant regulated activity, in this case, managing VA and VA funds (subject to some exceptions). It will be difficult to demonstrate the Upgrade Applicant's ability to properly manage VA funds in a regulated context without such experience.
Trading Platforms: It is generally expected that all the counterparties of the VA fund and the VA Fund Manager, including the trading platform used by the VA fund for trading of VAs, should be appropriately regulated by an internationally recognized regulator in the relevant jurisdiction.
Custodian: Similar to the requirements for trading platforms, a custodian of the VA of a VA Fund should be appropriately regulated by an internationally recognized regulator in the relevant jurisdiction. The Upgrade Applicant should also demonstrate that the proposed custodian has appropriate cybersecurity and financial ability to safeguard the VAs owned by the VA fund.
Fund Administrator: Fund administrators that the VA fund proposes appointing should have sufficient experience, capability and expertise in dealing with similar VA funds. In particular, the administrator should have capability in dealing with valuation of VAs. Engaging an experienced fund administrator prior to the launch of the VA fund would help make the launch smoother, as the administrator would be able to provide practical advice in relation to the launch and the terms of the VA fund.
Auditor: Similar to traditional fund administrators, the auditors that the VA fund proposes to appoint should have sufficient experience, capability and expertise in dealing with similar VA funds.
Cybersecurity: Generally, the cybersecurity arrangement of the Upgrade Applicant should be upgraded such that it closes any gaps between the existing arrangement of the Upgrade Applicant and the terms set out in the VA Fund Manager T&Cs. Having an IT consultant would help identify and close any such gaps to ensure compliance, as well as ensuring that the VA Fund Manager, upon approval, is less susceptible to cybersecurity vulnerabilities and hacking in relation to its VAs.
Types of Assets: At present, the VA fund terms that have been vetted by the SFC (as part of an Upgrade Applicant’s submission) have only allowed investments in coins, on a ‘long’ basis, with high liquidity and market capitalization, meaning that the investment universe is restricted. The market understands that there are VA funds that can also enter into certain derivative instruments with traditional financial instruments for leveraged transactions, hedging and shorting. We have also recently assisted a client such that their VA funds can engaging in staking with appropriately licensed platforms. It remains to be seen whether the SFC is ready to accept applications that propose investments in other types of instruments and with more "crypto-native" features, such as initial coin offerings, simple agreements for tokens (SAFT), VC-type funds, OTC derivatives and on-exchange derivatives with VA trading platforms (centralized or decentralized), non-fungible tokens (NFTs), redemption/ subscription in VAs, etc.
Risk Management: The Upgrade Applicant should put in place risk management policies, process and procedures that are commensurate with the types of VA funds an applicant proposes to manage. For example, the risk management approach for an actively managed VA fund would be different (and likely more extensive) from that of a passively managed index tracking VA fund.

Conclusion

Looking at the developments of the Hong Kong laws and regulations in relation to VAs, including the VA Fund Manager T&Cs regime, it is encouraging to see that the Hong Kong Government has lived up to its pledge to open up the virtual asset industry to provide Hong Kong with a competitive edge as a virtual asset hub in the Asia region. Hong Kong has developed a wide array of licensing and regulatory regimes which allows VA industry players to navigate the market in confidence.