Regulation
Hong Kong’s Successful Approach to Cryptocurrency Regulation
A number of measures show that Hong Kong is committed to fostering a “vibrant ecosystem” for virtual assets and other related products.
Jill Wong, partner at the law firm Reed Smithwrites about how Hong Kong is tackling cryptocurrency regulation, a task that involves judging how to balance innovation and risk.
The editors are pleased to share these views and invite readers to respond. Usual editorial disclaimers apply.
tom.burroughes@wealthbriefing.com
As in many other countries, the initial reaction in Hong Kong to the advent of bitcoin and other cryptocurrencies was to ask: “What is it?” This question has since evolved, although in the early stages of regulatory thinking, virtual assets (VAs) were regulated only to the extent that they fit within existing financial services laws. For example, VAs that resemble traditional securities were treated as “securities” or “futures” under existing securities laws and were subject to licensing, marketing and other requirements under Hong Kong law.
However, because these laws were not formulated with AVs in mind, some of them did not fit neatly into traditional definitions and thus fell outside the regulatory framework. The securities regulator, the Hong Kong Securities and Futures Commission (SFC), took steps to address this issue in the form of public statements, warning the public that AVs, like cryptocurrencies, needed to be licensed. For example, Initial Coin Offerings (ICCs) could be considered “collective investment schemes” and therefore required a license under the Securities and Futures Ordinance (SFO), while bitcoin futures also required a license under the SFO as “futures contracts.”
Things accelerated in 2018 when the SFC extended its regulatory oversight to cover existing SFC licensees that were portfolio managers and distributors of VA funds. This was an important step in bringing greater oversight and stability to the VA ecosystem.
In 2019, the SFC published a position paper outlining a new regulatory framework for centralised VA trading platforms (VATPs). VATPs that provide trading services in both non-securities-related VAs and securities-related VAs would fall under the SFC’s regulatory net. However, there was a loophole: VATPs that only dealt in non-securities-related VAs remained unregulated.
This situation was quickly resolved. In June 2023, after extensive consultations, Hong Kong adopted a comprehensive licensing regime for VATPs. Under this regime, VATPs operating in non-security AVs are required to obtain a VATP license under the Anti-Money Laundering and Combating the Financing of Terrorism Ordinance (AMLO).
The current situation and prospects
Hong Kong has ambitions to become a hub for virtual innovation. The country is already moving in the right direction, with the UN Trade and Development Report 2023 ranking Hong Kong ninth in the world in terms of frontier technology readiness. Hong Kong’s commitment to innovation (while providing adequate investor protection) and a crypto-friendly legal framework have also positioned the territory as a global leader in virtual innovation.
Hong Kong regulators continue to complement the current VA framework. This includes the introduction of licensing regimes for issuers of fiat-referenced stablecoins and over-the-counter trading of VAs. Regulators have already completed public consultations on these regulatory proposals and plan to introduce the relevant legislation shortly.
Hong Kong also became the first jurisdiction in Asia to offer retail investors the ability to trade Bitcoin and Ether ETFs for cash, ushering in an in-kind redemption mechanism. This gave investors additional flexibility to buy and sell shares of crypto tokens with a portfolio of securities, financial derivative instruments, or VA instead of cash.
This is a crucial step to integrate VAs into mainstream financial products in Hong Kong. The inclusion of Ether also opens the door to new ETFs tracking other major cryptocurrencies. This will further diversify the offering of exchange-traded products in Hong Kong, which now includes a metaverse ETF, a blockchain ETF, and some VA futures ETFs.
Hong Kong is also investing heavily in fintech, a key factor in the city’s competitive advantage. For example, the Hong Kong government has tasked the Hong Kong Monetary Authority (HKMA) with subsidizing the training costs of eligible financial sector professionals under the Fintech Grant Scheme.
The latest “Fintech Promotion Roadmap 2023” has set out five key pillars for development, focusing on the adoption of fintech solutions across Hong Kong’s banking sector, expanding the fintech expert workforce and improving data infrastructure. At the same time, the HKMA’s exploration of a retail central bank digital currency, e-HKD, reflects the regulator’s commitment to staying at the forefront of digital currency innovation.
Earlier this year, the HKMA launched a “sandbox” for stablecoins. This allows potential issuers to conduct experiments under relaxed regulatory conditions and will facilitate dialogue between issuers and regulators. A notable example is that a fintech company, founded by a former senior regulator, is actively working on a Hong Kong dollar-backed stablecoin, partnering with leading players in the digital payments and AV sectors to explore the use of its stablecoin in retail and cross-border payments.
Legal benefits?
Hong Kong’s legal system also provides a favourable environment for the VA sector. Cryptocurrencies have been recognised by Hong Kong courts as “property” that can be the subject of a trust in a liquidation context. The courts have also granted freezing injunctions on cryptocurrencies as asset preservation measures. These decisions provide welcome certainty to traders and investors.
That said, while Hong Kong may be considered a crypto-friendly jurisdiction, it is not an “easy” jurisdiction for regulatory arbitrage. The current VATP licensing regime is strict and robust (some say too strict). The existing licensing regime sets out detailed criteria for applicants’ financial resources, management and governance structure, admission requirements for VA tokens, custody of customer assets, and anti-money laundering and counter-terrorism financing policies.
The SFC also reiterated that VATPs cannot serve mainland Chinese residents. These stringent requirements and the lack of access to mainland Chinese customers may have prompted several major exchange players to withdraw their VATP license applications.
However, a strong regulatory regime is arguably a necessary foundation for sustainable growth. It gives credibility to companies that commit to compliance and builds investor confidence. This would explain the continued interest in Hong Kong among the 17 VAT companies awaiting a licence.
Is Hong Kong ahead of the competition?
Traditional financial institutions interested in VA distribution or fund management should be encouraged by the recent initiatives of the HKMA and the SFC. In December 2023, the HKMA and the SFC issued the Third Joint Circular on Intermediaries Dealing with VAs, expanding the manner in which brokers, advisers and fund managers can provide VA-related services.
Additional safeguards are provided to protect investors: most AV-related products are likely to be considered complex products and, except in limited circumstances, distributors will therefore need to comply with existing requirements for the sale of complex products. This includes an assessment of the suitability of the AV-related product for investors.
Only professional investors have access to these products. However, retail investors have access to some options, as they can trade in VA-related products traded on the Hong Kong Stock Exchange and other specified exchanges, as well as VA funds authorised by the SFC to be offered publicly. This is expected to be a major asset for the VA markets in Hong Kong.
In addition, the SFC has already given the green light to 25 funds allowing them to have portfolios investing more than 10% in VA.
Traditional banks and stockbrokers can also offer VA trading services through partnerships with SFC-licensed VATPs. Several stockbrokers have already been granted approval by the SFC and, while there are currently only two licensed VATPs, it is likely that there will be more in the future.
These measures demonstrate Hong Kong’s commitment to fostering a vibrant ecosystem for AVs, innovative products and those who distribute, manage and invest in them. The global market is competitive, but Hong Kong has positioned itself at the forefront of this global market and is well placed to reap the benefits in the years to come.
Disclaimer: This is provided for informational purposes only and does not constitute legal advice.