Hong Kong firms that manage virtual asset funds on behalf of HNW customers are now subject to a new set of rules, issued by the Securities and Futures Commission.

With the release of its 'Proforma' [i.e. lists of] Terms and Conditions for Licensed Corporations which Manage Portfolios that Invest in Virtual Assets, the SFC has imposed a comprehensive set of licensing conditions on firms. Contravention of a licensing condition is likely to be considered as misconduct under the Securities and Futures Ordinance because it will cast a shadow on the fitness and propriety of a virtual asset fund manager and may result in disciplinary action by the SFC. The regulator is, however, quite forbearing by the standards of its British and American counterparts.

On 1 November 2018, the SFC issued a statement about its intentions towards virtual asset portfolio managers, fund distributors and trading platform operators. Among other things, it said that it would impose terms and conditions on each firm with (i) a stated investment objective to invest in virtual assets; or (ii) an intention to invest 10% or more of the gross asset value of the portfolio in virtual assets.

The set of terms and conditions starts off with some general principles with which a virtual asset fund manager must comply. These dictate that it should act honestly, fairly and in the best interests of investors. It should act with due care, skill and diligence and be effective in employing its resource. Conflicts of interest are to be avoided whenever possible. It should safeguard the fund's assets and make clear, concise and effective disclosures to investors. It should also comply with the instrument of incorporation and its senior managers should bear primary responsibility for ensuring the maintenance of appropriate standards of conduct.

If the fund manager holds virtual assets on behalf of the funds it manages, it must at all times maintain liquid capital which is not less than an amount equal to HK$3 million or its variable required liquid capital, whichever is the higher.

Vital duties and functions must be segregated. This applies especially if the same person performs several duties and might therefore make undetected errors, commit abuses or expose the investors to 'inappropriate' risks.

Senior management responsibility

Unlike many regulators, the SFC explains what it means by the term 'senior management.' This applies to the fund firm's managing director, its board of directors, its chief executive officer and other senior operating management people who wield authority over the fund manager's business decisions.

All these people must be principally responsible for compliance by the firm with all regulatory requirements and nurture a good compliance culture. They must maintain clear reporting lines, provide everybody who works for the firm with up-to-date information about its policies and procedures that apply to them and have the firm's performance 'reviewed' at least annually.

The compliance function and the compliance officer should be independent of other functions and report directly to these people, "unless this is not reasonably practicable given the size of the Virtual Asset Fund Manager." In these exceptional cases, the SFC wants the firm's senior management to "assume the role of compliance officer." They may delegate compliance jobs to qualified professionals, but not their responsibility for compliance.

Where practicable, the fund manager should maintain an independent and objective audit function.

Virtual asset fund management

Each fund manager should ensure that transactions carried out on behalf of each fund are in accordance with the fund's stated investment strategy, objectives, investment restrictions and guidelines, whether in terms of asset class, geographical spread or risk profile. 'Best execution,' i.e. the execution of fund orders on the best available terms in a way that avoids 'concentration risk,' is de rigeur. Concentration risk happens when a firm owes too much money to too few people.

Unless specifically permitted in the fund mandate, a fund manager should not participate in underwriting activities on behalf of a fund. If it participates in an initial offering of virtual assets on behalf of funds that it manages, it should ensure that:

• the allocation of virtual assets received in the offering provides for a fair and equitable allocation amongst the funds it manages;
• preferential allocations are prohibited; and
• records of (i) the intended basis of allocation before a transaction is effected, (ii) the actual allocation after the transaction is effected and (iii) the reasons for the differences between the intended and actual allocations, are made.

The manager should only carry out transactions on behalf of a fund with a 'connected person' if the transaction happens on an arm's-length basis and at a commission rate no higher than customary institutional rates.

The fund manager should not deposit virtual assets with, or borrow them from, a connected person, or undertake cross trades, except in certain strict conditions. He/it should always tell investors the expected maximum lever of debt or 'leverage' that it may employ on behalf of the fund and the basis for its calculation. The SFC's rules for liquidity management are detailed.

Custody

To safeguard assets, the fund manager should select a custodial firm that is functionally independent of it. A formal custodial agreement is de rigeur. It should ensure that fund assets are segregated from its own assets and, unless held in an omnibus client account, the assets of other clients.

If a virtual asset fund manager receives fiat currency on behalf of the funds it manages (client money), it should set up a segregated bank account to hold it. It should then put it in the account or pay it into the fund within one business day after receiving it.

When assessing the characteristics of its custodial arrangements it should look at the hardware and software involved, the virtual assets that it is supporting, controls over key generation, storage, management and transaction signing, software upgrades and the handling of blockchain forks. It should write down the reasons for selecting its custodial arrangements, including the self-custody of virtual assets (where the user holds his own assets on a blockchain).

Dealing with HNW investors

If an investor asks the fund manager to see its latest audited financial statements, it should comply. It should deal with complaints "in a timely manner." If someone complains, it should either entrust the compliance officer with its response or "a person designated by senior management other than an individual directly concerned with the subject of the complaint."

Marketing

The fund manager should only allow professional investors to invest in the virtual asset fund. These are investors who have, under certain circumstances, portfolios of not less than HK$8 million.