Digital assets hub

Hong Kong presses forward with its ambition to become a vibrant digital assets hub

Hong Kong is on a bold mission to reinvent itself as a leading digital assets hub, a strategic step in its plan to rejuvenate the city’s appeal as a global financial centre.

The Hong Kong government issued a policy statement in October 2022 outlining its ambition to develop a vibrant ecosystem for virtual assets and inviting industry collaboration to create “favourable conditions” for operating their businesses in the city. Since then, the government has introduced a new licensing regime for virtual asset service providers, reviewed property rights for tokenised assets, and assessed the legality of smart contracts. It has also been actively involved in pilot projects exploring stablecoins, tokenised green bonds, and the e-HKD.

In the same month, the city’s capital market watchdog, the Securities and Futures Commission (SFC), began accepting applications for exchange-traded funds (ETFs) that provide exposure to crypto assets through futures contracts. By December, two ETFs managed by CSOP Asset Management Hong Kong, which invest in bitcoin and ether futures listed on the Chicago Mercantile Exchange in the US, were approved for trading on the city’s stock exchange. Another bitcoin futures ETF from Samsung Asset Management Hong Kong was launched the following month.

The speed of approval was impressive, even though the three funds have amassed just US$80 million in assets as of mid-September this year after 20 months.

Momentum continued into 2023, with a new licensing regime on virtual asset service providers coming into effect in June and the SFC opening applications for retail crypto trading licences. By August, HashKey Exchange and OSL became the first licensed cryptocurrency exchanges to provide retail services in Hong Kong.

In December, the Hong Kong Monetary Authority (HKMA) issued a consultation paper to seek public input on its proposed regulatory framework for stablecoin issuers, a key step in bridging cryptocurrencies with fiat money and laying the groundwork for various Web3 services.

The pace of development hasn’t slowed down this year, with the SFC seeking public comments in late February on its proposed rules for providers of virtual asset over-the-counter (OTC) trading services. Then in March, the HKMA launched a stablecoin issuer sandbox for testing, targeting to introduce stablecoins by the end of 2024.

Retail spot crypto ETFs

In April, Hong Kong became the first jurisdiction in Asia to launch retail spot crypto ETFs, listing three bitcoin ETFs and three ether ETFs on the Hong Kong Stock Exchange. These funds were issued by China Asset Management Hong Kong, Harvest Global Investments, and Bosera Asset Management Hong Kong in partnership with HashKey.

Investors can now directly hold the associated cryptocurrency through these ETFs. Unlike the cash-settlement model in the US, these ETFs offer an in-kind subscription and redemption mechanism, allowing investors to directly exchange the underlying crypto assets for ETF units and vice versa. This feature is particularly appealing to crypto natives, market makers, and digital-asset exchanges, as it enables greater efficiency and arbitrage opportunities.

As of September 16, the total market capitalisation of these six funds reached nearly $300 million, with daily turnover of $5.8 million. The bitcoin ETFs were especially popular, accounting for 88% of the total capitalisation.

In addition to crypto funds, other digital investment products available in Hong Kong include the world’s first digital government green bond issued by the Hong Kong Government in 2023 and the first tokenised gold fund, the HSBC Gold Token, which allows retail investors to acquire fractional ownership of physical gold. The government also aims to facilitate the development of a diversified suite of digital products.

At the Greenwich Economic Forum in June, SFC chief executive officer Julia Leung emphasised in her speech that the Hong Kong government’s support for the Web3 ecosystem “should not be taken as an endorsement of the virtual asset class”.

She explained that despite the inherent risks, bitcoin has survived multiple cycles of boom and bust over the past 15 years, demonstrating its staying power as an alternative asset. Furthermore, its underlying technology, distributed ledger technology (DLT), is poised to play a significant role in the future of finance. To maintain Hong Kong’s standing as an international financial centre, the city must take proactive steps to integrate these assets into the regulatory framework to meet investor demand.

“As things currently stand, virtual assets are highly speculative in nature with extreme price volatility. Therefore, while meeting investors’ demand, we have made sure that wide-ranging safeguards are in place to protect investors,” Leung stated.

Investor protection

While cryptocurrencies present numerous opportunities, preventing fraud and cybercrime is a serious challenge. The high-profile collapses of the FTX crypto exchange in November 2022 and JPEX in September 2023 serve as stark reminders of the risks involved. Both cases have resulted in significant financial losses for many Hong Kong investors.

Hong Kong is adopting a technology-neutral approach under the principle of “same business, same risks, same rules.” Regulations applied to virtual assets regarding financial stability, money laundering/terrorist financing, and investor protection are similar to those for traditional financial assets, even though DLT operates differently by moving financial activities and transactions onto blockchains.

The HKMA requires custodians of digital assets to conduct independent systems audits. They must securely store a substantial part of their clients’ digital assets in cold storage, perform comprehensive risk assessments, and carefully manage any identified risks.

Similarly, the SFC requires virtual assets trading platforms to implement proper asset custody, cybersecurity protocols, accounting and auditing standards, risk management practices, and measures preventing conflicts of interest, money laundering and terrorist financing. Additionally, they must put in place appropriate investor protection measures for retail investors, including client suitability assessment when establishing business relationships.

Walking a tightrope

Hong Kong is not the first jurisdiction in Asia to integrate cryptocurrencies into its regulatory regime. Japan began regulating cryptocurrency exchanges in 2017, and Singapore since 2020.

Singapore’s biggest bank, DBS Group, has championed a digital exchange for its clients and is gradually expanding access to the mass affluent. However, the city-state’s government remains cautious about fully opening the retail space for cryptocurrencies and has been tightening regulations to enhance investor protection.

Some critics argue that Hong Kong’s traditional financial framework needs adaptation to effectively accommodate the crypto world, despite its resilience in safeguarding its status as an international financial centre through various financial crises in recent decades. They warn that overly conservative financial regulations could hinder innovation in the industry.

Such criticisms were particularly pronounced this June when the SFC identified “unsatisfactory practices” among 11 crypto trading platforms under review for full licenses. The issues ranged from shortcomings in anti-money laundering standards, cybersecurity measures, to operational risk management and investor protection.

These platforms, which existed before the new regulatory regime, were granted a one-year grace period to continue operating until June while undergoing regulatory review. They have several months to address the identified deficiencies, and failure to do so could result in the SFC revoking their status or denying their license applications.

This situation underscores the challenge faced by the city’s regulators, who are walking a tightrope in balancing risks and innovation.

Beijing’s stance

Meanwhile, Beijing’s stance on the crypto developments in Hong Kong remains ambiguous. China banned initial coin offerings and ordered closure of crypto exchanges in 2017, and declared all crypto-related businesses illegal in 2021. There is no sign that it will soften those policies anytime soon.

Many crypto players believe that the central government has given Hong Kong implicit consent to explore crypto opportunities, allowing the city to establish its own policies and regulations on virtual assets under the “one country, two systems” arrangement. They suggest that Beijing is using Hong Kong as a sandbox to determine how to approach Web3.

However, if cryptocurrencies remain banned in mainland China, it will be challenging for Hong Kong to fully realise its potential as a crypto hub.

That said, Hong Kong has made significant strides in developing a robust Web3 ecosystem. The city has experienced a notable surge in crypto activities, propelling its ranking to 30th place in Chainalysis’ latest Global Cryptocurrency Adoption Index, up 17 spots from last year. The report highlights that the regulators’ acceptance of cryptocurrencies and their decisive efforts in establishing a consistent regulatory framework have fostered increased institutional adoption.

However, Hong Kong’s success will ultimately depend on the stability of the global crypto ecosystem and the reliability of cryptocurrencies as investment assets. The road to becoming a leading digital assets hub is likely to be long and bumpy.

*This article was published in Asia Assets Management’s October 2024 magazine under the same title.