Here’s what you need to know about the SFC’s latest circular in regards to the custody of digital assets

The Hong Kong Securities and Futures Commission (SFC) has released its circular detailing how asset managers should handle digital assets.

Some of the key points and directives from the SFC include:

• Fund managers of “virtual assets” — basically anything that is represented by a token — should appoint an independent digital custodian.
• Auditability is a key concern and must be run in an independent fashion whether internally or with external partners.
• AML/KYC are highlighted for specific attention, and the SFC directs that virtual asset managers must comply with guideline provisions as if they are conducting a regulated activity no matter what the underlying token represents — even if the underlying token does not represent what might normally be considered a security.
• Very importantly, “virtual assets” are defined based on the representation of the value — basically the fact that the asset, whatever it might be, is represented by a digital token. Because of this, cryptocurrencies, traditional securities, physical property, or quirky physical assets that are digitized on-chain are all treated the same and all need to follow the same rules.

The Hong Kong SFC has released its circular on the terms and conditions that licensed entities will have to follow when investing in what it terms virtual assets — meaning any type of tokenized security or item of value. The document is relatively straightforward and an easy read (it can be found on the SFC website, search for ‘Hong Kong SFC terms conditions virtual assets’ and it should be your top result.) There are however several key points that anyone interested in financial blockchain solutions should note.

First, the important topic of custody is detailed with specific instructions as to the need for a functionally independent custodian — meaning effectively that fund managers should not try to do both. Where fund assets are held in an omnibus client account assets belonging to each fund should be properly recorded so as to identify the value of each, however, a good custody solution should allow for separate funds to be kept in independent accounts and wallets with complete independence and safety.

The custody process is also detailed to use proper whitelisting techniques when assets are moved between trading platforms and custody accounts. Overall the section on custody is sensible and simply points to the need to use best practices to best protect the asset owners’ interests.

Special mention is made of the need to employ proper audit techniques. The use of good custody practice makes meeting this requirement straightforward as proper segregation to the account and sub-account level means that on-chain auditing can be readily employed. Asset managers will still need the independent oversight to sign off, but the data will all be indelibly present.

Given global concerns over the use of cryptocurrencies for possible money laundering, it should be no surprise that the topic of KYC/AML (Know Your Client/Anti-Money Laundering) earns a special mention. The SFC even spells out that the proper safeguards must be employed “…especially in respect of subscriptions made by the fund investors using Virtual Assets.”

One of the key points here is that the SFC states that asset managers should comply with the provisions “…as if it were conducting regulated activity, even if the funds (or parts of the funds) under its management invest in Virtual Assets which do not amount to “securities” or “futures contracts.”” In other words, simply having some asset represented by a token now means that the SFC will look for firms to treat it as being part of regulated activities. This greatly increases the scope of SFC and means that it now sits over any digitized asset, from property to future trade cash flows to racehorses. If it is a tokenized asset the SFC will oversee it, and they will expect firms to be particularly vigilant in their AML/KYC process. Being able to provide a history and checklist for all clients and client transactions will be critically important.

This last item is particularly important as it concerns another key point from the paper, namely that asset managers should only allow professional investors to invest in a virtual asset fund. As the underlying assets could be ones that would otherwise allow full retail involvement, this current finding effectively limits funds in their ability to use tokenization to provide better service for more traditional asset class investment. It is likely that this tight restriction is due to current concerns over cryptocurrency volatility and questions as to its suitability for long-term retail investment. Professional investors will likely push the SFC to revisit this topic so as to allow asset managers to use the utility of blockchain technology to better deliver traditional alpha to the full breadth of their clients. Cryptocurrencies are of course one application of blockchain, but the technology is much broader, much more powerful, and much more enabling in its potential to better protect and serve all investors in providing trust and security of asset ownership.

If you’re an asset manager in Hong Kong, or hold digital assets, and would like to know how Hex Trust can help you, please reach out to us: enquiries@hextrust.com

About Hex Trust

Hex Trust is the Asian leader in enterprise-grade custody for digital assets. Led by innovators from the institutional financial services space, Hex Trust has built a proprietary platform that delivers a modern custody solution for financial institutions, asset managers, and corporations to safely and efficiently operate in the blockchain ecosystem. ZeroKey(TM), a proprietary technology, enables seamless transacting and fast access to assets stored on multiple blockchains while maintaining the highest levels of security of cold storage solutions. As a registered Trust Company under the Hong Kong Trust Ordinance and holding a Trust or Company Service Provider (TCSP) license under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance, Hex Trust offers a truly end-to-end digital asset servicing solution. Visit www.hextrust.com to learn more.

Enquiries: media@hextrust.com
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