Compliance Best Practices for Virtual Asset Fund Managers in Hong Kong
“Virtual assets” means digital representations of value which may be in the form of digital tokens (such as digital currencies, utility tokens, stablecoins or security- or asset-backed tokens), any other virtual commodities, crypto assets or other assets of essentially the same nature, irrespective of whether or not they amount to “securities” or “futures contracts” as defined under the Securities and Futures Ordinance (“SFO“).
In this publication, we discuss the regulatory landscape in Hong Kong, focusing specifically on the Securities and Futures Commission (“SFC”) guidelines for virtual asset fund managers, as outlined in the Proforma Terms and Conditions for Licensed Corporations which Manage Portfolios that Invest in Virtual Assets (subsequently referenced in this publication as “Terms and Conditions” or “T&Cs”).
Virtual asset fund managers (“VAFM”)[1] in Hong Kong operate in an evolving regulatory landscape that requires them to comply with various rules and regulations.
The T&Cs is designed to promote investor protection and mitigate risks associated with virtual assets (“VA”), which are still a relatively new and rapidly evolving asset class and gaining mainstream acceptance.
PDF version: Compliance Best Practices for Virtual Asset Fund Managers in Hong Kong
To ensure compliance with these rules, the SFC from time-to-time issues guidelines for entities dealing in VA.
Pursuant to the T&Cs, regulated firms under Type 9 (“RA9“) intending to invest 10% or more of their gross asset value (“GAV”) in VA (the “de minimis requirements”) must notify the SFC of their investment objective to invest in VA and must comply with the principles and requirements (where applicable) of the T&Cs.
Terms and Conditions for Virtual Asset Fund Managers Management
The T&Cs set out the principles and requirements that VAFM must comply with when managing portfolios (or portions of portfolios) that invest in VA and meet the de minimis threshold. These T&Cs are imposed on VAFM as a licensing condition and any contravention could be regarded as misconduct under the SFO which will reflect adversely on the fitness and properness of a VAFM to remain licensed and may result in disciplinary action by the SFC.
In relation to the scope of application of the T&Cs, some commentators suggest that the T&Cs may only apply to the management of funds with direct investment in VA. Hence, if a fund invests in the share capital of a VA company, such fund may not subject to the T&Cs.
Outlined below are principles and requirements that VAFMs should comply with as stipulated in the T&Cs:
General Principles
Operate within principles which include:
- Honesty and fairness
- Diligence and capability
- Avoidance of conflicts of interest
- Proper safeguarding of, and accounting for client assets
- Provision of clear and timely disclosures
- Compliance with legal and regulatory requirements
- Senior management responsibility for appropriate conduct and procedures
These principles are similar to SFC’s Code of Conduct for Licensed Persons and aim to promote the best interests of investors and the integrity of the market.
Organization and Management Structure
i) Operate in a sound, efficient, and effective manner and maintain effective management and organizational structure, financial and human resources, and sufficient internal controls, compliance procedures, risk management governance structure, and adequate insurance cover
ii) Maintain a minimum liquid capital of the greater of:
- HK$3 million; and
- the variable required liquid capital (5% of adjusted liabilities as calculated in accordance with the Securities and Futures (Financial Resources) Rules).
This requirement applies where the fund manager holds client assets, aligning with the SFC’s objectives to ensure recovery of client assets, as the risks of holding non-securities or futures virtual assets for managed portfolios are comparable to the risks associated with holding client money or client securities.
iii) Have and implement comprehensive compliance and risk management policies and procedures which address all applicable regulatory requirements, in addition to an independent compliance officer.
Virtual Asset Fund Management
i) Ensure that transactions align with the fund’s investment mandate and are executed on best available terms.
ii) Ensure equitable allocation of VA received in an initial offering among the funds it manages, prohibit preferential allocations, and keep records of intended and actual allocation and reasons.
iii) Should not engage in underwriting activities unless permitted by the fund mandate, and any fees or commissions received should be credited to the fund account.
iv) Ensure compliance with applicable requirements relating to order allocation, portfolio turnover, connected person transactions, cross trades, operational control, house accounts, leverage, termination, risk and liquidity management.
Custody
i) Ensure that any fund assets entrusted to it are segregated, accounted for properly and safeguarded.
ii) Assess and select the most appropriate custodial arrangement for holding VA based on factors such as accessibility and security and document the reasons for selecting its custodial arrangements.
iii) Implement effective policies and procedures, select and monitor capable independent custodians, consider appointing multiple custodians, and acquire adequate insurance coverage to ensure the safety of assets.
iv) Ensure a formal custody agreement is in place with specified duties and liabilities, and monitor compliance on an ongoing basis.
v) Properly disclose the custodial arrangements, intended distribution of assets, material risks, and any significant changes to fund investors, and also disclose the existence and risks of self-custody arrangements, additional safeguards, and insurance coverage details if applicable.
Operations
i) Establish valuation policies, procedures, and due diligence in selecting valuation services. Regularly review asset valuation and periodically review policies with independent third party.
ii) Ensure experienced, capable and independent auditor is appointed to perform an annual audit of the financial statements of the fund. Fund investors can request the audit report which shall be prepared in compliance with generally accepted accounting principles and fund constitutive documents, while VAFMs must ensure counterparties provide required information to the fund’s auditor.
iii) Ensure compliance with applicable requirements relating to record keeping, side pockets, reconciliations and net asset value calculation and pricing.
Dealing with the Fund and Fund Investors
i) Provide sufficient information about its business and any material changes upon request. This includes information about the trading platforms, custodians used, and key risks associated with the fund’s investment in VA.
ii) Ensure compliance with applicable requirements relating to confidentiality and handling of client complaints.
Marketing Activities
i) Only allow professional investors[2] to invest in their funds and establish measures to ensure the fund is only distributed to professional investors if using distributors.
ii) Ensure that all representations made, or information supplied to the fund, investors, or distributors are accurate and not misleading. All advertisements and marketing materials should be clear, fair, and present a balanced picture of the fund with adequate risk disclosures, contain timely and consistent information with the fund’s offering document, and only include performance claims that can be verified.
Fees and Expenses
i) Disclose to the fund and investors the amount and basis of its fees and charges. All fees and charges must be fair and reasonable and characterized by good faith.
ii) Receive soft dollars and rebates only if they are beneficial to the fund, consistent with best execution standards, with written consent from the fund, and disclosed periodically.
Reporting to the SFC
i) Report to the SFC as soon as practicable upon the any actual or suspected material non-compliance with the T&Cs or any applicable regulatory requirements.
ii) Notify the SFC of any significant change in its business activities, at least 7 business days before the change takes place.
iii) Provide any information requested by the SFC on a periodic or ad hoc basis, in a prompt, open and cooperative manner.
iv) Ensure all information provided to the SFC is complete, accurate, and not misleading, and promptly inform the SFC if it becomes aware that any information provided does not meet this requirement.
Requirements for VAFMs Conducting Discretionary Accounts
Appendix 1 of the T&Cs set out the additional requirements applicable to VAFMs who shall manage discretionary accounts.
Some of the key requirements are:
Target Clients
- Only engage with professional investors (“PIs”), which include individual, corporate, and institutional professional investors as defined in Section 1 of Part 1 of Schedule 1 of the SFO and the Securities and Futures (Professional Investor) Rules.
- Assess whether clients have knowledge or experience in investing in VA or related investment exposure such as venture capital investments. In the situation where the client lacks knowledge or experience, the manager can only proceed if it’s in the client’s best interest.
Suitability
- Ensure that the investment portfolio is suitable for the client based on their personal circumstances, document their assessment, and give a copy to the client. They must also ensure the total amount invested in VA is reasonable based on the client’s net worth.
- Regularly check the mandate or investment portfolio they’ve created for a client, at least once a year, and whenever there are significant market changes. They should consider the client’s current situation and suggest any necessary changes to the investment portfolio. They should document the reasons for their recommendations and share them with the client in writing.
Client Agreements
- Have a written agreement (Discretionary Client Agreement) with a client before providing any services or making transactions on their behalf.
- Outline the terms and conditions of discretion and include certain minimum information as contained in Appendix 1 of the T&Cs.
Performance Review and Valuation Reports
- Review the performance of each discretionary account against agreed benchmarks, at least twice a year.
- Provide valuation reports to the client no later than 10 business days after accounting period or at such shorter intervals as provided in the Discretionary Client Agreement.
The following requirements do not apply to a Virtual Asset Discretionary Account Manager:
- Liquidity management tools and measures affecting redemption rights and explanation in offering documents
- Termination process requirements
- Side pocket arrangement requirements
- Audit of financial statements and accounting information in annual report for funds
- Valuation frequency and related disclosure requirements
- Net asset value calculation of different share classes requirements
However, a Virtual Asset Discretionary Account Manager should observe relevant requirements set out in the Discretionary Client Agreement. They should also observe other liquidity management principles based on the capital withdrawal policy in the agreement and relevant valuation provisions.
Minimum Content of Discretionary Client Agreement
The minimum content of a client agreement should include information on the following:
- Client’s full name and address, verified by official documents
- VA Discretionary Account Manager’s identifying information such as business name, address, licensing status, and CE number
- Appointment of the firm as VA Discretionary Account Manager and details of services provided
- Client’s investment policy and objectives, including proportion of asset classes and risk profile for pre-defined model portfolio
- Details of all fees to be paid by the client, including third-party fees
- Consent for receiving soft commissions or retaining cash rebates
- Custodial arrangement details, if applicable
- Details of periodic reporting to the client
- Risk disclosure statements
- Undertakings to notify the other party of any material changes in the agreement
Risk Management Control Techniques and Procedures
Market Risk
Establish effective risk management measures to quantify the impact of changing market conditions on the fund, covering all risk elements associated with it.
These measures should include estimating potential losses using an appropriate value-at-risk methodology and conducting stress testing to determine the effect of significant changes in market conditions on the fund.
Liquidity Risk
- Monitor liquidity mismatches and establish measures using quantitative metrics or qualitative factors.
- Establish procedures to alert staff responsible for liquidity management to potential default problems.
- Consider obligations to creditors, counterparties, and third parties, liquidation price, settlement time, and dependence on other market risks and factors.
Counterparty Risk
- Establish and maintain an effective credit assessment system to evaluate the creditworthiness of the funds’ counterparties.
- Limit the fund’s exposure to different counterparties, such as trading platforms and custodians. This can be achieved by using multiple custodians to hold the portfolio’s assets, reducing the risk of overconcentration.
Operational and Cybersecurity Risk
- Prioritize physical and functional segregation of incompatible duties, proper and timely accounting record-keeping, secure and reliable information systems, competent staffing, and prompt trading information reconciliation.
- Establish sufficient and suitable security measures for its systems, including techniques that preserve the confidentiality and integrity of information stored within and transmitted between internal and external networks, as well as operating controls that deter and identify unauthorized access, security breaches, and security attacks.
- Establish and maintain a business continuity and transition plan to address potential business disruptions or operational interruptions.
