Legal update: SFC warns of risks associated with NFTs

In this snapshot legal update, we report that on 6 June 2022, the SFC issued a warning regarding risks associated with investing in non-fungible tokens (NFTs).

The SFC noted that NFTs have risks that are similar to other virtual assets. These include Illiquid secondary markets, volatility, opaque pricing, and hacking and fraud. The SFC reminded investors to be mindful of these risks, and not to invest in NFTs if they did not understand the associated risk or could not sustain the potential loss of their investment.

The SFC acknowledged that many NFTs are intended to represent a unique copy of an underlying asset such as a digital image, artwork, music or video. If the NFT is a genuine digital representation of a collectible, then activities related to it are not within the SFC’s regulatory remit.

The SFC noted that some NFTs may have characteristics that may make them a financial asset. This can include fractionalized or fungible NFTs structured in a form similar to securities, or an interest in a collective investment scheme. Once a financial asset in Hong Kong is a security or an interest in a collective investment scheme, then persons engaged in activities such as marketing or distributing the NFTs may be engaged in a regulated activity for which a licence from the SFC could be required. Also, any offer to the Hong Kong public may trigger a requirement for authorisation under the Securities and Futures Ordinance.

The SFC statement follows on from a recent written reply on 16 February 2022 by Mr. Christopher Hui, the Secretary for Financial Services and the Treasury, to Legislative Council questions on NFTs. Mr. Hui noted that the proposed licensing regime for virtual asset service providers will follow the approach of FATF and define VA by reference to their function. The virtual asset must be a medium of exchange accepted by the public for payment, settlement of debts or investment, and that it can be transferred, stored or traded electronically. If a virtual asset meets the definition and does not fall into an exempted category, then it will be a virtual asset subject to the regulation specified in the proposed legislation. Then, turning to NFTs, Mr. Hui noted while some NFTs may be used for collection purposes, others may be linked to other assets – even securities. An NFT could be covered by the proposed virtual asset service provider licensing regime depending on its specific terms and characteristics.

The full SFC warning can be seen here. The full question and response by the Secretary for Financial Services and the Treasury regarding trading of digital assets is available here.

Pádraig Walsh

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Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.