Web3 Lawyer: How do cryptocurrency quantitative funds operate in compliance in Hong Kong?

Crypto quantification, the choice is important

Author: Manqun Lawyer, Manqun Blockchain Legal Services

"Those crypto market investment gurus, not relying on luck but on their strength, how do they lead the crypto market? Crypto quantitative investment refers to achieving crypto investment returns through mathematical modeling, data analysis, and automated trading strategies. 24-hour trading, scientific and objective, high efficiency, the quantitative team based on the advantages of the crypto market, through high-frequency trading and automated strategies, reduces the impact of human emotions on investment decisions, and safely and transparently obtains returns."

In 2017, the Hong Kong Securities and Futures Commission (SFC) issued the "Announcement on Initial Token Offerings", clearly stating that the digital tokens involved in initial token offerings (ICOs) may be "securities", and engaging in related activities requires a license; and the release of the "Circular to Licensed Corporations and Registered Institutions on Bitcoin Futures Contracts and Cryptocurrency-related Investment Products", all of which indicate that Hong Kong has begun to regulate crypto currencies.

In 2023, the Virtual Asset Service Providers (VASP) licensing regime will be implemented, and all centralized virtual asset exchanges operating in Hong Kong or promoting services to Hong Kong investors must be licensed by the Hong Kong SFC and be subject to its supervision.

The evolution of these policies provides investors with a stable market foundation, making Hong Kong the preferred destination for the development of the crypto world and blockchain technology.

These names may be familiar to many people: HashKey Group, OSL, MaiCapital, and the success of these leading crypto exchanges and funds in Asia is inseparable from their quantitative teams.

In this city with unlimited potential, the crypto investment market may face unprecedented opportunities and challenges.

Next, let Manqun Lawyer take you in-depth to understand why Hong Kong can become the preferred destination for crypto investment quantitative teams.

Common Quantitative Trading Strategies

Crypto asset quantitative trading has specific structures and applicability based on their different characteristics, and has gradually become an important part of the crypto market. These trading strategies are driven by algorithms, reducing the impact of human emotions on trading, thereby improving trading efficiency and accuracy. The following are several major quantitative trading strategies:

I. Hedging Transactions: This refers to investors simultaneously conducting two related, opposite, and equal-sized transactions in different markets. In simple terms, it is simultaneously buying and selling highly correlated crypto assets in different markets, with relatively low trading risk. This is commonly used by startups for venture capital or private equity investments to maintain a diversified asset portfolio.

Legal and Compliance Considerations: Since hedging transactions involve multiple markets and trading platforms, fund managers need to ensure the qualifications and security of the trading platforms, especially in cross-border transactions, and comply with anti-money laundering (AML) and know-your-customer (KYC) requirements.

II. Trend Trading: Utilizing market conditions and trend indicators, automatically determining buy and sell timing through computer programs. When the market shows a clear trend, it automatically generates buy or sell signals. This trading strategy is relatively complex, but can help investors capture market uptrend or downtrend opportunities.

Legal and Compliance Considerations: Trend trading involves high-frequency trading (HFT). The Hong Kong Securities and Futures Commission's (SFC) regulation of HFT is mainly focused on the traditional financial market, with fewer specific regulations on crypto asset trading. However, fund managers need to ensure their algorithmic trading systems have adequate risk management and audit mechanisms to mitigate potential compliance risks from operational errors.

III. Hybrid Model: Combines the characteristics of multiple modes, including trading of crypto assets and their derivatives, as well as equity investments in related companies. Hong Kong fund management companies have established strict investment allocation and redemption mechanisms, and conduct regular audits to ensure the security and fairness of the fund. This structure provides flexibility for managers to switch between different investment strategies based on market conditions and investment opportunities.

Legal and Compliance Considerations: The hybrid model involves different types of assets and trading methods, and managers need to comply with the regulatory requirements of the relevant fund types. For example, equity investments must comply with the Securities and Futures Ordinance (SFO) requirements, while crypto asset trading must comply with AML and KYC regulations.

Types of Funding Sources and Compliance Requirements

1. Own Funds: Funds may come from the personal assets of team members, internal accumulation of the team, or the team's own profit accumulation. This type of funding does not involve external investors' funds, so the compliance requirements are relatively lower, but internal risk management and internal control processes still need to be followed.

2. Private Placement Funds: Private placement funds are usually from high-net-worth individuals, corporate professional investors, or institutional investors. Compared to authorized retail funds, this type of funding usually has a higher investment threshold and is subject to relatively relaxed regulatory requirements. If the fund management activities are carried out in Hong Kong, a Type 9 license is required regardless of the nature of the fund. Under the Hong Kong Open-ended Fund Company (OFC) framework, these funds need to be registered with the Hong Kong SFC. Private funds can be closed-end or open-end, depending on the overall investment structure and investment assets. Private funds require a licensed fund manager and external fund administration and auditors. Compliance requirements for such funds include compliance with AML and KYC procedures, as well as periodic compliance audits and risk management reporting.

3. Public Funds: Some funds may come from crypto ETFs, which are open to public investors, have stricter regulations, often use passive strategies, are custodied by third parties, and trade on the secondary market. Their compliance requirements involve the public offering and trading of the funds, including information disclosure, investor protection, and market conduct standards.

Regulatory Framework

1. Compliance Requirements in Hong Kong, Singapore, Switzerland, and the United States

Singapore: In 2024, the Monetary Authority of Singapore (MAS) will introduce stricter regulations on and digital payment token (DPT) services, covering areas such as custody services and cross-border fund transfers. In November, two new industry frameworks were released, aimed at promoting the tokenization of funds and fixed income instruments.

Switzerland: The Swiss Financial Market Supervisory Authority (FINMA) is one of the first financial regulators globally to establish a clear regulatory framework for and blockchain technology. FINMA ensures the legality and transparency of business activities through its "Swiss Blockchain Act" and the "Financial Market Infrastructure Act (FMIA)".

United States: The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) play important roles in regulating activities. However, due to the decentralized state-level regulation in the US, discussions need to be conducted on a regional basis.

Hong Kong: The Hong Kong Securities and Futures Commission (SFC) provides a transparent and stable regulatory environment. Depending on the business activities, different licenses are required, with at least a Type 9 license needed, primarily to regulate fund managers and fund products.

2. The Role of the Hong Kong Securities and Futures Commission (SFC)

To enhance public understanding of the operation and function of funds, provide protection for the public who invest in or hold products, and reduce illegal and criminal activities in the industry, the Hong Kong regulatory authorities have imposed a series of compliance requirements on fund teams.

The Securities and Futures Commission (SFC) is the primary regulator of the securities and futures market in Hong Kong, as well as the main regulatory authority for the market. The SFC formulates and implements relevant regulations, such as the Securities and Futures Ordinance, to ensure that funds operate under regulation, and to improve the transparency and standardization of the market.

3. SFC's Regulatory Principles

Compliant Operation: The SFC regulates the market through the formulation and implementation of the Securities and Futures Ordinance and other guidelines and circulars related to virtual assets, ensuring that the entire market operates under SFC supervision.

Licensing System: All exchanges and platform operators operating in Hong Kong are required to obtain a license, raising the safety and stability threshold for these platforms.

Due Diligence: All -related companies must comply with Hong Kong's anti-money laundering and counter-terrorist financing (AML/CTF) regulations, implement know-your-customer (KYC) procedures, and report suspicious transaction activities.

Regulatory Sandbox: The SFC and the Hong Kong Monetary Authority (HKMA) have jointly established a financial technology regulatory sandbox, where -related companies can test their products and services in a controlled environment and conduct risk assessments in advance.

Compliance and Risk Management

So, what aspects of risk management need to be focused on when operating a crypto fund?

1. Compliance Framework: A comprehensive compliance framework and effective risk management strategy must be established, including anti-money laundering (AML) and counter-terrorist financing (CFT) measures, to mitigate the risks of virtual asset investments.

2. Asset Segregation: Ensure that assets are segregated from the manager and other affiliated parties' assets to maintain the safety of investors' property.

3. Know Your Customer (KYC): All crypto-related businesses, including exchanges and wallet service providers, must implement KYC and report suspicious transaction activities.

4. Internal Controls and Monitoring Mechanisms: Internal controls and monitoring mechanisms need to be established, with regular audits and activity reporting to ensure compliance.

5. Cold Storage Solutions: Cold (offline) storage should be used to prevent hacking and asset theft.

6. Periodic Reporting: Custodians need to provide regular asset reports to the management company and investors to ensure timeliness and transparency of information. Therefore, it is not a small task to mitigate these risks and successfully establish a crypto quantitative team, and proper planning and professional team support are crucial.

Conclusion by Mankun Lawyers

Risks and opportunities coexist. The crypto asset market is complex with high volatility, and the development and maintenance of such assets have a certain technical complexity, which increases the difficulty of risk management for the quantitative team. The successful teams and platforms operating in Hong Kong have benefited from Hong Kong's development-friendly regulatory environment and the continuously improving legal framework, providing crypto investors with a safe and compliant investment channel. As the Hong Kong government has made crypto asset technology innovation a development priority, we can foresee that Hong Kong's regulation will play an increasingly important role in the global crypto industry, leading the industry's development at the international forefront.

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