Web3 Legal Education: How to Set Up a Compliant Crypto Fund in Hong Kong?

Author: Mankun Blockchain

In the rapidly changing financial world, crypto funds are quickly emerging as the new darling of the investment community. However, choosing the right region to establish a crypto fund is crucial. Hong Kong, as an international financial center, is attracting more and more attention with its unique advantages and vast prospects.

Establishing a crypto fund in Hong Kong is not only a strategic decision but also an important step towards future financial innovation.

So, why are more and more investors and fund managers choosing to set up crypto funds in Hong Kong? Lawyer Bai Chen from Mankun Law Firm will unveil the background and far-reaching significance behind this decision.

Advantages of Establishing a Crypto Fund in Hong Kong

Establishing a crypto fund in Hong Kong has many advantages, primarily reflected in its robust legal and regulatory environment. Hong Kong has a stable legal system and friendly financial regulatory policies, especially with the transparent and stable regulatory framework provided by the Securities and Futures Commission (SFC), which safeguards the operation of crypto funds. This environment provides reliable legal protection for investors and fund managers. Additionally, Hong Kong's financial regulatory system is mutually recognized with those of major developed countries, paving the way for the sale of Hong Kong financial products in other regions under limited conditions.

Moreover, Hong Kong's tax incentives are also an important factor attracting crypto funds. Known for its low tax rates and certain tax exemption policies, Hong Kong offers a significant competitive advantage in tax costs for funds. For crypto funds looking to optimize their tax structure globally, Hong Kong is undoubtedly an ideal choice.

Finally, as an international financial center, Hong Kong has a highly developed financial market and convenient cross-border financial services. This not only promotes the liquidity of funds but also provides crypto funds with vast market opportunities and diversified investment channels. The degree of internationalization in Hong Kong makes it an important hub connecting Eastern and Western financial markets.

Requirements for Submitting Applications to the SFC

To manage a crypto fund in Hong Kong, it is necessary to apply for a Type 9 (Asset Management) license from the Securities and Futures Commission (SFC).

Business Involved

The businesses that require applying for and holding a Type 9 license (Asset Management) fall into two main categories:

Securities Management. If the investment portfolio managed by the fund includes securities or futures contracts, this license must be applied for. Securities can include digital tokens representing equity or debt.

Virtual Asset Management. The SFC has implemented an extended licensing regime for managing portfolios of virtual assets such as Bitcoin and Ethereum. This involves additional terms and conditions attached to the existing Type 9 license (Pro Forma T&Cs).

It is worth noting that for companies managing a portfolio (or part of a portfolio), if:

Less than 10% of the total asset value of the portfolio (minimum threshold); or

Indirectly investing in virtual assets (e.g., investing in a fund of funds that invests in virtual assets)

The SFC will regulate these fund managers under the existing traditional regime of the Securities and Futures Ordinance, and the additional terms and conditions of the Type 9 license will not apply to such companies. Conversely, if a company falls into any of the following categories, the terms and conditions for virtual asset fund managers will apply:

• Type 9 License. Fund managers managing portfolios that invest in securities/futures contracts, as well as portfolios that invest in virtual assets.
• Type 9 License. Fund managers managing portfolios that invest in both securities/futures contracts and partially in virtual assets.
• Type 1 License. Managing collective investment schemes that invest solely in non-securities/futures contract virtual assets and distributing or planning to distribute these assets in Hong Kong.

Application Materials

If the above conditions are met and you are about to apply for a license, the applicant or applicant entity needs to prepare the following main documents:

• Business Plan. A detailed description of the business model, target market, and strategy.
• Compliance Manual. An overview of compliance policies and procedures to ensure adherence to regulatory requirements.
• Risk Management Framework. A description of risk management strategies, including measures to address market, operational, and liquidity risks.
• Corporate Governance. Information about the governance structure, including the composition and responsibilities of the board of directors.

Application Challenges

At this point, what are the challenges in applying for a Type 9 (Virtual Asset) license?

Applying for a traditional Type 9 license typically takes 4 to 12 months from the preparation of the application to the final approval. However, the timeline may vary significantly when applying to become a crypto fund manager. Here are the main reasons why the application process may take longer and key points to pay special attention to during preparation.

First, the SFC will carefully review the key personnel to ensure they have relevant experience in virtual asset fund management (preferably 3 years of experience within the past 6 years). In particular, the SFC will focus on senior management personnel of the company, such as department heads, team leaders, and key investment personnel.

Second, the SFC will closely examine the operational processes proposed by the company. The following questions need to be considered:

• Is there appropriate separation of key functions (e.g., portfolio management, risk management, valuation, asset custody)?
• Who are the personnel involved when transferring assets from the fund or custodian, and what security measures are in place?
• Who is responsible for reconciling trades and positions, and how frequently is reconciliation performed?
• What is the pricing method and who is responsible for it, and how is the reasonableness of each virtual asset's pricing assessed?

Third, undoubtedly, the company's information technology will be a focus of the SFC's attention. The following questions need to be considered:

• How will the company ensure appropriate controls and access? For example: a. Wallet private keys? b. Transferring assets from location X to location Y? c. Maintaining an appropriate ratio of assets between hot wallets and cold wallets?
• Does the company self-custody assets? If so, has appropriate insurance been purchased?

The above are just some key considerations; the actual nature of fund management activities and the trading platforms, custodians, and other counterparties involved also need to be taken into account.

Process of Establishing a Crypto Fund in Hong Kong

In addition to applying for a Type 9 license, the process of establishing a crypto fund in Hong Kong includes the following steps:

Preliminary Assessment

• Determine Regulatory Scope. Assess whether your fund's investment portfolio includes securities or futures contracts to determine if a Type 9 license is needed.
• Virtual Asset Classification. Clarify whether the digital assets in the portfolio are considered securities under Hong Kong law.

Application Preparation

• Document Preparation. Prepare the required documents, including a detailed business plan, compliance manual, risk management framework, and corporate governance structure.
• Consultation. Work with legal and compliance advisors to ensure all documents meet SFC standards.

Submit Application

• Submit Application. Submit a complete application package to the SFC, including all required documents and application fees.

SFC Review

• Review Period. The SFC reviews the application, which may involve multiple rounds of feedback and requests for additional information. This process may take several months.

License Decision

• Decision Notification. After approval, the SFC will grant the license. If there are additional conditions, they must be adhered to ensure compliance.

Fund Establishment

• Establish Fund Structure. Create the legal structure of the fund, hire service providers (administrator, auditor, custodian), and set up the necessary operational infrastructure.
• Investor Account Opening. Begin marketing the fund to potential investors and handle the subscription process.

Costs of Establishing a Crypto Fund

The costs of establishing and maintaining a crypto fund in Hong Kong can vary significantly. Specific costs depend on various factors, including the size of the fund, management strategy, and compliance requirements. Typically, legal and audit fees are incurred to ensure compliance with local regulations. Additionally, the costs of license application and annual fees should also be considered. To enhance operational efficiency and cost-effectiveness, it is advisable to collaborate with professional service providers familiar with the crypto fund market. The following table outlines typical costs:

Mankun Lawyer's Advice

Crypto funds are revolutionizing the investment landscape, bringing exciting opportunities as well as complex challenges. Successfully integrating virtual assets into traditional fund frameworks requires a meticulous approach. Future asset managers must carefully select service providers and legal advisors with deep expertise. This includes a thorough understanding of the unique risks, characteristics, and operational details of crypto funds. By assembling the right team and leveraging expertise, asset managers can effectively navigate the complexities of this innovative asset class and fully unlock its potential in the evolving financial market.

Establishing a crypto fund in Hong Kong is a complex process that requires careful planning and adherence to regulatory requirements. By understanding the licensing requirements, following the outlined processes, and budgeting for related costs, you can successfully establish and operate a crypto fund in one of Asia's leading financial centers. However, despite Hong Kong's structured regulatory environment, interest in registering fund structures in Hong Kong remains low due to past tax issues. Offshore tools are more popular among investors and fund managers. Past tax issues have made jurisdictions like the Cayman Islands or British Virgin Islands more attractive, highlighting the need for Hong Kong to continue enhancing its appeal as a destination for crypto funds.

In summary, while establishing and managing a crypto fund is fraught with challenges, with proper planning and professional team support, it is possible to carve out a niche in the emerging financial market. Despite facing obstacles in certain areas, Hong Kong still has the potential to become an important center for crypto funds. To achieve this goal, Hong Kong must continue to optimize its regulatory and tax environment to enhance its attractiveness to global asset managers.