Lawyer interprets the legal attributes and compliance of NFT in Hong Kong

Attorney Deciphers the Legal Characteristics and Conformity of NFT in Hong Kong

Author: Lawyer Wu Wenqian

Editor: Techub News-Junge

Since the Hong Kong government began implementing the Web 3 policy last year, many NFT projects have wanted to develop in Hong Kong. However, many people say that there are currently no regulations regarding NFT in Hong Kong, so they believe that there is a greater risk of legal compliance and licensing. On the one hand, the Financial Secretary of Hong Kong, Paul Chan Mo-po, stated in a recent interview that if NFT has the nature of collective investment or securities, then approval from the Securities and Futures Commission is required for public sale. On the other hand, King Leung, the head of financial technology at InvestHK, has also stated that if NFT is not classified as a security in Hong Kong, then it will not be regulated by the Securities and Futures Commission, and NFT is completely legal in Hong Kong. This article aims to explore how to define whether NFT is compliant in Hong Kong and whether a license is required in Hong Kong.

The following content is for reference only and does not constitute legal advice.

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Is NFT considered a security?

According to the Securities and Futures Ordinance of Hong Kong, the definition of securities can be roughly divided into the following categories:

(a) Shares, stock units, warrants, bond units, funds, bonds or notes;

(b) Rights, options, and interests in shares, stock units, warrants, bond units, funds, bonds or notes;

(c) Certificates of rights or interests in shares, stock units, warrants, bond units, funds, bonds or notes, participation certificates, temporary certificates, medium-term certificates, receipts, or warrants;

(d) Interests in collective investment schemes;

(e) Interests, rights, or property commonly referred to as securities;

(f) Structured products.

The above criteria apply similarly to determining whether a general token is considered a security.

The categories (a), (b), (c), (e) are relatively easy to distinguish. In simple terms, if an NFT (or token) is linked to a company/entity/business/institution or has a creditor relationship with the issuer, it will be classified as a security.

As early as September 5, 2017, the Securities and Futures Commission provided a simple guide on how to determine security tokens, mainly divided into three scenarios:

(i) If the token represents the equity or ownership of a company, for example, if token holders are granted shareholder rights, including the right to receive dividends and the right to participate in the distribution of remaining assets upon liquidation of the company, then the token can be considered a security;

(ii) If the token is used to generate or confirm the issuer’s debts or liabilities, it may be considered a “bond”. For example, the issuer can repay the investment principal to token holders on a fixed date or upon redemption, and pay interest to token holders;

(iii) The token can be considered an interest in a “collective investment scheme” provided that the token is collectively managed by the scheme operator for investment purposes, with the aim of allowing token holders to participate in sharing the profits brought by the project.

For general NFTs, if they only represent ownership rights to artwork or collectibles, or represent avatars/characters within a game, they are unlikely to fall into categories such as shares, stocks, bonds, etc.

As for whether they belong to collective investment schemes, it primarily depends on whether NFT holders acquire assets through the NFT issuer or if the issuer uses funds from selling NFTs to acquire assets and provide returns to NFT holders. There are a few key principles:

(i) NFT holders do not have day-to-day control over the assets;

(ii) The assets are managed as a whole by the issuer/operator;

(iii) The overall arrangement aims to provide NFT holders with returns through asset acquisition.

It’s important to note that some projects may use NFT sales for fundraising, where NFT holders receive project tokens through airdrops in the future. In these cases, it is worth considering whether they fall under the definition of a collective investment scheme.

Furthermore, airdrops require careful consideration. If airdrops to NFT holders are based on project profits or earnings, it could potentially involve rights to dividends or a collective investment scheme. While there are no cases in Hong Kong, under US regulations, the Boring Ape project faced an investigation by the SFC to determine whether Boring Ape NFTs were considered securitized tokens.

As for the definition of structured products, it usually refers to products tied to the prices of securities, commodities, indexes, assets, interest rates, currency exchange rates, or futures contracts. NFTs generally do not fall into these definitions, so we won’t delve into this topic further.

Finally, if an NFT is classified as a security, the issuer will be subject to regulation by the Securities and Futures Commission.

Are NFTs considered virtual assets?

Next, we need to explore whether NFTs are considered virtual assets and whether licensing is required.

According to the Anti-Money Laundering and Counter-Terrorist Financing (Financial Institutions) Ordinance, virtual assets are generally defined as digital representations of value, which include:

1) Expressions in digital form denominated in units of account or with economic value;

2) Publicly accepted as a medium of exchange and fulfill one of the following:

a) Used for payment, debt settlement, or investment;

b) Confer voting rights for management, operation, or governance;

3) Transferable, storable, or tradable electronically

Excluded from virtual assets are:

1) Central Bank Digital Currencies (CBDC)

2) Securities or futures

3) Reward points or in-game assets

So, whether NFTs are considered virtual assets depends on what each individual NFT represents.

For the majority of NFTs in the market, the key condition is whether the NFT is “publicly accepted as a medium of exchange” or considered a “reward point or in-game asset.” For example, if it represents land in a game like Sandbox, it could be classified as a “game asset.” As for less popular NFTs and whether they are considered a publicly accepted medium of exchange, the line becomes blurry.

If NFTs are considered virtual assets and not securities, then the issuers do not need a license from the Securities and Futures Commission (SFC). However, if they are operating as an exchange, they may require a license. Currently, the SFC’s Virtual Asset Service Provider (VASP) license is for regulating centralized exchanges. In theory, if the project is a centralized exchange and includes NFTs as virtual assets, then a VASP license would be required.

But it’s important to note that in the definition, a centralized exchange must have an Order Book and Matching Engine. In reality (or technically), each NFT is unique, so most NFT art and collectibles can only be traded through auctions or bidding, or through peer-to-peer (P2P) transactions. Auctions or bidding may not be considered as an exchange. Regarding P2P, the SFC’s consultation paper from February already indicated a leaning towards not regulating P2P forms, such as decentralized exchange models. So as long as it’s not a centralized exchange, a VASP license is not required. However, it’s necessary to carefully consider the business services and operations, as well as stay updated on all the latest policies from the SFC.

For example, on Opensea, the transactions are conducted on-chain and matched through auctions. Therefore, platforms like these are not within the definition of a centralized exchange.

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