Understanding Hong Kong’s New STO Regulations in One Article Circular on Intermediaries Engaging in Tokenized Securities Activities

Simplified Guide to Hong Kong's Latest STO Regulations Circular for Intermediaries Involved in Tokenized Securities Activities

Author:

Will Awang, US International Commercial Law Master, ten years of legal practice experience, serial entrepreneur in the technology industry, investment lawyer, focused on Web3 virtual assets.

Recently, the popularity of tokenization has spread from DeFi to TradFi. We can see that MakerDAO has extensively deployed tokenized US Treasury assets in recent years, and the Bank for International Settlements (BIS) has been promoting various CBDC tokenization pilots. The Securities and Futures Commission (SFC) of Hong Kong has also observed that financial institutions in the global financial market are increasingly interested in tokenizing traditional financial instruments. Intermediaries for securities tokenization and distribution of tokenized securities to customers are also growing.

The SFC believes that now is the time to provide more guidance on activities related to tokenized securities (such as Security Token Offering, STO). This will help clarify the regulatory requirements for intermediaries engaged in these activities and provide guidance to intermediaries on managing and addressing new risks arising from the use of this new tokenization technology. It will support continued innovation in the industry while taking appropriate precautions from an investor protection perspective.

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Therefore, on November 2, 2023, the SFC issued two circulars on tokenized securities: “Circular on Intermediaries Engaged in Activities Related to Tokenized Securities” and “Circular on SFC Recognized Investment Products for Tokenization“. These two circulars are collectively referred to as “Tokenization Circular“.

This article will analyze the definition of tokenized securities and the content of activities related to tokenized securities (issuance, trading, providing advice, fund investment, etc.) from a legal perspective, helping everyone better understand the new STO regulations in Hong Kong.

1. Summary of the Tokenization Circular

The essence of tokenized securities is traditional securities packaged in the form of tokens (Tokenised Securities). They are still regulated based on the positioning of the underlying assets. They are subject to the existing laws and regulations of the traditional securities market.

The SFC allows products that are licensed by the SFC under Part IV of the Securities and Futures Ordinance to be tokenized and traded on the primary market. However, these tokenized products need to be authorized by the SFC and have sufficient risk control measures to address the new risks brought about by tokenization.

Intermediaries engaging in activities related to tokenized securities should have the necessary manpower and expertise to understand the nature of the business (especially new risks related to ownership and technology) and conduct due diligence on tokenized securities based on all available information to identify the key features and risks of tokenized securities.

If intermediaries issue (product issuers) or substantially participate in the issuance, trading, or provision of advice on tokenized securities, even if they outsource some functions to third-party vendors, they are still responsible for the overall operation of the tokenization arrangement.

“Tokenization Circular” replaces the “Statement on the Issuance of Tokenized Securities” of 2019 and no longer classifies tokenized securities as “complex products,” canceling the mandatory requirement of “restricted to professional investors.”

Although the “Tokenization Circular” considers tokenized securities as essentially traditional securities, intermediaries should still adopt a “perspective” approach to assess the complexity of the underlying traditional securities related to tokenized securities.

The restriction of the “Minimum Exemption Requirement” – the previously stated minimum exemption requirement, which does not apply to tokenized securities, has investment portfolios that have indicated investment objectives in virtual assets and have invested 10% or more of their total asset value in virtual assets.

The Securities and Futures Commission supports intermediaries to engage in any activities related to digital securities (including tokenized securities), but they should communicate their business plans with the Securities and Futures Commission in advance.

2. What are Tokenized Securities?

Tokenization involves recording rights to assets that exist in traditional ledgers on programmable platforms, including the use of Distributed Ledger Technology (DLT) in the lifecycle of securities. This can be seen as recording and storing in a digital form, while incorporating the rules and logic used to govern the transfer of assets.

The potential value of tokenization for the financial market includes: improving efficiency in the traditional financial industry, increasing transparency, shortening settlement time, and reducing costs. The Securities and Futures Commission supports intermediaries to take measures to tokenize traditional securities, while also being aware of the new risks associated with using this new technology.

2.1 Tokenized Securities = Securities Regulated by Traditional Securities Market Regulations

The “Tokenization Circular” states that tokenized securities refer to traditional financial instruments (such as bonds or funds) that fall under the definition of “securities” in Schedule 1, Part 1, Article 1 of the Securities and Futures Ordinance, and use DLT (such as blockchain technology) or similar technology (tokenized securities) in their lifecycle.

According to the understanding based on the Tokenization Circular of the Securities and Futures Commission, tokenized securities refer to traditional regulated securities (such as fixed-income bonds, ABS, MBS, REIT, etc.) that have added a layer of blockchain DLT technology to the product design level, and then tokenize (Wrapped Securities) after packaging the traditional securities with the added shell. Here, the underlying traditional securities are already regulated, and the Tokenization Circular imposes additional regulatory requirements for risk control, information disclosure, investor protection, and other aspects on the tokenization layer.

Take mutual funds as an example of traditional financial securities. Any stage in the lifecycle of a fund that uses DLT or similar technology for issuance, subscription, redemption, trading, transfer, settlement, etc. should be classified as tokenized funds and fall within the scope of tokenized securities. For example, Franklin Templeton’s Franklin OnChain U.S. Government Money Fund (FOBXX), launched in 2021, has U.S. Treasury bonds as underlying assets. It is the first fund in the United States to be approved by the SEC and uses Stellar blockchain technology to process transactions and record ownership of tokenized securities.

 (For more information on tokenized funds, refer to: RWA Research Report: The value, exploration, and practice of fund tokenization)

2.2 New Risks of Tokenization

The primary principle of the regulatory guidelines of the Securities and Futures Commission is “same business, same risks, same rules.” Besides complying with the existing laws and regulatory requirements applicable to traditional securities, intermediary agencies should also manage all ownership risks (such as the transfer and recording of ownership rights related to tokenized securities) and blockchain technology risks (such as forking, blockchain network interruptions, and cybersecurity risks).

The Securities and Futures Commission notes that there are several common prototypes of DLT networks, including: (a) private permissioned; (b) public permissioned; and (c) public permissionless. The risks associated with these networks may vary depending on the type of DLT network used, and should be addressed through the implementation of comprehensive monitoring measures.

Although tokenized securities issued on public permissionless networks have not been observed, the network security risks associated with such tokenized securities may be higher and more challenging to achieve, requiring more public chains that align with traditional financial practices. Additionally, due to their transferable nature and anonymous characteristics, these tokenized securities may have higher risks in terms of money laundering and KYC compliance compared to registered tokenized securities.

Therefore, the upcoming tokenized securities projects will mainly focus on private permissioned and public permissioned networks.

For example, Bank of China International (BOCI), the first company to issue tokenized securities in Hong Kong, announced the successful issuance of CNY 200 million tokenized notes on the Ethereum blockchain (without involvement of a central securities depository), using the Ethereum public permissioned network. Similarly, on October 2, 2023, UBS launched a pilot project for tokenized funds, also on the Ethereum network. The fund tokens are represented as smart contracts on Ethereum, representing ownership rights to underlying money market funds. Tokenization helps enhance the issuance, distribution, subscription, and redemption processes of the funds.

In the Genesis project by the BIS Innovation Hub and the Hong Kong Monetary Authority, tokenization and a unified ledger were used to issue green bonds. This project was implemented on Goldman Sachs’ private permissioned network, the GS DAP digital platform. The architecture and primary issuance process of this project are shown in the diagram below.

 (Tokenization of Hong Kong Bond Market)

3. Considerations for Engaging in Tokenized Securities Activities

The “Letter on Tokenization” clarifies that tokenized securities are essentially traditional securities packaged with tokenization. They are regulated based on the underlying assets of the securities and are subject to the existing laws and regulations of the traditional securities market. Specifically, the issuance of tokenized securities will be governed by the prospectus system under the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Chapter 32) and the investment offer system under the Securities and Futures Ordinance Part IV.

Intermediary institutions conducting the following activities will be subject to the existing regulations for securities activities: distributing tokenized securities or providing advice on tokenized securities, managing tokenized funds, managing funds invested in tokenized securities, and conducting secondary market trading of tokenized securities on virtual asset trading platforms.

In addition, the Securities and Futures Commission also requires intermediary institutions engaged in tokenized securities activities to have the necessary manpower and professional knowledge to understand the nature of the business (especially new risks related to ownership and technology) and manage these risks properly.

Intermediary institutions should act with appropriate skills, diligence, and care, and conduct due diligence on tokenized securities to identify their key characteristics and risks using all available information. This includes the responsibility of intermediary institutions to conduct due diligence on the product itself (such as tokenized bonds or funds) under the existing regulations, as well as the responsibility to conduct due diligence on the technological aspects of the product involving tokenization.

From the “Letter on Tokenization,” it can be seen that after defining tokenized securities as securities, all intermediary institutions engaged in tokenized securities activities still need to comply with the laws and regulations of the traditional securities market. This means that apart from intermediaries involving blockchain DLT technology, other participating entities are still traditional licensed financial institutions.

 (Chapter 571 "Securities and Futures Ordinance" - Schedule 5 Regulated Activities)

3.1 Issuance of Tokenized Securities

If an intermediary institution issues (product issuer) or largely participates in the issuance of tokenized securities for buying or selling or provides advice, even if it outsources certain functions to third-party vendors, it is still responsible for the overall operation of the tokenization arrangement.

When assessing the risks involved in tokenized securities, intermediaries should consider the following factors:

(a) Experience and track record of third-party suppliers (such as tokenization technology developers, tokenization platform providers, wallet service providers/custodians, and anti-money laundering solutions);

(b) Technical scope of tokenized securities: (i) Audit of smart contract code; (ii) Security and robustness of DLT network; (iii) Interoperability issues among backend systems of participating parties; (iv) Robust policies, procedures, systems, and monitoring measures to support the operation of tokenized securities;

(c) Legal and regulatory considerations related to tokenized securities, particularly: (i) Legal status regarding finality of settlement; (ii) Enforceability of any attached rights (if applicable); (iii) Enforceability of any external rights and potential impact of tokenized securities trading activities on relevant markets; (iv) Regulatory status in Hong Kong and whether regulatory approvals are required under relevant laws;

(d) Business continuity plan for handling DLT emergencies;

(e) Appropriate measures for addressing data privacy risks;

(f) Money laundering and terrorist financing risks;

(g) Consideration of the most suitable custody arrangements, especially when dealing with public-permissionless networks.

3.2 Trading, providing advice, or managing portfolios of tokenized securities

Intermediaries involved in trading, providing advice, or managing portfolios of tokenized securities must comply with the following requirements:

(a) Conduct due diligence on issuers, third-party suppliers involved in tokenization arrangements, and the characteristics of tokenization arrangements and the risks they pose;

(b) Before engaging in relevant activities, understand and acknowledge the monitoring measures adopted by issuers and their third-party suppliers to manage ownership and technology risks associated with tokenized securities, with reference to the factors to consider in the issuance of tokenized securities as outlined in 3.1;

(c) Make full disclosure of specific material information relating to tokenized securities, including: (i) Finality of off-chain or on-chain settlements; (ii) Restrictions imposed on the transfer of tokenized securities; (iii) Whether smart contract audits have been conducted prior to deploying the smart contract; (iv) Key management and monitoring measures for DLT events and business continuity plans; and (v) Custody arrangements;

(d) Assess the complexity of underlying traditional securities related to tokenized securities in a “look-through” manner and comply with relevant regulations on the sale of complex products (including suitability requirements).

(e) If the issuance of tokenized securities is not approved by the Securities and Futures Commission (“SFC”) under Part IV of the Securities and Futures Ordinance or does not comply with the prospectus regime, only professional investors can be provided with services related to such tokenized securities (unless exempted under other applicable circumstances).

3.3 Managing investment portfolios that may invest in tokenized securities

Since tokenized securities are essentially traditional securities packaged as tokens, the restrictions on the “minimum exemption requirement” mentioned in the Terms and Conditions for Licensed Corporations or Registered Institutions Managing Portfolios that Invest in Virtual Assets, issued on 4 October 2019, do not apply to tokenized securities.

The restrictions of the “minimum exemption requirement” (which apply to portfolios that have stated investment objectives in virtual assets and allocate 10% or more of total asset value to virtual asset portfolios) only apply to “virtual assets” as defined under section 53 ZRA of the Anti-Money Laundering and Counter-Terrorist Financing Ordinance, which include assets such as BTC, ETH, stablecoins, utility tokens, and governance tokens.

3.4 Safeguards for licensed virtual asset trading platforms

According to section 10.22 of the Guideline for the Regulation of Virtual Asset Trading Platforms, virtual asset trading platforms must have compensation arrangements approved by the SFC to provide safeguards against potential losses of security tokens (such as third-party insurance and internal control mechanisms).

If these measures can convince the SFC that the risks of financial loss for customers holding such tokenized securities due to loss thereof can be effectively mitigated (for example, virtual asset trading platforms can demonstrate that issuers have implemented management and monitoring measures, such as transfer restrictions or establishment of permission lists, to guard against theft and hacking risks, thereby protecting tokenized securities holders using public non-permissioned networks), the SFC may, based on an application from a licensed institution, remove the relevant security tokens from the scope of safeguards.

IV. “Circular on Tokenization” replaces the “Statement on the Issuance of Security Tokens” issued in 2019

4.1 Tokenized Securities = Securities

The “Statement on the Issuance of Security Tokens” published by the SFC on 29 March 2019 had a more cautionary stance, treating security tokens as “complex products” and aiming to remind companies or individuals involved in the issuance of security tokens to be aware of relevant applicable laws and regulatory requirements. To avoid any confusion, this “Circular on Tokenization” will replace that statement.

According to the current “Circular on Tokenization,” tokenized securities are essentially traditional securities packaged as tokens. In addition, intermediaries must ensure that the new risks associated with the use of new technologies are effectively mitigated and do not impact investors. Therefore, in this context, tokenization should not alter the complexity of the relevant securities and they should still be classified as securities.

4.2 Complex Product Classification

In the “Statement on the Issuance of Tokenized Securities” issued by the Securities and Futures Commission (SFC) in 2019, intermediary institutions are reminded to comply with all existing laws and regulations regarding “complex products” when promoting or distributing tokenized securities. Additional investor protection measures should also be taken by intermediary institutions.

Although this “Tokenization Circular” considers tokenized securities to be essentially traditional securities, intermediary institutions should still conduct complexity assessments on the underlying traditional securities of tokenized securities using a “due diligence” approach. If intermediary institutions are distributing tokenized securities that fall under the category of “complex products,” they must adhere to the regulations governing the sale of “complex products,” including ensuring the suitability of the products (regardless of any solicitation or advisory activities).

Therefore, intermediary institutions should refer to the factors mentioned in Chapter 6 of the “Guidelines on Online Distribution and Investment Consultation Platforms” and Section 5.5 of the “Code of Conduct for Licensed or Registered Persons” issued by the Securities and Futures Commission to evaluate the relevant traditional securities of tokenized securities and determine if they are “complex products.” Intermediary institutions should also consider the guidelines periodically issued by the SFC.

4.3 Removal of Restriction to Professional Investors Only

In the “Statement on the Issuance of Tokenized Securities” issued by the SFC in 2019, restrictions were imposed on the distribution and promotion of tokenized securities to “professional investors only.” At that time, tokenized securities were still an innovative asset class and had not yet entered the market in the form of tokenized securities as they are now.

As this “Tokenization Circular” classifies tokenized securities as securities, the SFC believes that there is no need to impose mandatory requirements for “professional investors only.”

However, intermediary institutions must still be aware that the provisions of the prospectus regime under the Companies (Winding Up and Miscellaneous Provisions) Ordinance and the investment offer regime under Part IV of the Securities and Futures Ordinance still apply to the public offer of tokenized securities in Hong Kong. This means that if the issuance of tokenized securities has not been authorized under Part IV of the Securities and Futures Ordinance, or does not comply with the prospectus regime, it can only target professional investors or be conducted under any other applicable exemptions provided by the public offer regime.

4.4 Activities Related to Digital Securities

Tokenized securities are a category within a broader range of digital securities. There is currently no universally accepted definition or classification directory for “digital securities,” and the market may have various different structures.

Digital securities that do not fall under the category of tokenized securities may have special characteristics, terms, and features. They may have more unique, innovative, or complex structures, which present greater legal uncertainties. Retail investors are unlikely to understand such digital securities under reasonable circumstances. Some of these securities may only exist on a DLT-based network and may not be linked to external rights or related assets. There may also be no monitoring measures to mitigate the risk of inaccurate ownership records. Digital securities that do not qualify as tokenized securities are likely to be considered “complex products” and may fall within the definition of collective investment scheme interests.

For example, digital securities that are not tokenized securities may include the tokenization of fractional interests in real-world assets or digital assets (such as artwork or land) in a manner that is different from traditional funds; or the tokenization of profit distribution arrangements in a form that is not considered traditional securities.

Intermediaries should note that digital securities cannot be offered to retail investors in a manner that violates the public offering regime. Intermediaries distributing these digital securities should comply with the regulations on the sale of complex products, including ensuring their suitability (regardless of whether any solicitation or advice is involved). If digital securities are distributed on an online platform, the platform must be properly designed and have appropriate withdrawal and control measures to ensure compliance with any sales restrictions that may apply to these digital securities.

Intermediaries should implement adequate systems and monitoring measures to ensure compliance with applicable laws and regulatory requirements before engaging in activities related to digital securities. In addition to the regulations related to tokenized securities mentioned in this circular, intermediaries should exercise professional judgment and evaluate each digital security that they deal with but is not a tokenized security, and implement separate internal monitoring measures to address the specific risks and unique characteristics of digital securities to protect the interests of their clients.

5. Notifying and Providing Information to the Securities and Futures Commission (SFC)

If intermediaries intend to engage in any activities related to digital securities (including tokenized securities), they should notify the relevant case officers of the SFC of their business plans in advance and discuss them. Intermediaries should provide any information requested by the SFC in relation to such services.

6. Practice of Security Token Offerings (STOs)

On September 10, 2023, according to Taikoo Capital, they announced the launch of PRINCE Token, the first real estate fund security token offering (STO) targeted at “professional investors” in Hong Kong. This STO is the first fund tokenization fundraising model approved by the SFC, with a target fundraising size of approximately 100 million HKD. The funds raised will be used to acquire five retail properties in the Prince Edward tourist hotspot in the Kowloon district, but details of the target properties have not been disclosed. If approved by regulatory authorities, they plan to seek the listing of PRINCE Token on the HKbitEX platform to achieve greater liquidity potential.

(First approved real estate STO in Hong Kong with a fundraising of 100 million HKD)

Information shows that PRINCE Token is issued by a closed-end fund managed by Taikoo Capital’s Pioneer Management. The entrance fee is 1,000 HKD, much lower than the usual requirement of 1 million USD for private real estate funds. By holding PRINCE Token, investors can receive rental income generated by the relevant properties annually and benefit from the future appreciation of the properties.

After completing the subscription agreement, Pioneer will arrange for the relevant investors to open a digital wallet account at ON1 ON Custody for the allocation and storage of PRINCE tokens. ON1 ON Custody is another subsidiary of Taiji Capital and is a licensed Hong Kong trust or company service provider, as well as a virtual asset custodian certified by the American Institute of Certified Public Accountants (AICLianGuai) SOC 2. The PRINCE tokens stored in ON1 ON Custody are eligible for virtual asset protection provided by a local insurance company. The PRINCE tokens will be settled on the public Ethereum blockchain, allowing investors to immediately access the secondary market through over-the-counter trading after subscribing to the tokens.

7. Thoughts on the “Tokenization Circular”

The “Tokenization Circular” clearly states that the essence of tokenized securities is traditional securities packaged in token form. They are still regulated based on the underlying assets of the securities and comply with the existing laws and regulations in the traditional securities market.

Although the qualification of tokenized securities has lowered many barriers, it still remains a market for licensed institutions, such as licensed institutions providing regulated activities under the Securities and Futures Ordinance ─ Table 5 and third-party suppliers of tokenized securities technology. After all, for the broad sense of Real World Asset (RWA) tokenization, both the asset side and the fund side are controlled by regulated traditional financial institutions.

There is room for imagination in comparing the qualification of tokenized securities with the potential possibilities for assets within mainland China. If it is feasible for mainland Chinese assets to be securitized in Hong Kong, then there are currently no significant obstacles to the path of tokenization, and further exploration will be conducted.

However, if tokenized securities are treated as securities, the current Hong Kong financial market will face significant challenges in supporting a new financing market.

Our Digital Technology team continuously monitors the regulatory rules and guidance in the virtual asset industry from major jurisdictions around the world. With deep industry understanding and extensive legal compliance experience in the Web3 virtual asset industry, we provide project compliance guidance and legal advice for licensed institutions, Fintech companies, investment funds, startups, and other entities involved in the virtual asset industry. We welcome discussions and exchanges related to the tokenization of real-world assets (RWA), STOs, Fintech, and other related projects in the virtual asset industry.

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