Interpretation of Hong Kong's SFC New Rules: Bitcoin / EthereumSpot ETF Will Be Approved Soon?

Compiler: Blog Post, Bailu Lounge

On 22 December, the SFC’s official website published the Circular on SFC-Authorised Funds Involving Virtual Assets, replacing the Virtual Asset Futures ETF Circular issued on 31 October 2022. **

At the same time, it is pointed out that for virtual assets (such as Bitcoin, Ethereum) that are allowed to be traded on licensed trading platforms, licensed institutions can issue and manage corresponding spot ETFs, and subscribe and redeem them in kind and cash on licensed trading platforms or recognized financial institutions. **

The following is a compilation of the full text:

This circular sets out the requirements to be met by the Securities and Futures Commission (SFC) when considering the authorisation of investment funds1 involving virtual assets. Under sections 104 and 105 of the Securities and Futures Ordinance, a fund publicly offered in Hong Kong (a virtual asset fund authorized by the SFC) has a net asset value (NAV) of more than 10%.

This circular supersedes the Virtual Asset Futures ETF Circular dated 31 October 2022.

Background

Globally, the virtual asset (VA) landscape has been evolving rapidly. Retail and professional investors now have access to a wider range and greater number of investment products that provide value-added exposure, including exchange-traded funds (ETFs) that are linked to value-added risk in key overseas markets, and these products are becoming increasingly popular. Demand for these products has also increased in Hong Kong.

In light of these developments, the SFC has introduced a regime to allow the sale of certain VA service products to the Hong Kong public subject to appropriate investor protection measures. For example, in October 2022, the Hong Kong Securities and Futures Commission began accepting applications for ETFs that primarily obtain VA exposure through futures contracts. The SFC’s virtual asset trading platform (VATPs) licensing regime also came into effect in June 2023, enabling Hong Kong investors to gain direct access to large spot VAT subject to certain eligibility requirements and robust investor protection measures.

This circular sets out that SFC-authorized funds are required to (i) invest directly in the same Spot VA Token that the Hong Kong public can trade on SFC-licensed VATPs; and/or (ii) obtain indirect investment in such VA, for example, through futures traded on conventional regulated futures exchanges and other exchange-traded products.

SFC requirements for authorised virtual asset funds

A VA fund authorised by the SFC should comply with the applicable requirements under the “Umbrella Principles” and the “Code on Unit Trusts and Mutual Funds” and the Code on Unit Trusts and Mutual Funds (UT Code) in the SFC’s Handbook for Unit Trusts and Mutual Funds, Investment-Linked Guarantee Schemes and Code on Unlisted Structured Investment Products. And;

The additional requirements listed below, as well as those in the Joint Notice on Activities Related to Virtual Assets of Intermediaries (Joint Notice), should be met.

Management Company

The management company of an SFC-authorized VA fund should have (i) a good regulatory track record and (ii) at least one qualified staff member with relevant experience in managing VA or related products.

The management company of a VA fund authorized by the SFC is subject to additional terms and conditions imposed by the Department of Licensing (if applicable).

Eligible virtual assets

SFC-authorised VA funds should only invest (directly or indirectly) in VA Tokens that are tradable by the Hong Kong public on the SFC-licensed VA trading platform in Hong Kong.

Investment Strategy

SFC-authorized VA funds may invest directly or indirectly in eligible VA Tokens in accordance with the requirements set out below.

For VA futures, only those traded on traditional regulated futures exchanges are permitted, but the management company must demonstrate that (i) the relevant VA futures have sufficient liquidity and (ii) the rolling costs of the relevant VA futures are manageable, and how these rolling costs are managed.

Indirect exposure to eligible VAs through other exchange-traded products is subject to the applicable requirements in the UT Code and other requirements that may be imposed by the SFC.

SFC-authorised VA funds should not have leveraged exposure to VAs at the fund level.

For SFC-authorised VA funds that predominantly adopt futures investment strategies, an active investment strategy is required to achieve portfolio flexibility (e.g. diversification of futures positions with multiple expiration dates), rollover strategies and to deal with any market disruptions.

Spot trading and direct acquisition of virtual assets

Spot VA transactions and acquisitions by SFC-authorized VA funds should be conducted through SFC-licensed VAs or authorized financial institutions (or subsidiaries of locally incorporated authorized institutions) and comply with the regulatory requirements of the Hong Kong Monetary Authority (HKMA). Especially:

(a) for cash subscription and redemption, it is expected that Spot VA ETFs authorized by the SFC will acquire and sell Spot Appreciation Transactions through an SFC-licensed value-added trading platform (on-platform or off-platform); and

(b) For physical subscription, Participating Dealers are required to transfer Spot VA held locally or overseas to an SFC-authorized Spot VA ETF in custody on a SFC-licensed VA trading platform or an authorized institution (or a subsidiary of a locally registered authorized institution). This process is the opposite of redemption in kind.

Spot VA ETFs authorized by the SFC can be subscribed and redeemed in kind and in cash.

For ETFs that invest in spot VA, their responsible persons should be (i) SFC licensed corporations or registered institutions, and (ii) subject to additional terms and conditions (if applicable) imposed by the Licensing Department.

Guardianship

The trustee/custodian of a VA fund authorised by the SFC should only delegate its VA custody functions (if applicable) to (i) SFC-licensed value-added service end customers, or (ii) an authorized institution (or a subsidiary of a locally registered authorized institution) that meets the VA custody standards issued by the HKMA from time to time.

The trustee / custodian and any grantee responsible for the custody of VA shares held in a VA fund authorized by the SFC should comply with the following requirements:

(a) should ensure that VA Holdings’ own assets are kept separate from those held for other clients;

(b) The majority of VA should be stored in Cold Wallet. The amount of VA holdings stored in the hot wallet and the holding period should be minimized for subscription and redemption;

© ensure that the mnemonic phrase and Private Key are securely stored in Hong Kong, (ii) are strictly restricted to authorized persons only, (iii) are sufficient to resist speculation (e.g. by generating in an uncertain manner) or collusion (through measures such as Multisig and Secret KeySharding), and (iv) appropriate backups to mitigate the risk to any individual individual.

Rating

For the valuation of Spot VA, the management company of an SFC-authorised VA fund should use an indexation method based on VA trading volume on major VA trading platforms (i.e. a benchmark index published by a reputable provider that reflects a significant share of underlying Spot VA trading activity).

Service Providers

The manager should confirm that all required service providers (e.g. fund managers, PDs, market makers and index providers) are sufficiently competent to provide support to SFC-authorised VA funds at any time.

Disclosure and investor education

The offering documents (including product highlights) of SFC-authorized VA funds should disclose the investment limits and key risks associated with VA risk.

The KFS of an SFC-authorized VA fund should disclose in advance the investment objective and the key risks associated with the VA exposure, such as:

(a) price risk, custody risk, cybersecurity risk and fork risk of Spot VA;

and (b) the potentially significant rolling costs and operational risks of VA futures investments (such as margin risk and risks associated with related party enforcement measures).

Management companies of SFC-authorised VA funds are required to conduct investor education prior to product launch in accordance with the existing requirements of the UT Code.

distribution

Please refer to the requirements set out in the Joint Circular in relation to the distribution of intermediaries and SFC-authorised VA funds.

Miscellaneous

In carrying out its functions, the SFC may consider introducing additional requirements or conditions that it considers necessary or appropriate.

Application & Advance Consultation

Subject to paragraph 29, the above requirements do not apply to schemes (including transferable securities scheme funds) and schemes under mutual recognition of funds (MRF) in recognised jurisdictions.

Prior SFC approval is required for (i) funds that have or intend to own VA exposure in excess of 10% of their Net Asset Value and wish to seek SFC authorisation, or (ii) existing SFC-authorized funds that intend to acquire more than 10% of their Net Asset Value 10%.