The Hong Kong Monetary Authority (HKMA) unveiled comprehensive regulatory standards on Feb. 20 for the sale and distribution of tokenized financial products by authorized institutions.

The initiative aims to foster innovation while ensuring robust consumer protection within the burgeoning field of tokenization, where real-world assets (RWA) are digitally represented using distributed ledger technology or similar systems.

The guidelines delineate the scope of tokenized products that fall under this new regulatory framework, explicitly excluding products already covered by the Securities and Futures Ordinance and specific regulations by the Securities and Futures Commission (SFC) and HKMA.

The move is a response to the rapid advancement in tokenization technologies and their application in the financial sector. Hong Kong has become increasingly open toward Web3 technology in recent months and is focused on implementing comprehensive rules for the sector.

Existing rules to apply

The regulatory notice establishes clear principles that existing rules and protections for traditional financial products should similarly apply to tokenized products, given their comparable terms, features, and risks.

This includes structured investment products and tokenized precious metals not regulated by the Securities and Futures Ordinance while explicitly stating that this notice does not cover stablecoins.

To ensure that authorized institutions adhere to these standards, the HKMA mandates thorough due diligence before offering tokenized products to customers. This includes understanding the product’s nature, features, risks, and continuous due diligence to adapt to any changes.

Institutions must also perform due diligence on issuers and third-party service providers involved in the tokenization process, assessing their experience, track record, and the risks associated with the tokenization arrangements.

Disclosures and risk management

In terms of product and risk disclosure, institutions are required to act in the best interests of their clients, providing full disclosure of key terms, features, and risks associated with tokenized products.

This includes risks associated with the underlying distributed ledger technology (DLT) networks, potential security threats such as hacking, and legal uncertainties regarding ownership and finality of transactions on DLT networks.

Risk management is another critical area outlined by the HKMA. Authorized institutions must establish adequate policies, procedures, systems, and controls to identify and mitigate risks related to the sale and distribution of tokenized products.

This includes a comprehensive risk management framework covering policies, internal controls, complaint handling, compliance, internal audit, and business continuity planning.

Meanwhile, institutions that provide custody services for tokenized products must comply with the HKMA’s expected standards for digital asset custody, ensuring that these services are secure and reliable.