Key takeaways from Hong Kong Fintech Week

Hong Kong Fintech Week 2023 saw several new policy and regulatory announcements by the Financial Services and the Treasury Bureau (the FSTB), the Securities and Futures Commission (the SFC) and the Hong Kong Monetary Authority (the HKMA).  The key developments are summarised below:

  1. The SFC issued a circular on tokenised securities-related activities that provides guidance to licensed intermediaries in addressing and managing risks arising from the use of this technology.
  2. The SFC issued a second circular setting out the requirements under which it would consider allowing tokenisation of SFC-authorised investment products for a retail offering in Hong Kong.
  3. The HKMA also announced various initiatives to strengthen Hong Kong’s fintech capabilities, including: (a) the launch of “FPS x PromptPay QR Payment” which links Hong Kong’s faster payment system (FPS) with Thailand’s PromptPay; (b) further collaboration with market participants to explore additional use cases for distributed ledger technology (DLT) in capital markets; and (c) completion of Phase 1 of the e-HKD Pilot Programme.
  4. The FSTB keynote included announcements relating to: (a) the launch of a new integrated fund platform (IFP) to be operated by the Hong Kong Stock Exchange (HKEX), to cover the front-to-back distribution life cycle of retail funds; (b) the launch of cross-boundary e-CNY applications to benefit cross-border travellers; and (c) promotion of real economy applications of virtual assets (VAs) and further development of the VA regulatory framework, including the stablecoin licensing regime and regulation of off-exchange VA trading activities.

SFC guidance on engaging in tokenised securities-related activities and tokenisation of SFC-authorised investment products

On 2 November 2023, the SFC issued two circulars, one  to provide guidance to intermediaries engaging in tokenised securities-related activities (the Tokenised Securities-Related Activities Circular) and the other to address the tokenisation of SFC-authorised investment products (the Tokenised Investment Products Circular).

These circulars supplement the SFC and HKMA’s joint circular issued on 20 October 2023 (the Joint Circular) which provided updated guidance to intermediaries conducting VA activities (previous blog post here).  The Joint Circular applies to activities related to VAs that do not constitute “securities” or “futures contracts” under the Hong Kong regulatory regime, whereas the Tokenised Securities-Related Activities and Tokenised Investment Products Circulars provide guidance for tokenised products that are classified as “securities”.

Part 1: Tokenised Securities-Related Activities Circular

A. Tokenised Securities and Digital Securities

Seeing increased activity in (and recognising the potential benefits of) the tokenisation of traditional financial products, the SFC considered it timely to issue guidance to licensed intermediaries seeking to operate in this space.  The SFC recognises that there is no accepted taxonomy – but essentially, it considers that tokenisation generally involves recording claims on assets onto a programmable platform rather than a traditional ledger.

For the purpose of the Tokenised Securities-Related Activities Circular, the SFC distinguishes between:

  • Tokenised Securities:  Tokenised securities are traditional financial instruments (e.g. bonds or funds) which utilise DLT or similar technology in their lifecycle (Tokenised Securities). Fundamentally, they are traditional securities with a tokenisation wrapper.  As a result, they are characterised as “securities” under the Securities and Futures Ordinance (the SFO); and
  • Digital Securities:  Tokenised Securities are a subset of a broader set of digital securities that utilise DLT or similar technology in their lifecycle (Digital Securities). Digital Securities which may be structured in more bespoke, novel or complicated forms, with some existing exclusively on a DLT-based network with no links to extrinsic rights or underlying assets and having no controls to mitigate the risks that ownership rights may not be accurately recorded.  This may include tokenisation of fractionalised interests in real world or digital assets, such as artwork or land, in a manner different from a traditional fund but such that the arrangement would amount to a collective investment scheme.

B. New risks arising from tokenisation

  • The SFC emphasised that existing legal and regulatory regimes governing traditional securities will apply, such as the licensing and financial promotions regimes under the SFO, the prospectus regime under the Companies (Winding up and Miscellaneous Provisions) Ordinance (C(WUMP)O) and the SFC’s conduct requirements applicable to intermediaries’ providing services related to securities (e.g. distribution, brokerage, advisory or asset management services).
  • However, given the new risks unique to Tokenised Securities, such as ownership risks (e.g., how ownership relating to the Tokenised Securities is transferred and recorded) and technology risks (e.g., forking, blockchain network outages and cybersecurity risks), intermediaries should also implement measures to manage new risks unique to Tokenised Securities.
  • Risks vary depending on whether the DLT network used is private-permissioned, public-permissioned or public-permissionless. Intermediaries should address risks unique to each type of DLT network by implementing adequate controls.  For example, compared to Tokenised Securities in registered form, there are higher cybersecurity and money laundering risks for Tokenised Securities in bearer form issued using permissionless tokens on public-permissionless networks.

C. Considerations for engaging in Tokenised Securities-related activities

The SFC will require intermediaries to consider the following when engaging in Tokenised Securities-related activities.

  • When issuing or being substantially involved in the issuance of Tokenised Securities, intermediaries:
    • remain responsible for the overall operation of the tokenisation arrangement (notwithstanding any outsourcing arrangements);
    • must perform due diligence on the underlying product being tokenised as well as the Tokenised Securities, including the experience and track record of service providers involved in the tokenisation arrangement, and understand the legal and regulatory issues and the technical and the business continuity planning (BCP) aspects associated with the Tokenised Securities;
    • must assess the features and risks of the Tokenised Securities when selecting appropriate custodial arrangements;
    • for Tokenised Securities in bearer form issued using permissionless tokens on public-permissionless networks, consider additional factors when selecting appropriate custodial arrangements, including the proposed custodian’s systems and controls, operational capabilities, financial resources and internal governance1; and
    • where applicable, comply with the requirements set out in the Tokenised Investment Products Circular (see update below).
  • When dealing in, advising on, or managing portfolios that invest in Tokenised Securities, intermediaries should:
    • conduct due diligence on issuers and service providers involved in the tokenisation arrangement, and the features and risks arising from such arrangement and be satisfied that the ownership and technology risks of the Tokenised Securities have been managed.2

D. Disclosure requirements

  • Intermediaries should disclose material information specific to the Tokenised Securities to clients in a clear and comprehensible manner.  This includes whether on-/off-chain settlement is final, whether a smart contract audit has been conducted prior to deployment, the limitations on transfers of Tokenised Securities, the controls and BCP for DLT related events, such as cyberattacks, network failure and forks, and the custodial arrangements.

E. Clarifications regarding SFC’s previous Statement on Security Token Offerings

  • As part of the Tokenised Securities-Related Activities Circular, the SFC also clarified and revised certain previous statements in relation to security token offerings.  By way of reminder, in March 2019, the SFC issued the “Statement on Security Token Offerings” circular inwhich it stated that security tokens are classified as “complex products” as well as mandating additional investor protection measures (Complex Product Requirements).  In addition, the SFC had mandated that security tokens should only be offered to professional investors (PIs).  The SFC has now moved away from this approach and has softened some of the requirements as set out below. 

(1) Complex product categorization

  • Since Tokenised Securities are fundamentally traditional securities, intermediaries can adopt a see-through approach when assessing whether a Tokenised Security is a “complex product”.  The analysis of whether a Tokenised Security is a complex product is dependent on the complexity of the underlying product3 rather than the fact that it has been tokenised.
  • As a result, a tokenised plain vanilla bond will be classified as a non-complex product and distributors will be subject to existing regulatory requirements that govern distribution of securities.

(2) PI-only restriction

  • The previous PI-only restriction imposed on Tokenised Securities will no longer apply.  However, intermediaries should still comply with the financial promotion and the prospectus regimes under the SFO and the C(WUMP)O, such that no offer of investment products can be made to the Hong Kong public unless such offer is authorised or exempt (e.g., an offer made to PIs only).  

(3) Other clarifications

  • Fund managers managing portfolios which invest in Tokenised Securities and meet the “de minimis threshold”4 will not be subject to the additional terms and conditions imposed by the SFC, unless the portfolios also invest in non-security VAs meeting the “de minimis threshold”. However, fund managers managing portfolios which invest in Tokenised Securities should comply with the requirements set out in the Tokenised Securities-Related Activities Circular.
  • Under the Guidelines for Virtual Asset Trading Platforms, an SFC-licensed VA trading platform operator (a VATP) should implement a compensation arrangement approved by the SFC to cover the potential loss of security tokens.   The SFC has clarified that it may, on application by a VATP and on a case-by-case basis, exclude certain Tokenised Securities from the required coverage.

Part 2:  Tokenised Investment Products Circular

A. Background

  • Tokenisation of investment products refers to the creation of blockchain-based tokens that represent ownership in an investment product.  The tokenised investment product can be recorded digitally on the blockchain, offered to end-investors, distributed by intermediaries or traded among the blockchain participants where permitted.
  • In response to market demand and to facilitate market development, the SFC considers it appropriate to allow primary dealing of tokenised SFC-authorised investment products, provided that providers of such products (Product Providers) can ensure that the underlying products meet all applicable product authorisation requirements and additional safeguards to address risks associated with the tokenisation arrangement.
  • However, the SFC adopts a more cautious approach in relation to secondary trading of tokenised SFC-authorised investment products and will continue to engage with market participants on proper measures to ensure the same level of investor protection to those investing in a non-tokenised investment product.  The considerations include maintaining proper and instant token ownership records, ensuring the readiness of the trading infrastructure and market participants to support liquidity and fair pricing of the tokenised products.

B. Requirements for primary dealing of tokenised SFC-authorised investment products 

  • Product Providers should comply with the requirements in the Tokenised Securities-Related Activities Circular and additional requirements including:  
    • Tokenisation arrangement – Product Providers remain responsible for, and upon SFC’s request should be able to demonstrate, the management and operational soundness of the tokenisation arrangement adopted and record keeping of ownership and the integrity of smart contracts.  In addition, they should implement measures to manage risks associated with cybersecurity, data privacy, system and public-permissionless blockchain networks.
    • Disclosure – The offering documents of a tokenised SFC-authorised investment product should set out clearly the tokenisation arrangement and the associated risks and the ownership representation of the tokens.
    • Intermediaries – Distributors of tokenised SFC-authorised investment products (including Product Providers who distribute their own products) should be regulated by the SFC and comply with existing requirements concerning investor protection and the conduct requirements set out in the Tokenised Securities-Related Activities Circular.
    • Staff competence – Product Providers should have at least one competent member of staff with relevant experience and expertise to operate and/or supervise the tokenisation arrangement and to manage risks relating to ownership and technology appropriately.

Prior consultation or approval

  • Intermediaries should notify and consult with the SFC or HKMA (if applicable) in advance if they intend to:
  1. engage in any activities involving Tokenised Securities;
  2. seek the SFC’s authorisation for new investment products that have tokenisation features; and
  3. tokenise existing SFC-authorised investment products, as such change may require the SFC’s prior approval.

Part 3: HKMA initiatives to strengthen Hong Kong’s fintech capabilities

On 2 November 2023, the HKMA announced various fintech related updates and initiatives, including:

  • e-HKD Pilot Programme:  The HKMA has completed Phase 1 of the e-HKD Pilot Programme and published an overall assessment of the pilot programme and the way forward.
  • Tokenisation in the bond market:  The HKMA is collaborating with market participants to explore further use cases for DLT in capital markets, including a second tokenised government green bond.
  • FPS x PromptPay QR payment:  The HKMA and the Bank of Thailand will link Hong Kong’s FPS to Thailand’s PromptPay and launch a new service called “FPS x PromptPay QR Payment” in December 2023.

The HKMA also announced a number of positive developments under its “Fintech 2025” strategy (announced in June 2021):

  • All banks go fintech:  The HKMA has implemented initiatives to proactively encourage fintech adoption in the banking industry, including Wealthtech, Insurtech, Greentech, Artificial Intelligence and DLT.
  • Central Bank Digital Currencies (CBDCs):  The HKMA has achieved a number of milestones in the phased development of wholesale CBDCs.  Project mBridge is now at the minimum viable product (MVP) development phase and the HKMA aims to launch the MVP next year to pave the way for a production-ready system.
  • Commercial Data Interchange (CDI): CDI, the HKMA’s next-generation financial data infrastructure promoting the development of a data-driven economy, launched in October 2022 and the utilisation rate has increased significantly.  The HKMA is exploring how it can be used to further digitalise and streamline various banking processes, such as KYC, and is working closely with the Insurance Authority to enable cross-sectoral data sharing.  By the end of 2023, the Companies Registry will become the first government data source to be connected to CDI via the government’s Consented Data Exchange Gateway.
  • Expanding the fintech-savvy workforce:  The HKMA is working to foster fintech talent in Hong Kong through initiatives including the Fintech Career Accelerator Scheme and the Industry Project Master’s Network.
  • Nurturing the fintech ecosystem with funding and policies:  The Fintech Supervisory Sandbox (FSS) 3.0 and FSS 3.1 Pilot offer funding support to fintech projects, as well as ongoing reforms relating to VAs and stablecoins.

Part 4:  FSTB initiatives to foster co-development of fintech and real economy

On 2 November 2023, the FSTB announced various initiatives, including:

  • Launch of a new IFP:  The new IFP will target the retail fund sector, covering the front-to-back distribution life cycle and value chain. The IFP, operated by HKEX, will serve as a communication hub, a business platform, and an information portal and is proposed to better serve investors, fund managers, distributors and other stakeholders within the ecosystem.
  • Cross-boundary e-CNY applications to benefit inbound and outbound visitors between the Mainland and Hong Kong:  Subject to regulatory approval and technical readiness, Octopus Cards Limited will provide an inbound solution facilitating Mainland tourists’ use of e-CNY in Hong Kong via a tourist mobile application.
  • Promoting real economy related applications and innovations by VAs and Web3.0:  
    • Market participants are encouraged to explore the potential of the underlying technologies of Web3.0 to empower and enable real economy related applications and innovations. 
    • The HK SAR Government intends to expand the regulatory remit to cover the buying and selling of VAs that take place outside of VA trading platforms (e.g., OTC trading services).
    • The widely anticipated consultation on the stablecoin legislative proposal is due to be published shortly. 
    • Industry consultation on banks’ provision of digital asset custodial services to ensure client assets are adequately safeguarded and that associated risks are adequately managed is being conducted.

If you would like to discuss, please contact Etelka Bogardi (etelka.bogardi@nortonrosefulbright.com) or Conrad Lam (conrad.lam@nortonrosefulbright.com).

1 For further details, please refer to the list of factors in Part A of the Appendix.

2 For further details, please refer to the list of factors in Parts A and B of the Appendix.

3 See Chapter 6 of the Guidelines on Online Distribution and Advisory Platforms, paragraph 5.5 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission and https://www.sfc.hk/en/Rules-and-standards/Suitability-requirement/Non-complex-and-complex-products.

4 The de minimis threshold refers to a situation where either: (a) the stated investment objective of a fund is to invest in non-security VAs or (b) the intention of a fund is to invest 10% or more of its gross asset value in non-security VAs.