Hong Kong, as Hong Kong FinTech Week 2023 kicks off, regulators declared the city’s ambitions to become a virtual asset hub. The government has announced that it will organize consultations to allow retail investors to invest on approved cryptocurrencies platforms and that it is ready to consider exchange-traded funds (ETFs) for virtual assets.
The situation is ironic, because Hong Kong, just a few years ago, was already a real hub. People who have been familiar with the crypto scene for a while will tell you that Bitmex had an office, complete with a shark tank, just above the Securities and Futures Commission, Hong Kong’s financial regulator.
Then the Securities and Futures Commission started knocking on doors, and exchanges began to fear they would be sanctioned for listing tokens without getting legal advice on whether it was dealing with securities in the jurisdiction. The costs were exorbitant, as obtaining legal advice could cost $10,000 per token.
The regulator has issued leverage warnings. It introduced a membership process through which virtual asset service providers (VASPs) can obtain licenses to trade securities and provide automated trading services. This procedure was rigorous. Only two companies have received positive news – BC Group, which operates the OSL exchange, is the only company to have obtained its licenses, and HashKey Group has received approval in principle.
It seemed that once its licensing regime went into effect, and it was no longer optional, the platforms would no longer be able to serve retail investors. In the meantime, retail investors have continued to use unlicensed exchanges.
Across the border, China has banned companies offering cryptocurrency services. Hong Kong politicians have insisted the city is still governed by the “one country, two systems” principle. This means that the city is part of China, but can organize its own affairs. But companies doubted that Hong Kong could retain its autonomy when it came to deciding how to regulate crypto. They left en masse for Singapore and other jurisdictions.
Covid-19 restrictions have compounded the difficulties for businesses. This time last year, Hong Kong had some of the strictest Covid-19 rules in place, including a three-week hotel quarantine for those coming to the city. The city has experienced a strong talent drain. Now, incoming travelers no longer need to be quarantined, but they still need to take tests. The city says business is back to normal. The question is whether business and talent will return.
Licensing requires a lot of effort
The VASP licensing scheme will come into effect in March 2023 and applicants will be given a nine-month grace period. Hong Kong will no longer have an opt-in regime. Either stock exchanges are allowed or they cannot operate in the city.
The VASP diet brings clarity. In the absence of clear regulation, “we are essentially self-regulating, benchmarking ourselves against the highest regulatory standards,” said Annabelle Huang, managing partner of Amber Group. She adds that the company has held itself to the highest standards of cryptocurrency regulation in the jurisdictions where it operates.
Padraig Walsh, a partner at law firm Tanner De Witt, says the proposed regime brings Hong Kong up to the standards expected by the Financial Action Task Force. He then said, “One of the areas where progress was expected was in anti-money laundering and KYC for virtual assets.”
According to him, Hong Kong’s approach is designed and planned for the long term. The licenses are “not for the greatest number, but for the fewest,” he said.
Market participants have expressed that they consider the VASP regime strict. They consider operating costs to be high, given the requirement to insure their assets, and they hold a high percentage of assets in cold wallets.
Ultimately, the regime emphasizes investor protection, the source said. For now, it seems to be focused on spot trading and does not allow staking, lending, copy trading, or the bread and butter of many exchanges – leverage. In essence, the Securities and Futures Commission (SFC) doesn’t want to see anything that isn’t present in the traditional stock market.
Other jurisdictions have introduced regulations and then amended them. Singapore, for example, has signaled to the market that it will tighten compliance obligations. Hong Kong set the bar very high from the start.
Some comparisons
Hong Kong “has absolutely lost ground to a few neighboring jurisdictions,” said HashKey COO David Leahy. But according to him, the strength of Hong Kong’s financial markets still makes it a dominant force in the region.
David Leahy added, “When we talk to digital asset desks, investment banks, and licensed intermediaries, the demand is high.”
Hong Kong has created “a very detailed set” of regulations for licensed crypto companies, said Gary Tiu, chief executive of BC Group. It took more than two years for OSL, the group’s digital platform business, to obtain its licenses from the Securities and Futures Commission (SFC) and start trading securities and providing trading services automated.
Gary Tiu said that many people think Singapore is more crypto-friendly, while Hong Kong is very strict. “The two regimes begin to converge in the middle,” he said.
Some investors appreciate its thoroughness. Tiu said he sees a lot of non-Hong Kong institutional interests spending a lot of time understanding the Hong Kong platform.
“They think the Hong Kong regime gives them the right level of protection that they can’t find elsewhere,” he said.
Mr. Walsh said there was a period, maybe a year ago, when it felt like Singapore was moving forward and Hong Kong was not. “I don’t think that’s the case today,” he said, citing the complexity of Singapore’s application process and the long processing time for license applications, which even the regulator describes as “painfully slow”.
Openness to discussions about individuals
In January, the SFC said that only professional investors can invest in crypto, that is, people or companies whose portfolio is worth more than HK$8 million ($1 million ) – and crypto didn’t count.
The industry welcomes the SFC’s willingness to reconsider retail investors and have a public consultation on the subject.
“This is a great opportunity,” said Leary of HashKey, which plans to take its exchange to market in the second quarter of next year.
He is waiting to hear if listing requirements will be the same for retail and professional investors and if the professional investor designation is going away.
“They are very careful about the quality of the projects that are listed on the stock exchange,” he said of the SFC.
If the SFC were to allow retail investors to invest, it would legitimize what is already happening. “If they don’t open up to retail, as this asset class becomes popular, these retail investors will invest through unregulated service providers outside of Hong Kong,” said Michael Wong, partner at the Dechert law firm. “If you regulate it, at least you have some control”.
Wong said the SFC could introduce a suitability requirement and require investors to complete questionnaires to show they understand the risk profiles of what they are buying. SFC-licensed trading platforms could be required to set up hotlines or physical branches to assist retail investors, giving them the opportunity to complain to the regulator if the platforms act dishonestly, he added.
According to him, investors are likely to head to regulated exchanges unless unregulated exchanges offer them services such as lending and staking.
An open door
There are still areas where companies want more clarity. Mr. Walsh awaits application guidelines.
“We have enough to be able to assess whether a particular company falls within the scope that requires a license or is outside of it,” he said. “But we don’t really have enough to know what they should do.”
The licensing regime requires exchanges to have two officers responsible for ensuring compliance with anti-money laundering and anti-terrorist financing requirements, among others. But people with these qualifications may not be familiar with virtual assets, said Viven Khoo, co-founder of the Asia Crypto Alliance. She has received calls from people with these qualifications about how they protect themselves when overseeing a business that includes virtual assets.
There are concerns that some unregulated companies are abusing the grace period by submitting an application knowing it won’t be accepted, just to get the most out of it, she added. Some market players are pushing for moderate restrictions in the meantime.
Nevertheless, the regime “leaves some leeway for the future,” Ms Khoo said. “If lawmakers decide to open it up more broadly, they don’t need to go through another round of legislative changes.”
If the diet is indeed lightened, it will probably be gradual. “The regulator said it would monitor stage one license holders and consider further changes,” said one of the government sources interviewed. The latter had concluded: “If they do not intend to do it, generally they will not say it”.
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