Five top tips for a successful Hong Kong crypto-fund launch (Updated)

Introduction

Bitcoin, Ethereum, and other cryptocurrencies / digital assets have become all the rage of late, not only among the general investing public (who have, no doubt, been captivated by the reports of Bitcoin's dizzying climb in value) but also among fund managers looking to set up cryptocurrency-focused funds.

At Simmons & Simmons, the Investment Funds team in our Hong Kong office has been dealing with the lion's share of crypto-fund establishment work for a large number of established and start up managers. In advising on structuring issues, we have come across common themes that managers appear to be facing.

So, if you're thinking of setting up a crypto-fund, here are some of the key issues you should be thinking about.

1. Licensing

Type 9 (Asset Management) licence for management of virtual assets

A Type 9 (Asset Management) licence is required if you want to carry on a business of managing a portfolio of "securities" or "futures contracts" ("SF Assets") in Hong Kong. The question of whether digital tokens or other digital assets amount to SF Assets remains to be settled, although the Securities and Futures Commission of Hong Kong (the "SFC") has indicated that this would require an analysis of the features and properties of each individual asset in your proposed portfolio. 

In its "Statement on initial coin offerings" (5 September 2017), the SFC set out that where digital tokens in an initial coin offering ("ICO") represent equity or ownership interests in a corporation (for example, where they give a token holder shareholder rights to receive dividends, or to vote, or to participate in a distribution on winding up), or if they give a holder rights that would be akin to the holding of debt or a liability (like a debenture), those tokens are likely to be considered "securities" under the Securities and Futures Ordinance (Cap. 571) (the "SFO"). In contrast, utility tokens that do not possess these qualities are considered "virtual commodities" and are not "securities" for the purposes of the SFO.

This licensing regime in relation to the management of virtual asset portfolios was confirmed in the statement titled "Regulatory standards for licensed corporations managing virtual asset portfolios" (1 November 2018), in which the SFC explicitly, using Bitcoin and Ethereum as examples, recognised that a firm managing a portfolio of virtual assets which do not amount to SF Assets will not require a Type 9 licence.

As a result, if you were to take the view that nothing in your proposed fund's portfolio would constitute an SF Asset under the SFO, then a Type 9 licence should not be required. 

Pro forma terms and conditions for licensed corporations and the Type 9 VA expanded licence regime

Nevertheless, the SFC now has a new licensing regime that will govern managers seeking to directly manage a portfolio of "virtual assets" (defined to include assets such as Bitcoin and Ethereum), which is structured as an expansion on the existing Type 9 (Asset Management) regulated activity licence (the "Type 9 VA Licence").

The Type 9 VA Licence regime was officially published in October 2019 to ensure that licensed corporations will observe essentially the same regulatory and compliance requirements in managing virtual asset portfolios and to afford better protection to investors.

The "regime" works, in essence, by the SFC imposing additional terms and conditions on the licence of an existing Type 9 (Asset Management) regulated entity (the "Pro Forma T&Cs").

For managers who are already licensed under a regular Type 9 (Asset Management) licence, should they wish to manage a portfolio consisting of virtual assets directly (with such virtual assets contributing to 10% or more of that portfolio's GAV), then it would be compulsory for those managers to expand their licences to a Type 9 VA Licence by agreeing to have the Pro Forma T&Cs imposed on their existing licences.

In addition, Type 1 (Dealing in Securities) licensed corporations which manage or intend to manage funds solely investing in virtual assets which are non-SF Assets and distribute or plan to distribute the same in Hong Kong would also need to have the Pro Forma T&Cs imposed on their licences.

Of note is that the Pro Forma T&Cs do not apply to licensed corporations which only manage funds of funds.  (For a new manager proposing to manage a fund of crypto funds ("Crypto FoFs"), the SFC has a "half-way house" regime that is not as onerous as the full Type 9 VA, but slightly more involved than a regular Type 9 Licence.  We have successfully helped one manager in Hong Kong obtain such a licence (and also launch their Crypto FOFs) - if this is of interest, we would be happy to discuss!).

The Pro Forma T&Cs provide for, among other things, general principles relating to virtual asset fund management, organisation and management structure of virtual asset fund managers, management rules (e.g. best execution, prohibition on market misconduct, order allocation, participation in initial offerings, cross trades, risk management, leverage, liquidity management), custody of portfolio assets and client monies, record keeping, audits and portfolio valuation, marketing activities, fees and expenses, and reporting obligations to the SFC.  Here is a link to my previous article covering the application of the Pro Forma T&Cs for managers considering acquiring a Type 9 VA Licence for the purposes of virtual asset portfolio management.

Importantly, for a new start up manager proposing only to manage pure virtual assets funds or portfolios (which are not also "securities" caught under the SFO, e.g. Bitcoin, Ethereum or other "utility" tokens), the Type 9 VA Licence is an "opt-in" regime only, and not compulsory.

Would such a manager want to be licensed under the Type 9 VA regime?  For one thing, it is not an easy application (to date, only one manager in Hong Kong has successfully managed to obtain this licence and that process took close to two years (we helped them with it)).  The SFC, in short, expects an applicant approaching them for such a licence to have in place an infrastructure (encompassing the team, strategy, processes and protocol) of a fully-fledged asset management outfit.  See my earlier article at this link which outlines the things potential applicants need to be thinking about if they want to apply for a Type 9 VA Licence.

In addition, after getting licensed, the burden of compliance (to stay licensed) would be high.  The Pro Forma T&Cs themselves are thorough (they run to over 30 pages in length) and on top of that, a manager would have to comply with all of the usual obligations imposed on an regulated entity (for example, under the Code of Conduct for Persons Licensed by or Registered with the SFC, and the Fund Manager Code of Conduct (the "FMCC")). 

Of course, being licensed does come with its benefits, including:

• Facilitating fund raising not only because having the Type 9 VA Licence would enable the manager to market the fund to individual and corporate professional investors (that is, family offices and HNWs) - who, for this type of investment product, would be the primary target market (without such a licence, the manager would need to rely on a third party distributor / placement agent with a Type 1 (Dealing in Securities) licence to market the fund, which comes with having to pay placement fees etc), but also because investor perception of a manager that is regulated by the SFC (which is very well regarded in the region and internationally) would be much better;

• Ease of dealing with service providers (such as fund administrators, custodians, auditors and advisors), many of whom would not onboard a manager that is not SFC licensed (although there are increasingly more players willing to make exceptions for crypto-fund managers); and

• Ease of bank account opening.

However, even if you were to come out on the side of applying for the Type 9 VA Licence after going through the cost benefit analysis above, there is one very important variable that remains as a material hurdle - and that is taxation.

2. Taxation

Prior to the introduction of the new unified tax regime last year, only offshore non-SFC authorised funds that met certain criteria were exempt from Hong Kong profits tax on their earnings (introduced by the Revenue (Profits Tax Exemption for Offshore Funds) Ordinance of 2006 which amended the Inland Revenue Ordinance (Cap. 112) (the "IRO")). For this reason, historically, almost all of the funds structured out of, and managed in, Hong Kong, were Cayman Islands entities.

Since 1 April 2019, the Inland Revenue (Profits Tax Exemption for Funds) (Amendment) Ordinance 2019 has further amended the IRO and unified the profits tax exemptions for all non-SFC authorised funds, irrespective of their size, type and location of central management and control, provided that qualifying transactions are carried out or arranged in Hong Kong by or through a specified person (essentially an SFC-licensed corporation or an SFC-registered authorised financial institution) or that the fund is a qualified investment fund.  Relevantly, one of the requirements (see Section 20AN of the IRO) to qualify for the tax exemption is that the profits are earned from transactions in assets of a class specified in Schedule 16C to the IRO, including but not limited to securities, shares, stocks, debentures, loan stocks, funds, futures contracts.

So, if you're satisfied that none of the digital assets your fund will be investing in qualifies as a "security" or a "futures contract", the good news is that you probably do not need to be licensed in Hong Kong to manage such a fund. The downside, however, is that the fund may not qualify for a tax exemption under Hong Kong tax laws.

This is the case even if you were to obtain the Type 9 VA Licence because unless all of the virtual assets comprising your fund's portfolio are "securities" (as defined under the SFO, and therefore fall into the definition of a "qualifying transaction"), the fund would not be able to avail itself of an exemption from profits tax in Hong Kong.  In that case, having the Type 9 VA Licence may, in fact, be disadvantageous from a taxation perspective as it would mean you have a presence in Hong Kong, and if the fund were to be managed from Hong Kong, this increases the risk of the fund being "pulled onshore" into the Hong Kong tax net (even if it were structured as an offshore vehicle). 

There are, of course, ways to structure around this, including, for example, the use of derivative instruments (e.g. total return swaps or futures) that may qualify as "securities", or the avoidance of a management presence in Hong Kong entirely (that is, to set up an "offshore" manager).

In relation to the latter, there are 2 considerations that need to be taken into account:

• With the introduction of economic substance in many offshore jurisdictions (including in the Cayman Islands and BVI), maintaining an offshore manager would require that entity to meet certain substance requirements "onshore" (for example, in the Cayman Islands or the BVI), which would include needing to have things such as a company secretary, office space, holding regular meetings, issuing certain reports from the offshore jurisdiction, and having a director who is physically based in that jurisdiction.  While there are providers who can now provide certain services / facilities that will enable the manager to meet such "substance" requirements, the fees / costs of doing so are not insignificant (and tend to increase in cases where a manager needs to carry out more intensive management activities in respect of a fund (for example, an opportunistic or quant strategy as opposed to a tracker strategy); and

• The frequency of management decisions - obviously, the more times investment discretion needs to be exercised (which would necessitate a board meeting offshore), the more times the directors of the manager will need to travel out of Hong Kong.  This could become practically infeasible where these meetings need to take place on a regular basis.  Similarly, if the manager were to engage a service provider to try to meet substance requirements in the offshore jurisdiction, the costs may become prohibitive for funds that employ a strategy requiring constant managerial intervention.

Given the above, it may be necessary to consider structural options that do not involve an offshore manager, for example, having the fund directly managed by its directors, or in the case of a limited partnership, by its own General Partner. 

Finally, a tax-advisor should probably be involved to provide you with a transfer pricing analysis, including whether your management and performance fees can be kept offshore, and if so, how much and how. Tax concerns aside, managers should also consider the flexibility that comes with having a manager in terms of being able to share fund economics with seeders or employees, versus, of course, the costs of maintaining an additional offshore vehicle.

3. Service providers

Most funds that are set up as open-ended vehicles (and that are Cayman Islands Monetary Authority ("CIMA") registered) would require, among other service providers, an independent auditor and fund administrator. It is relevant to note that not all auditors and administrators may be equipped or prepared to deal with cryptocurrency funds, although in our experience, the majority of service providers that we work with in the usual course have been more than happy to work with cryptocurrency and other digital assets as part of the fund portfolio. We have also seen a rapidly growing number of service providers that have jumped on the bandwagon and have begun equipping themselves with the relevant capabilities to handle fund portfolios comprising cryptocurrency and other digital assets.

What may be more difficult to find is a custodian that can provide independent third party custody of digital assets. Practically speaking, the starting point for any manager would be to determine what portion of the fund's portfolio would remain "on exchange" and traded, and what portion would be in "cold storage". In our experience, because cryptocurrency and other digital assets are usually "on the exchange", a number of managers take the view that the assets are not capable of being custodised, but instead, would seek to keep most of their private keys in "cold storage", i.e. held offline.

There are a number of institutional custodians of digital assets, but they are generally limited in their offerings (to mainly Bitcoin and Ethereum). We understand that these custodians use multiple layers of cryptography, coupled with physical vaults for cold storage. We have also seen some managers enter into arrangements with specialist third party storage service providers to physically store their private keys in secured vaults.

To this end, it is important to note two points: In Hong Kong, (a) if a manager is licensed, it is likely that one of the conditions of its licence would be that it is not to hold client assets (even if it does, standard terms and conditions relating to custody will apply (see Paragraph 4.1A of the Pro Forma T&Cs); (b) under the revised FMCC licensed managers will need to ensure there is segregation, safeguarding and independent custody of fund assets, as well as processes to ensure proper and independent valuation of portfolio.

Securing a custodian, firming up the custody arrangements for the fund, and ensuring proper valuation processes are in place to ensure compliance with the existing laws and regulations in Hong Kong will, therefore, be of even more importance for any prospective manager going forward, but in particular, a crypto-fund manager (assuming that manager will be licensed by the SFC, as the case may be). To ensure proper valuation processes are in place, cryptocurrency exchanges would provide independent price quotes, however, for portfolios comprising less liquid tokens, managers will have to deal with how to source a valuation from an independent third party that satisfies the requirements of the FMCC. 

4. Structure

As previously mentioned, the vast majority of funds structured and managed in Hong Kong are Cayman Islands entities, for primarily 3 reasons - tax efficiency (in Hong Kong, prior to the introduction of the new unified tax regime in April 2019, a non-SFC authorised fund must be "offshore" in order to qualify for a tax exemption); investor familiarity; and infrastructure / support.

With the enactment of the unified tax regime, and with the introduction of Hong Kong's own open-ended fund company ("OFC") and limited partnership fund ("LPF") regimes, it would be open to a manager to use Hong Kong domiciled structures for their crypto-fund as well.  The discussion below would apply equally to such Hong Kong structures.

In considering the right structure for your fund, some of the primary determinants you should be thinking about include the following:

Should my fund be open-ended or closed-ended?

The cardinal rule here is liquidity matching, that is, is your underlying portfolio liquid, highly illiquid, or something in between? Closed-ended PE-styled funds are the "gold standard" for illiquid assets. Open-ended hedge fund-style funds are best suited for liquid portfolios, while an "in-between" structure may be an open-ended structure that imposes hard locks on redemption (up to 3 or 4 years, for example).

Two other factors inform this decision. What is your experience with running a closed-ended fund vs open-ended fund structures? Keep in mind, the documentation, mechanisms, and operation of each are fundamentally different. Closed-ended PE-styled funds usually do not track net asset value ("NAV"), management fees are based on committed and drawn capital, and performance fees (or carry) are determined from a "distribution waterfall". In contrast, open-ended hedge fund-styled funds allow investors to subscribe and redeem at their option, management fees are determined based on NAV, and performance fees are typically charged on appreciation in NAV over a set period, above a "high water mark". As a general rule, prospective managers should stick with a structure that they are familiar with, otherwise, the documentation may be difficult to understand, and the establishment process will become confusing, drawn out, and likely costly.

Costs also play a big factor. As a general rule, closed-ended PE-styled funds are a lot more expensive to establish because the structure is, essentially, a contractual arrangement, which means there is a lot of room for investor negotiations at closing. If each investor is represented by legal counsel, each with its own set of comments and requests (usually by way of a side letter), the costs can start mounting up pretty quickly and will likely far exceed the documentation costs. Open-ended hedge fund-style funds, on the other hand, are much more straightforward to set up, and there is usually not much more legal costs to be incurred beyond the initial documentation costs.

What about specific structures?

Even within each sub-set (open-ended vs closed-ended), there are options such as GP-LP vs corporate structures (for closed-ended funds), and standalone, SPCs, or master-feeder structures (for open-ended funds). Each structure comes with its own unique set of advantages and disadvantages.

In the crypto space, we have seen the Cayman Islands SPC structure (which a Hong Kong OFC can also replicate) gaining popularity because, among other things, it allows a manager to run different portfolios and strategies (one for Bitcoin, one for Ethereum, for example) in a segregated manner that effectively works like a "sub-fund", each with its own assets and liabilities that, technically, should not spill over into another portfolio. This, in turn, allows the manager to offer its investors a choice of which portfolio to gain exposure to, without all of it being in a blind pool. Many managers also perceive the ease and relative cost / time efficiency of setting up a segregated portfolio to be an added bonus.  

5. Documentation

Finally, is your fund properly documented, and is the quality and standard of your documentation not only technically relevant to your strategy, but also attractive to international professional grade investors?

The private placement memorandum ("PPM") is arguably the key piece in your fund's suite of documents. Contrary to popular wisdom, the PPM is not merely a marketing document. It also has contractual significance (as investors subscribe to your fund based on the representations and terms that are set out in the PPM and that are imported by reference into the contractual matrix with the fund), and the risk and conflicts disclosures that are set out in your PPM provide important pre-emptive defences against potential claims from disgruntled investors and other third parties.

For it to be effective, therefore, the PPM must be tailored to address the risks, dynamics, and operational features of a cryptocurrency strategy, including, for example, digital custody risks, blockchain regulatory risks, forking (and to that end, do you have the set of tools available to allow you to manage such liquidity risks including side pockets, gating, and suspension of redemptions etc), loss and theft of digital assets, risk of potential manipulation of blockchain, and the general volatility of digital assets.

Conclusion

Cryptocurrency and other digital asset funds represent a novel and exciting new development in the investment funds space. Trying to fit these "assets" into a more traditional fund framework brings with it a whole host of challenges and issues. For any prospective manager, the task of getting your crypto-fund up and running will be made much simpler by engaging the right service providers and counsel who are equipped with the knowledge and understanding of this new asset class, its unique risks, features and operational dynamics, and the ability to tailor your fund structure to best deal with these issues.