What a prospective fund manager should think about when launching a crypto currency or digital assets fund in Hong Kong or Singapore.
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 teams in both our Singapore and Hong Kong offices have 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.
A Type 9 (Asset Management) licence is required if you want to carry on a business of managing a portfolio of “securities” in Hong Kong. The question of whether digital tokens or other digital assets amount to “securities” remains to be settled, although the Securities and Futures Commission of Hong Kong (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 stated 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 (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.
If a fund manager were to take the view that nothing in a proposed fund’s portfolio would constitute a “security” under the SFO, then a Type 9 licence should not be required. However, having such a licence has the added benefit of allowing 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 a Type 9 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.
Corporations with fund management as their principal business activity in Singapore have to be either (1) registered fund management companies (RFMCs) or (2) licensed fund management companies (LFMCs) which hold a capital markets services licence for fund management. RFMCs and LFMCs are regulated by the Monetary Authority of Singapore (MAS) under the Securities and Futures Act of Singapore (SFA).
Similar to Hong Kong, “fund management” includes, amongst others, “the management of a portfolio of securities”, and it is unclear whether digital tokens or other digital assets would be deemed “securities”. In a statement issued by the MAS on 1 August 2017, it clarified that the offer or issue of digital tokens in Singapore will be regulated by the MAS if the digital tokens constitute products regulated under the SFA. For example, where digital tokens represent ownership or security interest over an issuer’s assets or property, an offer of such tokens may be considered an offer of shares or units in a collective investment scheme under the SFA. Alternatively, digital tokens representing a debt owed by an issuer may be considered a debenture under the SFA. This position was further reiterated in the MAS’ “A Guide to Digital Token Offerings” (14 November 2017).
Nevertheless, it would be advisable for fund managers in Singapore to obtain LFMC or RFMC status if they intend to manage a crypto-fund. Further, as discussed above, regulated fund managers are typically able to better market their funds as their regulatory status would instill investor confidence.
Under the current tax regime, offshore funds that meet certain criteria are exempt from HK 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)). For this reason, almost all of the funds structured out of, and managed in, Hong Kong, are Cayman Islands entities. Relevantly, one of the requirements (see s.20AC to the Inland Revenue Ordinance (Cap.112)) to qualify for the tax exemption is that the fund only carries out “specified transactions”, of which dealing in “securities” is one.
The definition of “securities” is substantially similar to that set out under the SFO, and encompasses all things we would usually consider to be a security, including shares, stocks, debentures, loan stocks, funds etc. (see schedule 16 to the Inland Revenue Ordinance (Cap.112)).
So, if you are satisfied that none of the digital assets your fund will be investing in qualify as a “security”, 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 your fund may not qualify for a tax exemption under HK tax laws.
There are, of course, ways to structure around this, including, for example, the use of derivative instruments (eg, total return swaps or futures) that may qualify as “securities”.
Tax incentives are generally available for funds managed by a fund manager in Singapore. There are three main tax incentive schemes and under each tax incentive scheme, “specified income” derived from “designated investments” is exempt from tax.
These are namely:
- the Singapore Tax Resident Fund Scheme (Section 13R of the Income Tax Act of Singapore (ITA)), available only for onshore funds structured as companies
- the Enhanced-Tier Fund Scheme (Section 13X of the ITA), available for both onshore and offshore funds but the minimum size of the fund must be at least S$50 million, and
- the Offshore Fund Scheme (Section 13CA of the ITA), available for offshore funds and certain onshore funds organised as trusts. Unlike the Singapore Resident Fund Scheme and the Enhanced-Tier Fund Scheme, no application to the MAS for approval is required.
Unfortunately, under the current tax regime in Singapore, digital currencies and other digital assets do not fall within the list of “designated investments”, and are therefore likely to be subject to tax at the prevailing rate.
3. Service providers
Hong Kong and Singapore
Most funds that are set up as open-ended vehicles (and that are 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 in Hong Kong and Singapore, 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”, ie 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; (b) as and when it comes into effect, the revised Fund Manager Code of Conduct (the Consultation Conclusions were published in November 2017 and it is expected that the amended FMCC will become effective by the end of 2018) will require segregation, safeguarding and independent custody of fund assets, as well as processes to ensure proper and independent valuation of portfolio assets of any fund managed by a licensed manager (Type 9) in Hong Kong.
Similar requirements for independent custody of client assets and independent valuation are found under the Securities and Futures (Licensing and Conduct of Business) Regulations in Singapore.
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 or Singapore 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 or the MAS, 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.
Hong Kong and Singapore
As previously mentioned, the vast majority of funds structured and managed in Hong Kong and Singapore are Cayman Islands entities, for primarily 3 reasons – tax efficiency (in Hong Kong, a fund must be “offshore” in order to qualify for a tax exemption; in Singapore, an offshore fund can rely on the Offshore Fund Scheme or the Enhanced-Tier Fund Scheme); investor familiarity; and infrastructure/support.
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 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.
Going forward, each of Hong Kong and Singapore will also be developing and offering their own open-ended fund structures (the Open ended Fund Company in Hong Kong (OFC) and the Singapore Variable Capital Company (S-VACC), which will provide even more options for prospective managers.
Tax efficiency and operational flexibility
On the management side, managers in Hong Kong would typically also consider whether a Cayman Islands manager is necessary, or whether the fund should delegate directly to the domestic manager. A tax-advisor is needed 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 Cayman Islands vehicle.
Hong Kong and Singapore
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.
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.
This document is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.
Simmons & Simmons JWS Pte. Ltd. is registered and incorporated in Singapore as a Joint Law Venture under the Companies Act of Singapore. We are licensed to practise Singapore law in the permitted areas of legal practice according to section 130A(1) of the Legal Profession Act of Singapore. The permitted areas of legal practice excludes (according to Rule 3(1) of the Legal Profession (International Services) Rules 2008 of Singapore) areas such as constitutional and administrative law; conveyancing; criminal law; family law; succession law; trust law; and appearing or pleading in court.